The Myth of a Replacement Reserve Currency
We are launching a new series today titled How it Works and our first topic is covering the almighty US dollar. The U.S. dollar is the world’s reserve currency, but pundits worry about its status and the possibility of China replacing it with the renminbi yuan. The process of how the U.S. became the wealthiest country on earth and the role of foreign currency reserves in global trade and currency pegging shows that it’s not as simple as countries deciding to shift to a new reserve currency.
This article explains how the U.S. grew its wealth through exporting goods and services and how other countries holding massive U.S. dollars as reserves has made it the world’s reserve currency. It also delves into the negative ramifications of currency pegging and sterilization policies on countries like Japan and China.
How the Dollar Earned its Status
Pundits often fret over the dollar losing its “status” as the world’s reserve currency. They seem to think China and other countries can just decide to jettison the dollar as the world’s reserve currency and replace it with the renminbi yuan. That’s not how it works.
The U.S. is the wealthiest country on earth, that wealth created mostly after WWII when the world rebuilt itself through our manufacturing. The U.S. exported goods and services to the world paid for with gold or a country’s currency. If a U.S. company sold a boat to France, the shipping manufacturer would take the Francs to a bank and exchange them for dollars. Ultimately the U.S. could hold those Francs as foreign currency reserves or exchange them for dollars on the global market. Regardless, the U.S. was getting rich selling stuff to the rest of the world.
Then in the 1970’s Japan began selling low-cost cars to the rest of the world. Then in the 1980’s China began selling low-cost goods (we won’t get into how they do it) of every kind to the rest of the world. U.S. companies began closing their domestic manufacturing facilities and bought and imported cheaper (both in price and quality) parts and low-cost/low quality versions of their products to sell. Dollars began pouring out of the U.S. to buy these goods. These “trade” dollars wound up as foreign currency reserves in many countries, but predominantly in Japan and China.
These exporting countries could have chosen to sell those dollars for their own currencies on the global market, but instead chose to hold them as foreign currency reserves. The reason is simple. If Japan and China chose instead to sell those dollars on the global market for their own currencies it would result in weakening the dollar relative to their currencies. For U.S. consumers this would drive up the price in dollars of those “cheap” goods from China and over time they would buy less and less. To avoid this China decided to instead hold all those dollars as reserves, buying U.S. assets like bonds with them.
When these countries buy our bonds, they are not doing so because they think it’s a good investment; it is merely a scheme to keep their currencies pegged to the dollar to prevent export prices in dollars from rising. It also keeps U.S. interest rates lower than otherwise they would be. In essence, these countries are lending cheap “money” to the U.S. to buy their stuff.
What about the Chinese company that sold goods to the U.S. and received dollars in payment? Being a domestic Chinese company, it doesn’t want dollars, it wants renminbi. So, it takes the dollars and exchanges them at the Bank of China for the yuan. Where does the Bank of China get the yuan? Well it prints it! How does it do that? It simply credits the company’s account and that IOU winds up as government debt. So two things are happening as a result. First, by keeping their currency artificially low relative to the dollar, China imports inflation (a weaker currency causes domestic prices to rise). Second, by printing yuan China has created over time massive government debt.
This is process of “sterilization” has in the long run some very negative ramifications for China. We can see what happened to Japan as the result of similar policies. By keeping the yen pegged to the dollar, Japan massively grew its government debt while at the same time imported U.S. inflation. Left alone market forces would have strengthened the yen slowly and the income generated from exports would have stabilized the Japanese consumer creating a more balanced economy. Instead, the combination of inflation and debt sent the economy into a recession and then a depression. The yen strengthened rapidly as debtors needed yen to pay back debt and liquidity collapsed.
Today almost every country holds massive U.S. dollars as reserves. These reserves are used in global trade and thus the U.S. dollar has become the world’s reserve currency. Conversely despite years of driving an export economy there are almost no foreign reserves in renminbi held by foreign countries.
You can’t be a world’s reserve currency if no country has your currency in reserves.
About the Author
John Succo is a finance expert with extensive experience in the derivatives market. He worked at Morgan Stanley and Paine Webber before joining Lehman Brothers in 1996. He then joined Alpha Investments before co-founding Vicis Capital, a hedge fund that became one of the world’s largest in its niche. He now teaches Capital Markets at Indiana University and partners in SS Financial, managing private companies in a variety of industries.
