Using Hard Currencies: Global Trends

April 21, 2020

Global Trends of Using Hard Currencies are Highly Skewed

(Published in the Financial Express in December 2019)

Dr. Shah Md Ahsan Habib[1]

Liberalization and globalization measures brought in growing cross-border economic transactions where trade is at the center.  To facilitate these transactions, a useful lead currency is the most effective. A currency can be regarded as the leading currency of the world economy if it is used for financial transactions or medium of exchange, as a monetary measure of value and as a reserve currency or store of value not only by domestic economic actors, but by many or almost all actors around the world. These features are best met by the US dollar (USD), and USA remained the largest economy with huge dominance.  

It is well known that USD is widely used for invoicing and settling import and export transactions around the Globe; and practically it is the USD that is holding the large share of foreign currency deposits, bonds, and official foreign exchange reserves maintained by the central banks and monetary authorities throughout the World. Use of USD is significantly higher in all cross border transactions covering settlement, investment, and maintenance of foreign exchange reserves as compared to all other hard currencies like Euro, Yen, GBP or Chinese Yuan. The wide scale use of USD in international and even in several domestic transactions make USD the lead currency or de facto global currency.

The movement of USD on the path of global currency started with the 1944 Bretton Woods agreement ; and before then, most countries were on the gold standard. Their governments promised to redeem their currencies for their value in gold upon demand. The world’s developed countries met at Bretton Woods, New Hampshire, to peg the exchange rate for all currencies to the U.S. dollar. At that time, the United States held the largest gold reserves. This agreement allowed other countries to back their currencies with dollars rather than gold. By the early 1970s, countries began demanding gold for the dollars they held. They needed to combat inflation. Rather than allow Fort Knox to be depleted of all its reserves, President Nixon separated the dollar from gold. By that time, the dollar had already become the world’s dominant reserve currency.

The USD has been the world’s premier currency for international trade and investment. More trade is done in USD than any other currency. More trade finance is issued in USD than in any other currency. The world relies on dollars to facilitate the flow of goods and services around the world. So, when there is a shortage of USD, global financial flows slow down, and this restricts global trade activity; some places may even experience complete blockages. The underlying cause of the slowdown in global financial flows associated with a strong dollar is restricted bank lending. As Hyung Song Shin of the Bank for International Settlements (BIS) explains, when the world experiences a shortage of dollars (indicated by a rising dollar exchange rate against all currencies), banks become reluctant to lend dollars across borders: This means that businesses in countries whose domestic currencies are falling versus the dollar can find it difficult to borrow the dollars they need to finance their international trade. The result can be a sharp fall in import-export trade, particularly involving developing countries (whose currencies tend to be more volatile in relation to the dollar), and a consequent decline in global trade.

Dominance of USD is very much obvious also with the extensive use USD for meeting internal needs and economic transactions. Cash is just one indication of the role of the dollar as a world currency. More than one-third of the world’s gross domestic product comes from countries that peg their currencies to the dollar. That includes seven countries that have adopted the USD as their own. Another around 90 percent countries keep their currency in a tight trading range relative to the dollar.

The dollar continues to be the world’s principal currency in international foreign exchange markets, reflecting its dominant global position both in terms of market turnover  and trade settlement. Around 90 percent of foreign exchange trading involves USD. The dollar is just one of the world’s 185 currencies according to the International Standards Organization List, but most of these currencies are only used inside their own countries. Theoretically, any one of them could replace the dollar as the world’s currency, but they won’t because they aren’t as widely traded.

A study by the National Bureau of Economic Research (NBER) and Harvard University in 2019 found that the proportion of global imports invoiced in USD was 4.7 times total U.S. imports, and the proportion of global exports invoiced in USD was 3.1 times total U.S. exports. This was a far higher proportion than the second-most-frequently used currency, the euro, for which total global imports and exports were only 1.2 times the Eurozone’s international trade. The study said that ‘the overwhelming share of world trade is invoiced in very few currencies, with the dollar the dominant currency.’

Highest debts are issued in USD. According to some recent studies, almost 40 percent of the world’s debt is issued in dollars. As a result, foreign banks need a lot of dollars to conduct business. This became evident during the 2008 financial crisis. In 2017, the banks of Japan, Germany, France, and the United Kingdom held more liabilities denominated in dollars than in their own currencies.

The USD’s strength is the reason governments are willing to hold the dollar in their foreign exchange reserves. Governments acquire currencies from their international transactions. They also receive them from domestic businesses and travelers who redeem them for local currencies. Some governments invest their reserves in foreign currencies. China and Japan deliberately buy the currencies of their main export partners. The United States is the largest export partner with both countries. They try to keep their currencies cheaper in comparison so their exports are competitively priced.

The dollar is held by foreign governments in their currency reserves. They wind up stockpiling dollars as they export more than they import. They receive dollars in payment. Many of these countries find that it’s in their best interest to hold on to dollars because it keeps their currency values lower. Some of the largest holders of USD are Japan and China. As of the first quarter of 2019, as noted by IMF, foreign governments held USD 6.7 trillion in U.S. dollar reserves. That’s 61 percent of the total allocated reserves of USD 10.9 trillion. It’s down from a height of 66 percent held in 2015. It’s even less than the 63 percent held in 2008. At the same time, the percentage of euros held in reserves was 20 percent in 2019. That’s less than the 27 percent held in 2008. All other currencies gained ground as banks diversified their foreign exchange holdings.

Because of the extensive use, fluctuations in USD and macroeconomic policies of USA have notable implications for global exports and imports.   While a weaker dollar makes US exports more competitive, a stronger USD makes borrowing costs higher, among other impacts. More importantly, the effect of macroeconomic policy decisions in USA or elsewhere may have a negative effect beyond the control of a developing economy. Searching for an alternative of USD may not be feasible for a developing country having low volume of cross border transactions and a soft currency. However, as a short term approach, there are evidences of minimizing transaction costs and exchange rate risks in trade transactions through regional payment arrangements of using hedging instruments.

There are tendencies amongst countries to maintain gold bullions as foreign exchange reserves. It is also considered as viable alternative asset for official reserves considering its requisite liquidity, correlation characteristics, and trust. Central banks seeking true risk diversification or insurance, therefore, are increasing their gold holdings. Currently, USA is holding the highest volume of Gold reserve in terms of Volume. In terms of proportion of total reserves, the highest Gold holding countries are: USA (76%), Germany (72%), Italy (67%), France (61%) and Russia (20%).

Considering the issuer of the global currency (USD), USA maintain continues watch on global economies. USA Treasury carefully monitors developments of the other currencies to maintain dominance and for the purpose of macroeconomic management. Especially, Chinese Currency is closely monitored by the USA authority.  According to the most recent USA Treasury Report to the Congress, ‘China’s exchange rate practices continue to lack transparency, including its intervention in foreign exchange markets. Based on Treasury estimates, direct intervention in foreign exchange markets by the People’s Bank of China (PBOC) over the last several months appears limited. Nonetheless, given China’s long history of facilitating an undervalued currency through protracted, large-scale intervention in the foreign exchange market, Treasury has continued to have ongoing discussions with the Chinese authorities about RMB developments and intervention practices. Moreover, in recent years, China has shifted from a policy of gradual economic liberalization to one of reinforcing state control and increasing reliance on non-market mechanisms. The use of explicit and implicit subsidies and other intervention practices are increasingly distorting China’s economic relationship with its trading partners.

[1] Professor and Director (Training), BIBM ([email protected]).

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