America’s strong-dollar problem
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The dollar “is our currency, but your problem”, US treasury secretary John Connally told his foreign counterparts in 1971. But it seems the dollar has now become a problem for the US too. President Donald Trump is of the view that the dollar is overvalued and is hurting US trade. The dollar index has gone up by over 25% since the beginning of 2014 and the dollar has strengthened after Trump’s victory.
However, the US is unlikely to get any significant relief on this front in the short run, as it appears that the Federal Reserve might be looking to normalize policy quicker than what the markets have factored in. Higher interest rates in the US are likely to attract capital flows, which could further strengthen the dollar. A significant appreciation in the dollar can actually undermine US interests, at least in the short run. According to a 2015 Federal Reserve Bank of New York study, a 10% appreciation in one quarter reduces gross domestic product growth by 0.5 percentage points over one year and 0.2 percentage points in the subsequent year.
In the medium- to long-run, one of the ways in which the dollar can depreciate significantly is if its dominance as the reserve currency reduces or is challenged by some other currency or set of currencies. But can it happen? In a new working paper, Exchange Arrangements Entering The 21st Century: Which Anchor Will Hold? economists Ethan Ilzetzki, Carmen M. Reinhart and Kenneth S. Rogoff concluded: “Our new algorithm for jointly determining a country’s anchor currency and its degree of exchange rate flexibility shows...the dollar’s dominance as an anchor/reference currency appears to be at least as great as it was under Bretton Woods.”
The paper also noted that as of 2016, 62% of 195 countries used the dollar as their anchor currency and two-thirds of the world’s foreign exchange reserves were held in dollars. The reason for continued dominance of the greenback as a reserve currency is that there is practically no alternative. For instance, the pound lost weight after the Bretton Woods system established the dollar’s role in the international financial system, followed by economic problems in the UK. The euro later gained traction, but is now weighed down by too many internal eurozone problems, and the yen never really reached a position from where it could challenge the dollar. Also, markets have not lost faith in the dollar even though America’s share in global output has declined over the years and developing countries have increased their presence. In fact, even though it was the epicentre of the financial crisis in 2008, capital moved to US assets in search of safety.
The currency that some economists believe can replace or challenge the dollar’s dominance is the Chinese renminbi. China is the second-largest economy in the world, with vast trade linkages. The renminbi is now also part of the International Monetary Fund’s special drawing rights. However, its role in international finance will depend, to some extent, on how well the Chinese administration is able to handle the ongoing economic rebalancing and the risk to financial stability. With China’s given political and institutional position, the role of the renminbi is likely to remain limited in the medium term.
The problem for the global financial system is that the US may not be able to supply reserve assets forever. In fact, continued overdependence on dollar assets may itself lead to market dislocation and increase risk. But reducing this dependence will require reforms in the international monetary system. Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey, for example, in their 2011 paper Reforming The International Monetary System, argued in favour of developing alternatives to US treasuries and enabling the transition to a multipolar world.
Better policy coordination between different governments and central banks can reduce the need for vast reserve accumulation. Apart from mercantilist reasons, insurance against uncertainty has been a big motivation for the surge in reserve accumulation, both in the boom period and after the crisis. Better policy coordination can address both these issues, but for this the US will have to play an important role—which looks unlikely at this stage. To be sure, the dollar’s dominance also benefits the US economy in a number of ways. For instance, it keeps the cost of borrowing low for both the government and the corporations, and businesses are able to transact in their home currency all over the world.
Some of the imbalances in the financial system will reduce as the global economy returns to normalcy. But this is likely to be a slow process and a significant shift in policy by the Trump administration remains one of the biggest risks for the global economy at this stage. At a broader level, the global financial system will be better off with more competition for reserve currency. It will not only allow countries with reserves to diversify their holdings, but will also reduce pressure on the US.
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