The Dominance of the Dollar

As the lockdown imposed to curb the spread of the Chinese flu sinks the global economy into a recession, perhaps unseen in recent times, the issue of dollar dominance and possible shortage once again is taking a centre stage. Dollar for long has dominated the international financial scene, post World War II in particular. Some experts believe, the financial crisis of 2008 highlighted the adverse consequences of dollar dominance. Yet they feel rather than a strategy to reduce the dollar dominance and its spread to rest of the world, the dominance has in fact been reinforced. The assets and liabilities denominated in dollars across the world continues to increase. This to some analysts puts pressure on the US Federal Reserve as it goes about its monetary policy.

 

The fears are nothing new or unusual. Post World War II, many countries feared the outbreak of World War III. The US was the only country that had escaped relatively unscathed in the War and thus dollar was the only currency that could be pegged to the gold standard. The other currencies pegged themselves to the dollar which in a way ended the dominance of the British Pound that dominated the world financial circuit till then. Fearing US might freeze assets, many countries started holding increased gold reserves besides issuing financial instruments in dollar denominations. These gave the rise to what is termed as the Eurobond market. The increasing demand for dollars led US to print more dollars with every passing year. In fact, US soon reached a stage wherein it simply was not in a position to redeem dollar for gold in case all dollar holders claimed so. It was merely the confidence in the dollar that kept it as the currency of the world as it does today. In 1972, US abandoned the Gold Standard and moved to managed float.

 

Meanwhile, the US needing to print dollars to keep it afloat as global currency was recognized by economists. Triffin argued that US has to run fiscal deficits to keep the dollar afloat the global reserve currency. As the demand for the dollars went up, the supply of dollars had to go up implying US needing to print more dollars. This resulted in increased fiscal deficit. This paradoxical effect came to be termed as Triffin Paradox.

 

Unlike other countries whose currencies are used predominantly by their own countries, dollars are used predominantly outside the US. If India were to trade with Latin America or Africa or Pacific Islands, the trade in all probability will denominated in dollars. Thus dollars are necessary for both these countries. Similarly, when banks lend to foreign borrowers, the lending in good probability will happen in dollars rather that other currencies. Investors seek to record their assets and liabilities in dollars to avoid currency mismatches and associated risks. Many corporates issue commercial paper and other borrowing instruments in dollars. Central Banks in Europe and Japan among other countries have issued instruments in dollars and have lent in dollars to their clients.

 

European banks often purchased dollars and used those dollars to buy mortgage based securities and expanded into other asset based securities. Most of these dollars were from the central bank reserves, purchased from large corporate clients and issuance of dollar denominated bonds. Corporates, financial institutions, insurance firms among others do park their excess liquidity in dollar denominated securities.  It is not unusual to find in recent years Asian insurance companies investing in US corporate bond market owing to lack of liquidity in the domestic markets. Some banks and corporates have borrowed from US money market mutual funds. Some issue cross currency swaps. Those banks and financial institutions swap euros for dollars and use the dollars to invest in asset based securities. With passage of time, many European banks remained European merely on paper or technical grounds but were essentially part of the US monetary system to the extent they participated in US Fed Reserve term auctions. Many Japanese banks and Canadian banks too have used swaps and repo to participate in the US monetary system. They too have lent and invested in dollar denominated assets and liabilities. Besides insurance and pension funds, there is significant amount of dollar denominated trade finance and dollar denominated project finance.

 

Dollar reserves and investments and denomination in dollar instruments was not just for purposes of risk but also the absence of liquidity in dollar currency markets. All these have led to a situation wherein a large quantum of dollar liabilities are held outside the United States. Contrary to the assumption that the developing and emerging markets hold significant amount of their reserves in dollar denominated instruments for safety reasons, the data shows otherwise. The data from BIS series indicates that the dollar holdings are significant in the advanced economies.  The biggest dollar based intermediaries are financial institutions in more advanced countries with sophisticated financial systems. They lend significantly in dollars thus being the creditors rather than users.

 

There exists in the opinion of some experts that if they desire, these holders will dump their liabilities on US resulting in the crash of the dollar. Many fear China which has perhaps highest dollar reserves to dump the dollar in case US thinks about acting against it. As a matter of fact, many fear that in case US acts tough against China in the current crisis, there could be a possibility of China dumping the dollar. Rumours keep floating in and out on the Chinese plan to dump the dollar.

 

An analysis of the deeper implications of the dollar dominance requires separate engagement but suffice to say dollar doesn’t face any immediate threat to its numero uno status. One of the principal reasons behind the same is the absence of any alternative instrument that can compete with the dollar. Euro is in its own crisis while Yuan is more of hype than substance. China frequently does float threats of abandoning its dollar reserves, but given the sheer quantum of the dollar reserves it owns, it would be foolhardy for it do so. In case the dollar collapses, the value of the Chinese reserves collapse and thus it is in its own self-interest to preserve the same. Moreover, US is key export market for China. In the global financial crisis of 2008, heavy Chinese lending and consequent expansion of Chinese influence in Europe was in part to Chinese desire to keep Europe afloat to protect its own export markets. Therefore it would be safe to argue about continuation of dollar dominance at the moment while we confront the economic crisis induced by the Chinese virus generated shutdown.