Does the buck stop with the US dollar?

By GARRY SHEERAN - Sunday Star Times

To quote (and misquote) Winston Churchill, it is not the end of American hegemony in global financial markets and the US dollar as the world's main currency reserve.

But it is the beginning of the end.

When the US Federal Reserve announced 10 days ago that it planned to pump an additional $US1 trillion into the US economy, the dollar suffered its biggest one-day drop since 1985.

Commentators dug deep into their bag of pessimistic prognoses to predict dire consequences for the US and global economies and currencies:

A further US dollar slide by 40-50 percent or a devaluation of the dollar in anticipation;

A mass exodus from US financial markets and a de-leveraging in US dollar-denominated assets;

A huge rise in the price of dollar-denominated commodities like oil and gold, with the latter (a hedge for the US dollar) hitting $US2000/oz;

The ditching of the US dollar as the world's main currency reserve.

A shift in economic power and wealth from west to east.

Hand-wringing in New Zealand was more immediate in its focus. The plummeting US dollar saw the Kiwi dollar climb from around US53c to US57c on Wednesday. And that, said BNZ Capital, "is the last thing we need right now".

A higher Kiwi dollar raises prospects of higher local interest rates, which is what the US was foisting on New Zealand as it pursued "beggar-thy-neighbour" policies, said BNZ.

But that is what happens when a country tries to manage its own internal financial problems as well as conduct its external policies as the holder of the world's main reserve currency, and finds that the two conflict.

Proposals for a new world currency (or currencies) order to succeed the hegemony of the US dollar are not new. But current concerns over the stability of the global financial situation have reignited such calls with new urgency.

Last week a United Nations Commission on International Financial Reform recommended to the UN that the world ditch the dollar as its reserve currency in favour of a shared basket of currencies.

Also last week China's central bank chief Zhou Xiachuan called for the greenback to be replaced by a new currency benchmark controlled by the IMF, "disconnected from individual nations and able to remain stable in the long run".

Every major government holds significant amounts of US dollars as part of their foreign exchange reserves, creating a hedge for them against their own presumably less stable currencies.

None more so than China, which holds $US1.4 trillion in US treasuries, estimated to be around 65-70% of its total foreign currency reserves. The plunging US dollar has slashed billions off the value of those reserves.

Like countries around the world, China is worried that actions taken in the US to yank the US economy out of recession will hurt them.

The Chinese move, in turn, is being seen as supporting an earlier call by Russia for the creation of a new global reserve, and which it intends to put before the meeting of the Group of 20 (G20) nations in London on Thursday.

Russia said its proposals had broad support from other key emerging market economies including Brazil, India, South Korea and South Africa.

"The End of Dollar Dominance?" asked a headline in the Washington Post last week. Definitely not, responded top US officials who discounted any suggestions the US would move away from the dollar to a global currency.

Yet according to Auckland University adjunct professor David Mayes, "the game is already up" for long-term dominance of the US dollar and American hegemony of world financial markets.

The euro was clearly a serious competitor to the greenback, and "it will be interesting to see how the Chinese economy and its currency strengthens and grows in the next decade".

Mayes, former chief economist at the Reserve Bank, adviser to the boards of several central banks, and a specialist in European financial integration, said the current crisis will have worried a lot of institutions and governments holding US assets and who had lost a lot of money.

"What really matters is not the state of their current portfolios, but what they do in terms of reinvesting and they will be looking to other places being a steadier bet than the US," he said.

US dollar-denominated reserves comprised 70.5% of official foreign exchange reserves in 2000, and the euro 18.8%. By 2007, the latest figures available, euro forex reserves comprised 26.5% of the total, and the US dollar 63.9%.

Mayes said he believed the euro will have climbed significantly. A Deutsche Bank report estimates euros will comprise 40% of total reserves by 2010, and international economists Jeffrey Frankel and Menzie Chinn say the euro will surpass the dollar in 2015.

But if change is coming, it won't be any day soon, said Mayes. Empires of all kinds had an internal inertia which meant that decay and decline was a long, slow, but still inevitable process.

The decline in the status of the British pound in the first half of the 20th century was part of a larger decline in the economic, military and political power of the United Kingdom during that time.

"Really, the game was over for the pound as dominant currency in 1919, but it was not until 1947 when the US dollar was placed deliberately at the centre of the system," he said.

But the outcome this time is less clear. Then, there was no clear alternative to the British pound other than the US dollar. A decade ago the euro looked the most likely contender as the major reserve currency, but the rise of China meant that was no longer clear-cut, said Mayes.

He said Europeans were aware of the difficulties of running monetary policy for one country or group of countries like the EU when the currency is also a reserve currency. "They are certainly not pushing for it." Neither did Europe have the sophisticated financial markets that would allow it to make the switch.

London did, and its continuing importance in global financial markets only made sense "because it once ran the game and had all the bits and pieces to make it work, and still does", said Mayes. And that was what the US and those advocating change would find out as well.

Mayes said China still managed its own currency, the renminbi (yuan), which disqualified it as a reserve currency of any sort now. And commentators have said China's promulgation of a new global currency at this week's G20 meeting is mainly designed to deflect criticism from its own currency policies.

China's plan does not involve it giving up the yuan or the US its dollar. But an international currency would be created, based on an obscure currency called "special drawing rights", or SDRs, created in 1969 by the IMF.

Critics say such a currency could be easily politicised, and would require acceptance by the private sector, which is seen as a huge hurdle.

In the meantime, governments and institutions will continue to hold more reserves, and conduct forex transactions in the euro, and other currencies such as the Swiss franc, the Japanese yen and the British pound.

Anthony Byett, currency specialist and principal of FXMatters, believes the future may not involve an alternative reserve currency to the US dollar, but rather markets working their way towards an acceptance of three reserve currencies the US dollar, the euro and an Asian currency, probably the yuan.

The world would also witness the continued and most likely accelerating waning of US hegemony in finance as well as other spheres of influence, said Mayes.

Being a major reserve currency confers considerable power. It means the US pays less to borrow and can set lower internal tax rates. The US can import and export in its own currency, and all major commodities are priced in US dollars.

But, said Mayes, reserve currency status and its diminution or less had big implications.

"Up until fairly recently, the US has been able to decide what it wants to do for the benefit of America, and recently it has been finding that when they try to do that, it isn't happening," he said.

He cited a recent G10 meeting where the US wanted to solve the current crisis by throwing money at it. Other countries had refused to go down that path, because they now felt strong enough to do things on their own.

Frankel, writing on the geo-political implications of the euro surpassing the US dollar as the premier international currency, said US deficits in the past had been manageable because allies had been willing to pay a financial price to support American global leadership.

In the 1960s, for example, Germany was willing to offset the expense of stationing US troops in Europe and saved the US from a balance of payments deficit; the Bank of Japan had repeatedly had been willing to buy US dollars through the 70s and 80s to prevent the US from depreciating.

In 1991 Saudi Arabia and Kuwait had been willing to pay for the war against Iraq, thus briefly wiping out the US current account deficit.

But since 2001, the US had lost popular sympathy and political support from much of the rest of the world. The next time the US asked other central banks to bail out the US dollar, they would be less willing to do so, said Frankel.

Technically, the US dollar has not been a reserve currency since 1971 when the US abandoned the gold standard, no longer guaranteeing that other central banks could sell their US dollar reserves at a fixed rate for gold. But the world continued to accept the dollar as the international currency because there was no other alternative.

In Churchillian parlance, that acceptance was the end of the beginning as far as US financial hegemony is concerned.

And it is coming back to haunt the rest of the world.