Reserve currency is a currency that is hold by other countries and financial institution without the worry that it will loose its value over time. Nations or financial institutions hold reserve currency for different reasons. Holding assets in different currencies serve as a diversification strategy for institution who don't want to be over-invested in one particular asset class. The reserve currency also reduces the transaction cost for corporation who do the trade in anchor currencies such as Dollars, Euros or Pound Sterling.
Over last several decades some exporting nations such as China have been amassing dollar reserves to prevent the appreciation of their currency. Currency appreciation is not liked by export-oriented economies because it affects the competitiveness of their exports in the world market. The accumulated dollars are pumped back into the US capital markets through sovereign wealth funds that reinvest the dollars in dollar denominated assets such as US stocks, US treasuries or even US companies.
One of the premises of reserve currency is that it should not loose its value over time. If I am an investor the first thing I should worry about is that my investments should not loose value over time. One dollar I invest today should buy the same amount (or even greater) of goods and services five or ten years from now. This implies that to attract investors to finance its increasing current account deficit, US should keep the dollar strong.
Strong dollar has its merits and demerits. On the positive side strong dollar reduces the commodity prices in the world market as most commodities are priced in dollars. On the negative side strong dollar makes US a consumer nation by increasing imports. Alternatively, it priced out US exports from world market by making them expensive as compared to other nations with weak currencies. The world sell its excess produce in US market and buys US consumer debt with hard earned dollars. After all who needs to get convinced that US assets are the safest bet in town till now. In pursuit to find good returns with minimum risks, financial institution started to bet in US consumers loans. These financial institution further fuels the credit boom by providing cheap credit to US consumers. Why consumers needs to worry if money is available at very low interest rates. This has created a credit cycle where people has started to consume more than they need to consume from cheap money.
This cycle continued, as long world believed that US consumers have the ability to pay back the money they have borrowed. After the credit crisis, rest of the world came to the realization that US consumers are broke and they have borrowed more than their ability to pay back. The easy way for US to fix its over indebtedness and make its way to prosperity is to weaken its currency. However, if the rest of the world perceives that the US is trying to gain competitive advantage via a deliberately weakening dollar, others may try to race US to the bottom by selling US debt, launching a potentially devastating sequence of events.
Does this imply that investor will loose faith in dollar and refuse to hold dollar assets?
US dollar won’t loose its reserve status in near future. There are few contenders to replace the dollar reserve status. After the dollar, the contenders for the title of the world’s dominant reserve currency are rather limited and obvious. The euro, representing an economic entity roughly the size, complexity, and productivity of the US economy can pose a serious threat to dollar. However the euro suffers from several deficiencies: It’s defined by highly fragmented capital markets that can’t offer the size and liquidity of the $600-billion-a-day US bond market. There is no central fiscal authority, the banking system is outdated, labor and resource mobility is limited, and reallocation is frightfully slow. Further, Europe suffers from the same dire fiscal outlook as the United States but with lower growth prospects, deeply embedded and well-protected national interests, crippling demographics, and without the advantage of substantial immigration to support population growth.
In Asia, which is the current roaring growth engine of the global economy, both the Japanese yen and the Chinese yuan are seen as posing a competitive challenge to the dollar. Japan is still the world’s second-largest economy. It possesses enormous wealth, a well-educated population, and has best-in-class corporations, notably in the export sector. But like the United States and Europe, Japan’s fiscal condition is precarious, with the country’s debt-to-GDP ratio now hovering at 200 percent and with massive deficits. The country also suffers from deflationary pressures that hamper consumption and capital expansion. Japan is also suffering from demographic trajectory that will increasingly weigh on growth.
China, the consensus choice as the new economic superpower, continues to make history with its rapid economic growth, highly open economy, breakneck pace of surging prosperity, and increasingly global firms. But China faces many challenges, too. It still has a closed capital account, a questionable banking system, an undeveloped legal system, rudimentary capital markets, and a less independent central bank. Without question, China suffers from an incredibly inefficient allocation of capital, which is unlikely to improve anytime soon.
In sum, while the dollar’s long-standing status as the preeminent reserve currency has caused more harm than good to US. World is seeing dollar as a risky bet and slowly diversifying it assets into other currencies from Asia and Europe. However, in short term we can assume that dollar is tallest midget in the room.
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