Since the advent of the global financial crisis in 2008, the US has issued massive amounts of debt, flooded markets with cash, and flirted with the possibility of a sovereign default. Yet, paradoxically, the US dollar has held firm, defying logic and even reinforcing its position was the world’s preeminent safe haven currency.
The reasons behind this apparent dysfunction in the international monetary system, and why it looks unlikely to change, is the subject of a recent book by Dr. Eswar Prasad, Tolani senior professor of trade policy at Cornell University.
The dollar’s reign as the world’s safest, most liquid asset, while “suboptimal” is set to continue and most likely strengthen, Prasad told a recent lecture organised by NUS Business School.
The US has the magic sauce that will keep the dollar as the dominant reserve and safe-haven currency for a long time to come
Dr. Eswar Prasad, Tolani senior professor of trade policy,
Put simply, he said, the equilibrium that underpins the dollar’s dominance is stable and self-reinforcing.
“That’s mostly because there is no alternative to the dollar; nor is one likely to emerge anytime soon,” Prasad told Think Business after the lecture.
“What we’ve seen repeatedly since the financial crisis is that every time there is turmoil anywhere in the world, people want a safe place to put their money, and the US is the only game in town.”
Drawing on analysis contained in his book “The Dollar Trap: How the US Dollar Tightened its Grip on Global Finance”, Prasad examined the paradox of how the financial crisis – which began in the US – and other incidents since, have ended up strengthening the dollar and why there are no challengers to its safe-haven status on the horizon; even from the increasingly weighty Chinese renminbi (also known as the yuan).
Any alternative safe haven currency must be backed by an open and transparent system of government, public institutions, including central banks, that the world trusts and an independent judiciary.
China does not, as yet, have these characteristics, said Prasad, who is also a senior fellow at the Brookings Institution and who previously headed the China Division at the International Monetary Fund.
As it becomes an ever more widely used currency of international trade, the renminbi will erode some of the dollar’s dominance, he said, but in no way will it seriously challenge it.
“The US has the magic sauce that will keep the dollar as the dominant reserve and safe-haven currency for a long time to come.”
Demand for safe assets
Prasad called the financial crisis of 2007-08 a game changer for the demand and supply of financial safe assets, primarily government bonds of advanced economies.
Since the crisis, demand for safety has increased from emerging markets because they are much more open to capital flows and need hard currency foreign exchange reserves as protection from volatility. Banks are also being asked to hold more safe assets.
Meanwhile, the supply of safe assets has been shrinking. Other traditional safe-haven bets of the past such as the Swiss franc and the yen have been restrained as Switzerland and Japan have tried to prevent their currencies from appreciating while the euro and bonds from the region have been slammed by the debt crisis.
Of the $5.8 trillion in debt issued by the US government from the end of 2007 to the present, foreign investors, including foreign central banks, have bought nearly 60 per cent.
The centrality of the dollar hinders discipline in the US and frustrates foreign governments, but, Prasad argues, there is no alternative to the greenback.
‘No other place to hide’
“Putting so much money into US dollar assets is not something that central banks feel comfortable about,” he said. “And the situation here where US policies themselves create turmoil in global financial markets is not necessarily a good thing because that imposes less discipline on US policies than would otherwise be the case.”
“But because the world has no other place to hide, everybody comes to the US for safety. So this is not necessarily good for the international financial system.”
For instance, even if China wanted to reduce its Treasury holdings of $1.3 trillion by $100 billion, it has no other asset in which to invest that amount.
The euro began with promise that it might quickly rise to become an alternative to the dollar.
But Prasad argues that for it to become a competitor, the Eurozone needs full economic union, not just monetary union, and given the continents deepening political problems that seem a long way off.
Assets like gold and the emerging virtual currencies such as bitcoin face other issues.
“The financial crisis taught us that it is the assets that can be produced in unlimited quantities like the dollar, not the ones in limited supply like gold and bitcoin, which are valued because at a time of crisis you can get more of these into the system,” Prasad said.
Bitcoin has the added drawback of not having an institution to back faith in it.
“Increasingly, we will move away from paper currencies to more digital or electronic currencies,” Prasad said. “But what this presages is not a move towards decentralised currencies such as bitcoin but perhaps fiat currencies that trade largely on electronic platforms.”
Although the dollar’s position as the predominant store of value in the world is secure, Prasad believes its other roles are set to diminish.
The renminbi is gaining traction as an international currency in trade and finance transactions, boosted by currency pacts Beijing has sealed with many countries it trades with, including countries in Asia, Nigeria, Chile and Russia, some of whom already hold part of their reserves in renminbi.
While others have argued that this is a sign of the renmimbi’s inevitable march to dominance, Prasad sees the move by China’s trading partners as a low-cost bet on a currency that is going to become more prominent.
As a medium of exchange, the dollar will become less dominant.
Commodities like oil are now largely denominated and settled in dollars. But as the price of trading in other currencies falls and as other financial markets develop, there is no good reason the dollar should remain dominant, Prasad said.