The role of the dollar called into question

People's Bank of China governor Zhou Xiaochuan recently sparked a new round of debate regarding the international monetary regime with his call for a new international reserve currency. While the dollar was not specifically mentioned, it is clear that the proposed new international currency is meant to replace the role that the US currency currently plays. When a senior official of a government that holds about 10% of the US government's marketable debt makes such a statement, people take notice. There also appears to be some international support for governor Zhou's idea, although the US is understandably less enthusiastic. So will we see the US dollar lose its international pre-eminence anytime soon?

Why the dollar dominance?
An evaluation of this question must begin with an understanding of why the US dollar is so well regarded globally in the first place. There are four main reasons for this. One, it has -- at least until now -- been a reliable store of value. Two, it is the most widely accepted means of international payment for goods and services. Third, large, deep, and liquid dollar financial markets exist for savers to invest their money in. And finally, a long period of dominance has allowed the currency to become a part of the international financial trading infrastructure.

The US dollar is the most frequently used currency in international trade today. The fact that the US is the world's largest trading nation is only part of the reason. The value of international trade that is invoiced in dollars is much larger than the total trade conducted by the US and countries with currencies linked to the greenback. This is particularly true in Asia, where many countries bill more than 80% of their exports in dollars.

Large international savers such as the Persian Gulf states and East Asian exporters also find US financial markets most attractive. Partly, this is because Gulf oil exports are paid for in dollars and because it is the most convenient currency with which to intervene in foreign exchange markets for Asian central banks. But more importantly, the US financial markets remain the most efficient place to intermediate global funds. In these markets, particularly the US Treasury market, large amounts of financial assets can be bought and sold without causing large movements in market price. Moreover, due to the narrow differences between buying and selling prices, the costs of transacting in these assets are lower than in any other market. Investing in US financial markets, and also through the dollar in other financial markets, therefore, lowers costs and increases the flexibility of portfolio decisions.

The previous two reasons also give rise to a third factor that keeps the US dollar as the world's currency. The dollar has become an integral part of international financial and commodity markets because it is so frequently used in international trade and investment. In quoting exchange rates, the value of a currency is most commonly stated in terms of the US dollar. Even in actual exchange, the dollar's role is important. A company wishing to exchange Thai baht for New Zealand dollars typically buys US dollars first, before converting them into New Zealand dollars. As a result, the US dollar is involved in one leg in close to 90% of all foreign exchange transactions, compared with less than 40% for the euro and 16% for the Japanese yen.

Similarly, commodities, such as oil and copper, usually have their quotes and their trades executed in US dollars. This prevalence also means that the dollar derivative markets are the most developed for anyone wishing to hedge currency and commodity price risks.

Confidence Is critical
The common factor crucial for the continued validity of the above support for the dollar's international status is confidence in the stability of its purchasing power and confidence in the government to honour its debts. Whether one is a trader or an investor, there is a need to hold the currency on an ongoing basis. People have to believe that it is a good store of value, in that the real effective exchange rate of the dollar is not expected to see large declines over the short to medium term. This belief rests on the strength of the US economy, the independence and checks inherent in key institutions, as well as the prudence and coherence of its policies. If even a significant minority of external creditors has doubts that these factors are no longer true, then the US dollar money and capital markets will become unstable. Real interest rates and equity premiums will rise sharply and the dollar will fall precipitously against other major currencies.