The Reserve, Part II The US Dollar: Still the Cleanest Dirty Shirt?

Executive Summary
In Part I of this series,1 we reviewed several features of reserve currency regimes: the rise of the dollar, the critical components that make up a reserve currency, and the myths that currently exist in sovereign debt analysis. In the meantime, we’ve seen a Chinese government that is beginning to understand the implications of a more open capital account and financial stability: Chinese savers have sought to diversify away from renminbi, periodically adding to volatility and capital flight. All of this makes the process of the internationalization of the renminbi particularly fascinating. Additionally, the drumbeat of protectionism resounding from within the United States may have longer-term implications for the dollar. Yet, despite the lack of clarity regarding forthcoming US policies and other issues, it is likely that the US dollar will retain its premier position against its nearest competitors.

When we initially undertook to write this series, the goal was to provide context for GMO’s clients who operate in a marketplace dominated by the US dollar, first by examining its path to becoming a reserve currency, and then by looking at its current status in the global economy. Additionally, we hoped to continue to dispel myths about sovereign debt in developed countries. As we showed in Part I, current metrics of sovereign debt sustainability appear to be rather meaningless for a developed country sovereign that issues in its own currency.2 Part II is meant to be read in conjunction with Part I, resulting in a foundational treatment regarding reserve currencies and sovereign debt.

At our 2016 Fall Client Conference, I presented a workshop on this current series. An astute client asked the critical question, “What can change the dominance of the dollar?” I answered quickly (too quickly, in hindsight), “By doing something self-destructive, such as defaulting on our debt.” Before jumping right into Part II, I would like to expand on that answer. We can also hasten the demise of the dollar if we deliberately limit its usefulness and its associated securities market (namely, the Treasury market): 1) diminish trade conducted in dollars;3 2) deliberately limit or inhibit the usage of the Treasuries’ market, particularly on the collateral side, by encouraging scarcity of Treasury bills;4 3) allow a critical global resource, such as oil, to be priced and traded in another currency; or 4) abandon the “strong dollar” language of the executive branch for a prolonged period of time, thus adding additional volatility into dollar exchange rates.

On November 30, 2015, IMF staff endorsed the renminbi (RMB) as a part of a basket that makes up the Supplementary Drawing Rights (SDR). The SDR is defined as “a potential claim on the freely usable currencies of IMF members.” Achieving SDR status has traditionally meant that a currency is in an exclusive club of international reserve currencies, which are currencies that are held as reserve assets by other countries. Member countries of the IMF are allotted an amount of SDRs that theoretically serve as financial assets for those countries. Countries with SDRs may use them to obtain the underlying currencies.5 The addition of the RMB to the SDR basket is a significant, albeit symbolic, step in the internationalization of the RMB. The criteria for inclusion in the SDR, as defined by the IMF staff, “are the currencies that are issued by members or monetary unions whose exports had the largest value over a five-year period, and have been determined by the IMF to be ‘freely usable.’”

However, inclusion within the SDR does not necessarily mean a currency has become internationalized. What’s more, internationalization does not necessarily mean achieving the status of a reserve currency, as discussed in Part I. Specifically, inclusion in the SDR does not mean the RMB will be the desired currency of a waiter in, say, Mumbai, the preferred collateral currency of a clearing house, or the liquid reserves of a central bank reserve manager.

But is an SDR a reserve currency?
The short, though nuanced answer, is no. The IMF cannot simply create more SDRs; it cannot take in assets and deliver SDRs through open market operations (the so-called “discounting of commercial paper” that is listed in the Federal Reserve charter discussed in Part I). Without being able to add to the flexibility of the currency, or having a central bank that will deliver the basket upon receipt of assets, the SDR is not, and unfortunately for the IMF, cannot be, an alternative currency. Indeed, even if the IMF were able to convince one central bank to accept SDR-denominated assets as collateral, the simple fact is that that particular central bank could only supply an infinite quantity of its own currency, not the other currencies within the SDR. Exhibit 2 illustrates a number of ways that a central bank can increase its currency outstanding, and also shows what the IMF cannot do.

The exchanges between banks and the Fed depicted in Exhibit 2 can be conducted almost infinitum, because the Federal Reserve can create dollars and reserves at will. The transactions with the IMF shown in the second diagram cannot because the IMF itself has only a limited number of reserves and cannot simply “create” new reserves to deliver to financial institutions. While the IMF can designate members to purchase SDRs in order to maintain the functioning of the SDR system, triggering such a mechanism is likely to be fraught with political danger. Indeed, it would involve coordination between several central banks whose currencies each make up the SDR. Such coordination, even in the best of times, is not something that can be counted on and assuredly would weaken any attempt at making an SDR a substitute for the current reserve currency regime. Furthermore, as the IMF states, “Additional hurdles to the development of an SDR-based system include potential resistance from reserve issuers who have no direct use of SDRs…the lack of deep and liquid markets; the need to convert SDRs into a freely usable currency for most payments transactions.”6

So, why not the euro?
Looking at the SWIFT data presented in Part I, one might assume the euro would challenge the dollar as a transactional currency. However, it broadly breaks the conditions discussed in the “Do Credit Ratings Matter?” section of Part I: The Eurozone is not one country, but rather a group of sovereignties operating with a common currency. In effect, each of the sovereign countries is issuing debt in a foreign currency, with a central bank that needs to consider the interests of all members, not any one member. In addition, in practice, the debt of each sovereign entity is not particularly fungible with another. Woe to the dealer who delivers to his client a French 10yr OAT or Italian BTP instead of a 10yr German bund. In reality, the fragmentation of the European sovereign market is more reminiscent of the US municipal market for state General Obligation bonds. Without a deep, liquid, and fungible market for government securities, the euro has little chance of becoming a genuine reserve currency as we have defined it in this series. The economic tragedy of Greece exemplifies the weakness of the common currency. For the euro to be considered a genuine reserve currency, it will need to engage in a more aggressive fiscal union.

So, why not the yen?
The yen exhibits some safe-haven characteristics, but it lacks several others related to a reserve currency. For example, the yen is still a relatively small portion of global reserve balances. In addition, it is unclear whether the Japanese government actually wants a stronger yen given its export-oriented economy. In the US, when the Secretary of the Treasury is asked to comment on the dollar (indeed, the only one authorized to speak on the value of the dollar), he generally states that the US operates with a strong dollar policy. That type of language is generally not spoken by the Ministry of Finance in Tokyo, and indeed, a stronger yen generally leads to more heartburn for Japanese economic policymakers.7