The Future of the U.S. Dollar– October 6,2020
Panelists discuss the post-COVID-19 role of the U.S. dollar, options for alternative currencies, and the impact of U.S. economic and foreign policy on both.
Speakers Eswar S. Prasad Tolani Senior Professor of Trade Policy, Cornell University; Senior Fellow, Brookings Institution
Carmen M. Reinhart Vice President and Chief Economist, World Bank Group; CFR Member
Benn Steil Senior Fellow and Director of International Economics, Council on Foreign Relations; @BennSteil
Laura D. Tyson Distinguished Professor of the Graduate School, Haas School of Business, University of California, Berkeley; CFR Member.
TYSON: Welcome, everyone, to today’s Council on Foreign Relations meeting on “The Future of the U.S. Dollar.”
PRASAD: As with most important questions in economics, the answer to your question is “it depends.” It depends to a significant extent on what exactly one views as the important roles of the dollar in international financial markets. Now as a unit of account and as a medium of exchange, that is, as a currency that is used to denominate trade or financial transactions, or for payments and settlements purposes, one can very well see the dollar’s role possibly giving way to other currencies.
There was a period about three or four years ago when, in fact, the euro had become the dominant payment currency in the world, although that’s again reversed and the dollar is once again the dominant payment currency.
But there are reasons why one might expect other currencies—the Chinese renminbi—perhaps even other emerging market currencies to start playing a bigger role in terms of international trade transactions. However, when we think about the dollar’s preeminence (superiority) as the reserve currency1, that is its role as a store of value, we enter very different territory.
1A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions to prepare for investments, transactions, and international debt obligations, or to influence their domestic exchange rate. A large percentage of commodities, such as gold and oil, are priced in the reserve currency, causing other countries to hold this currency to pay for these goods.
The dollar has, despite the fact that the global financial crisis began in the U.S., despite the fact that the U.S. has been taking a pretty big hit during the pandemic-induced recession. It doesn’t seem like there is much of an alternative to the U.S. dollar. At times of turmoil in global financial markets, investors want safety. And it turns out there is really only one currency that affords the kind of safety that international investors seem to want, and that is the U.S. dollar.
Now, this does not necessarily mean that the U.S. is going to be as dominant in terms of the global economy, as it has been in the past, China is fast catching up. But in terms of the depth and breadth of its financial markets, that is the amount of foreign assets that investors have access to and the amount of trading that goes on in those markets, and the institutional framework that supports the currency, it is hard to envision a rival to the dollar. Now there has been some notion that there are other currencies such as the renminbi nipping on the dollar’s heels. What we’ve seen in the last few years is actually something interesting that there has been a rejiggering (rearrange) of the relative importance of the second-tier currencies (second official foreign exchange) in which I would include the euro. So the dollar’s position remains as dominant as ever as a reserve currency. I don’t see that changing in the foreseeable future
REINHART: So, it’s actually hard to disagree with what, you know, 99.9 percent of what Eswar has just outlined. Let me start out by putting a little backdrop in terms of the historical role of the dollar. Its prominence was established and anchored in Bretton Woods.
And after the breakdown in Bretton Woods for a variety of reasons, it lost ground and it lost ground through the ’80s, apart from the prominence of the Deutsche mark during that time, there was also the ruble block. This is relevant for today’s discussion, because what could one say about a parallel renminbi block?
In its post-war trajectory, troughs and peaks. As Eswar highlighted, defying expectations in some dimensions the surge in the share of global GDP that China has, the dollar is close to or at its peak as a global reserve currency, and that is not just as a reserve currency of what central banks hold, it’s what currency the developing world denominates its debt in.
It’s also what role it plays in exchange rate policies, , what currency do emerging markets anchor their currency to and by all those metrics, the dollar really is going strong. I am skeptical of the belief that a replacement for the dollar is around the corner. For starters, financial institutions and investors don’t hold dollars, they hold greenbacks, they hold debt, and the liquidity, the depth, of the U.S. Treasury market at the moment is unparalleled.
The euro in the post-2008 crisis landscape was that pre-crisis, pre-2008 global financial crisis, the perception for better or worse, was that there was a euro and there was a euro market sovereign debt. After the crisis, it became clear that there wasn’t a euro-fixed income market in anything resembling homogeneity, that Greek debt was a very different animal from German debt and German debt was very different from Irish debt and so on and so forth. So, in terms of the mechanics of the global financial architecture, the euro is fragmented in a way that stands in contrast to the very unparallel Treasury market.
Now, the renminbi is an interesting one because up until about 2015, the view was that the renminbi was going to gain ground and the perception that China’s rise in the real side of the economy would be matched by a rise in the financial dominance as well. Interesting, I have done quite a bit of research on China’s overseas lending, primarily to developing countries and mostly low-income countries.
Now, the overwhelming majority of that lending is denominated in dollars also. So unlike the, I alluded to the ruble block, historically, in which the internal transactions of Eastern Europe and the ruble block were indeed rubles. China, just to put it in perspective, is the largest official creditor is bigger than all the Paris Club creditors combined. And those debts, those transactions are mostly dollar denominated, so we can debate the medium-term outlook, and what are some of the warning signs that one may look to, to see that, receding in prominence, but over the near-term, this is as to the issues that Eswar has already alluded to, it’s hard to see a competitor.
STEIL: Let’s start with COVID. COVID, I think has been largely a non-event in terms of the international position of the dollar, and that’s because the Fed handled the surge in international demand for dollars very well.
Now, there was this mad scramble period back in mid-March, where everyone was desperately scrambling for dollars and it took the Fed quite a while to get its bearings. The Fed bought up a record $450 billion of Treasuries from investors at the time, but they handled the surge in international demand actually much better than they handled the initial surge and domestic demand.
By the end of March, the Fed had extended currency swap arrangements to fifteen central banks overseas. Five had permanent swap access, they added nine on an emergency basis, and in the first few weeks of April, they extended nearly half a trillion dollars of loans to foreign central banks through currency swaps. Furthermore, although this hasn’t gotten much attention, about 170 more central banks around the world have access to Fed lending facilities using U.S. Treasuries as collateral. So I think the Fed did an extremely competent job on the international front using 2007 as a template. In 2007, I think that, the Fed was largely improvising, but they had that playbook, they dusted it off, and they handled it well.
Now, looking out to the future focusing on the RMB, I remember vividly this front-page article in the Economist back in 2014, saying that the internationalization of the RMB was “remorseless and unstoppable.” It was almost impeccable timing because less than a year after the article came out, the internationalization of the RMB went into sharp reverse. In 2015, the RMB hit its peak, in terms of its percentage of global payments, it had reached 2.8 percent. Within three years, that was back down to about 1.6 percent. Right now, it’s about 1.8 percent.
It’s been pretty stable as a percentage of total central bank foreign exchange reserves at about 2 percent. So what happened? My reading is that the idea of internationalization was never really clear, it wasn’t that people were scrambling for RMB because they wanted to use it for international payments. From 2005 to 2013, the RMB was steadily and consistently appreciating, almost month by month. And as we know, the People’s Bank of China was slowing down that appreciation.
But buying RMB during that period was seen as a one-way bet. So there were massive speculative flows going into the RMB. After 2014, that stopped. Since then, the PBOC has at times had to intervene to keep the RMB up. Once those speculative inflows stopped, the internationalization of the RMB went into shock reverse, and there are actually no signs that we’re seeing the RMB emerge as any sort of competitor to the U.S. dollar.
TYSON: So, Carmen mentioned the idea of a block. So one possibility is the RMB becomes increasingly important in a trading bloc that China dominates. I wanted to get your sense of that. And also, I know that Eswar talked about the rise of the digital currency, the central bank digital currency in China, and could that change things?
So Carmen, why is it the case that one could not have—I don’t know why is China lending in dollars and why would it not develop over time an RMB-focused block around its own trade and financial transaction? And I’ll now go to Eswar to just sort of think about digital currency here.
REINHART: So this really goes to the heart of the point that Benn was making, you had a period in which China was growing at double digits, its currency was really a one-way bet, it was steadily appreciating and during that capital inflow—big capital inflow phase—the idea of financial liberalization also took more root, concerns about capital flight were not anywhere in the cart until 2015.
And, August 2015, you had a small by almost any metric depreciation of the RMB that was taken as a signal of a turning point. The outcome of that was a tightening of capital controls, specifically controls on outflows. For a global reserve currency, capital controls, as Rudy Dornbusch used to say, you went to a party because you knew you could leave at any time you wanted, if not, you wouldn’t go. And that was a big turning point.
Now, this is entirely speculative. We could be at a conjuncture, they have once again moved to liberalize some inflows into there, in effect there have been, you know, big bond flows very recently as a result of liberalization that, there is some, some comeback in that dimension. But, for global financial transactions, a convertibility is still, and capital controls are still major hurdles.
Now, what about the central bank digital currency? Well, it faces some of the very same issues. Right? Now, it is true that, China’s bilateral lending to low-income countries, which soared especially during a period of rapid growth where they needed a lot of commodities—they were big buyers of commodities. And also, without derailing the conversation, the recipient countries, the low-income commodity exporters had relatively clean balance sheets at the time because of the HIPC [Heavily Indebted Poor Countries] Initiative. They’re debt write-offs, and so they look like an attractive, you know, venue for lending.
Post-COVID, it will be questionable or highly suspect whether those countries remain an important destination for Chinese outward flows. And having said that, you know, this connects to your question about central bank digital currency—could China in these bilateral agreements denominate some of its debt in RMB or in the newer central bank digital currency, yes, but why would it do that? It’s really not at all clear. I’d like to conclude though on, you know, the point that we may be seeing if the divergence, say, between China’s growth and U.S. growth goes in the direction that we’ve been seeing recently given that China got its pandemic house in order sooner than the rest of the world, we may be seeing a period of renewed inflows. But that’s a different cyclical, if you will, or you know, rather than some of the structural issues we’ve been discussing here.
TYSON: Right. So Eswar, you’ve written about the rise of the digital central bank currency in China. So I’d like your views on whether that strengthens the outlook of the RMB. And then also, maybe we can make this the transition in your comments to well why should we care? What are we doing in the United States that could weaken the U.S. currency? And as we do that, what are the dangers to the U.S.? So let me turn to Eswar.
PRASAD: Before I answer your set of questions, Laura, I should say that a lot of what I know in international finance, I’ve learned from talking to Carmen and from her writings, so I’m really eager to hear what 0.1 percent of my initial remarks she does not agree with because I’m sure we’d learn a lot from that.
On the China issue, I think it’s worth keeping in mind that as both Benn and Carmen have pointed out, the initial promise of the currency does not seem to have been borne out. And I think it really comes down to credibility, the Chinese government has committed to keeping the capital account open, that is to allowing free flows of capital both into and out of the Chinese economy, and to moving towards a market-determined exchange rate where the People’s Bank of China, the central bank, does not intervene extensively to control the exchange rate’s value. Neither of these commitments seems to be completely ironclad.
As Carmen pointed out, when pressures on the capital account started building up with a lot of capital outflows in 2015 and 2016, China did return to the old playbook of using capital controls. So at the moment, we do have a fair bit of capital flowing into China, because China does provide a lot of opportunities to investors for better yield, better diversification. But I think a lot of money that is going in is really passive money because China is becoming included in stock and bond fund indexes around the world. But the sort of flows one might expect, given that China has now thrown open its doors, especially its corporate and government bond markets to foreign investors and largely its stock markets as well, we don’t see that many inflows and I think this credibility is an issue.
That comes to the broader point that connects what is keeping down the Chinese renminbi and what is keeping up the U.S. dollar, which I really think comes down to the institutional framework, and that has some critical elements. So if you think about not just a reserve currency, but a safe-haven currency, one that investors around the world turn to at troubled times, you need certain institutional elements such as an independent central bank, you need the rule of law, such that even the government has to play by the rules that have been set, you may or may not like the rules, but even the government is bound by them, and you need an institutionalized checks and balances system.
China doesn’t quite have this institutional framework. Now one can certainly make the argument that in the last four years, in particular, every element of the institutional framework that I mentioned, has been undercut in the U.S. The rule of law isn’t quite what it was, the independence of the Fed, again, has been challenged, and the checks and balances don’t seem to be working terribly well. But in international finance, ultimately, it’s all relative.
So if you put together this combination of institutional framework, and one hopes that the checks and balances will work in the U.S., if you put together and, what Carmen referred to, the enormous depth of U.S. fixed-income markets especially the Treasury securities market and the liquidity in those markets, there really is no alternative. So does this matter for the U.S.? Does it matter for the world?
In the lead up to the global financial crisis the concern was that this dominance of the dollar was letting the U.S. basically get away with running very large current account deficits, borrowing from the rest of the world very cheaply, and that this was creating imbalances in the global capital flows. Those imbalances did peter away a little bit after the global financial crisis, but they have come back up and certainly the level of debt to the U.S. is accumulating to the rest of the world even though that may be somewhat overstated in official measures, but it’s still a large amount. That is a potential problem. But the question again becomes if there is no alternative, if one cannot think about a better system, maybe having a unipolar world is not the best of all possible worlds, but among the available worlds, it may not be such a bad one