Tuesday, April 22, 2008

Q&A on Dollar's Reserve Status

Stephen Jen at Morgan Stanely's Global Economic Forum weighs in on this ongoing discussion:

Question 1. Are Central Banks Aggressively Diversifying from USD Assets?
There are different ways of thinking about this question. The most popular data that investors refer to are the IMF’s COFER quarterly data on the currency composition of the world’s reserve holdings... According to these data, the USD’s share in total world foreign reserves has declined from 72.7% in 2001 to 63.9% as of end-December 2007, with developed economies having a higher (69.4%) concentration of USD holdings than developing countries (60.7%). During the same period, EUR’s share rose from 17.6% to 26.5%, with developing economies having a higher exposure to the EUR (29.0%) than developed countries (22.2%). Thus, the short answer to this question is ‘yes’, there has indeed been a decline in the USD’s share in the world’s official reserve holdings in the past few years.

While this may be the short answer, it is not a complete answer. First, to conclude that the world’s central banks have been diversifying out of USD, one would also need to address the question of how the swings in the exchange rates may have affected the COFER currency shares... more than 100% of the change in the currency composition of reserves reported by the COFER database can be explained by changes in the exchange rate...The USD’s share seems low mainly because of the weak dollar, and its share was high in 2002, similarly, due to the strong dollar then...

Second, while at 63.8%, the USD’s share in total reserve holdings may be low, certainly lower than the 72.7% registered in 2001, the dollar’s share actually declined to below 50% in the early 1990s. Thus, the decline in the USD’s share is unremarkable, from a longer-term perspective, despite the angst.

Question 2. Will the Euro Challenge the Dollar’s Hegemonic Reserve Currency Status?
Again, the answer to this question is not straightforward. There are several considerations in thinking about this question. Some academic works on this matter have taken a quantitative approach to calculating the currency share of official reserves that can be explained by fundamental variables such as the size of the economy in question, the rate of return and the liquidity in the financial markets of the reserve currency. On these measures, the EUR seems to be a very serious challenger to the dollar. Further, if the UK joins the EMU, many of the liquidity and market size measures for the EMU could surpass the size of the capital markets of the US. For example, the combined market capitalisation (bonds and equities) of the EMU and the UK in 2007 was US$37.4 trillion, representing 30% of the world. The same metrics for the US would be US$43.5 trillion and 35%.

Having said the above, there are two reasons to believe that the EUR will not be able to supplant the USD’s hegemonic reserve currency role, even though the former can take some market share away from the USD. (Similar to car racing, it may be easy to catch up to another car. Passing it is another story.)

First and foremost is the advantage of being the incumbent. Increasing returns to scale are immensely powerful. In our previous writings on this topic, we have used the analogy of languages, that English is the preferred international language not necessarily because it is superior to other languages, but because it is ‘in the lead’ as the most widely spoken foreign language in the world, and so it will most likely remain in the lead as more people around the world learn English in order to communicate with the rest of the world. The positive characteristics of other currencies will need to be much superior to those of the dollar to offset this ‘incumbent advantage’...

The second consideration is related to the first, that the issue is really not the US versus Euroland. Rather, we need to ask what currency standard the rest of the world (that does not have a reserve currency) will have. Specifically, Asia, in our view, will likely remain on a dollar standard for a very long time to come. Even though few Asian currencies are now pegged to the dollar, most of the international transactions are still conducted in USD, reflecting the less-than-full convertibility of most currencies and the preference of Asian countries for invoicing and settling trade and transactions with each other in US dollars rather than each other’s currencies. For example, we hear people comment that Asia now trades as much, if not more, with Euroland than with the US. Statements like this one miss the point, because Asia trades with itself in dollars, and 43% of Asia’s trade is with other Asian countries.

Question 3. What Is the Prospect of the CNY as a Challenger to the US Dollar?
It is a probable, not just a possible, scenario that China’s economy will exceed the size of the US economy in our generation. This makes the CNY, or a form of Asian currency unit centred on the CNY, a much likelier challenger to the USD. [Hey Stephen, you really did not do justice to this last question!]

Bottom Line
We maintain our view that the dollar will likely remain the dominant international currency for the foreseeable future. Available data do not unambiguously support the view that central banks in the world have been aggressively diversifying from the USD. While assets denominated in EUR have experienced a sharp improvement in liquidity and depth since the establishment of the EMU, Asia and other parts of the world continue to rely on the USD as the medium of exchange and unit of account. The ‘incumbent advantages’ that the dollar enjoys will be difficult to overcome. The most likely challenger to the USD will be the CNY or an Asian currency unit centred on the CNY. But the key precondition is that Asia manages to develop its financial markets.

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