The Dollar as the Reserve Currency of the World
The U.S. dollar has enjoyed its status as the global reserve currency of choice for some time now. Since the implementation of The Bretton Woods Agreement, the dollar has been considered the anchor of the global financial system. Under this agreement, the United States guaranteed other central banks that they could sell their dollar reserves for a fixed rate of gold.
In the 1960s and 1970s, some flaws were seen in this system, however. The Triffin Dilemma was first identified in the 60s by economist Robert Triffin who believed that a conflict of interests undermined the system. According to Triffin, this conflict arose out of differences in short-term domestic objectives and long-term international objectives.
Triffin also pointed out that the country who was supplying other countries with its currency for reserve purposes must be willing to supply enough of the currency to fulfill global demand, and this extra supply of currency leads to a trade deficit.
This dilemma is often cited as one of the most-if not the most-significant problems with the Bretton Woods Agreement.
This eventually led to a balance of payments dilemma as well. The U.S. had to run a balance of payments current account deficit to ensure enough liquidity for the conversion of gold into dollars. The influx of dollars led speculators to believe that perhaps the dollar had become overvalued. As more dollars were converted for gold, it also meant that the country’s gold reserves were not as robust. Less gold in the country led to even more concern about the dollar’s value, and the country had to run a balance of payments current account surplus in order to boost the dollar. Needless to say, the country cannot run a balance of payments current account deficit and surplus simultaneously.
Clearly the system was flawed, and in 1971 then-President Richard Nixon initiated “Nixon shock” under which dollars could no longer be exchanged for gold. This was, in effect, the demise of the Bretton Woods System.
As confidence in the dollar was a concern, President Nixon negotiated a deal with Saudi Arabia for all future oil sales to be dollar denominated. In exchange, the U.S. would provide Saudi Arabia with protection for its vast oil fields. Other OPEC members also followed suit. These agreements ensured that demand for U.S. dollars would remain robust, and helped to support the dollar’s value.
While demand for dollars has been strong due to the fact that nations need dollars in order to transact oil, this agreement also likely boosted demand for U.S. debt in the form of treasuries. The dollar’s reserve currency status as well as demand for U.S. debt has been advantageous for the U.S., as it has kept interest rates down, although a stronger dollar can have negative effects on exporters.
The Dollar’s Future as the Global Reserve Currency of Choice
There has been much discussion over the years about the dollar’s status as the preferred reserve currency of the world. The currency markets appear to be currently undergoing some significant changes, and the dollar could potentially be challenged.
Several nations have already begun a move away from dollars. China, Russia, even France have all set up swap lines to facilitate transactions outside of U.S. dollars. Even some multinational corporations have also taken similar measures.
Some believe, in fact, that the only issue preventing a direct challenge to the dollar is the ongoing petrodollar system. If Saudi Arabia and other oil producers made a move away from dollars, it could potentially set the stage for massive dollar depreciation as capital could flow out of dollars and into other currencies, while demand for U.S. treasuries could also potentially see a dramatic decline. If many of these dollars found their way back home, the rapid increase in supply could severely undermine the value of the dollar and possibly lead to rapid inflation in the U.S. as well as rising interest rates.
The Yuan as the Next Preferred Reserve Currency
It’s no secret that China has taken steps in recent years to bolster its position both economically and politically. The country has also been reportedly buying massive amounts of gold, although the country’s exact holdings remain unknown. Some estimates put China’s gold reserves at 3000 tons while others believe the country could be holding 8000 tons.
Whatever the case may be, it is possible that China is looking to bolster its gold reserves in an attempt to gain more credibility for its currency, the yuan.
On October 20th of this year, the yuan is set to become a member of the International Monetary Fund’s (IMF) Special Drawing Rights. This would mean that the yuan is now accepted as a global reserve currency and could potentially be the first step in a direct challenge to the dollar.
While much of this may be pure speculation at this point, it would not be far-fetched to see even more countries moving away from dollars and into yuan.
China is the world’s second largest economy, and has been experiencing rapid growth in recent years. As China looks to further cement its place among the global elite, it will likely continue to push for additional acceptance of the yuan as a preferred global reserve currency.
While the dollar remains the global reserve currency of choice, the currency could potentially see outflows into a viable alternative such as the yuan.
Clearly, China believes that owning gold is important. Gold is symbolic of power and prestige, as well as financial stability. As uncertainty over the dollar’s future as the world’s reserve currency mounts, gold may see additional demand from other nations as well as smaller investors looking to hedge against currency risk.