The faith of people on the US dollar around the world in present times could perhaps be compared with a Cinderella-type love story — almost everything to do with look and happenstance, but little to do with logic and cerebellum. At times, the phenomenon of the dollar’s strength assumes an illogical proportion, so much so that the strength of the currency could even get isolated from the strength of the US economy. In fact, there are many instances when a crisis in the US economy has been accompanied by an outflow of funds from the emerging markets and an appreciating dollar, perhaps defying economic logic!
What explains this illogical superiority of the dollar? For one, it is advantageous to hold the dollar, both for the private agents and the central banks. There could be three distinct roles of an international currency for private agents: a stable medium of exchange; a unit of account for invoices; and a store of value for banking. For official agents like the central banks, an international currency could also serve three distinct purposes: a medium for intervention in the foreign exchange market; a foreign currency to which the domestic currency can be pegged; and a reserve currency in which foreign exchange assets can be held.
The dollar is perhaps the only currency that has been serving all these six functions consistently since the breakdown of gold exchange standard in the 1970s. Such a prime position has been termed by economist Barry Eichengreen as an “exorbitant privilege.” However, can these privileges last forever? Does the recent experience of US Federal Reserve’s balance sheet cast some doubt in the future of the dollar?
Bulging balance sheet
At the end of the day, the dollar represents the Fed’s liabilities, which are backed by assets like gold, US government securities and other securities of the various US institutions that qualify as an asset of the Fed. There has been an enormous increase in the size of the Fed’s balance sheet since the global financial crisis, in tune with the country’s policy of quantitative easing whereby liquidity support to various US financial institutions was accommodated as part of the monetary stimulus.
Aggregate assets of the Fed, which were around $890 billion in 2007, jumped to $2.2 trillion in 2008 and continued rising thereafter. After reaching a high of $4.5 trillion by the end of 2017, the Fed balance sheet started contracting, and by September 2019, it touched $3.8 trillion. Since then, the Fed started pumping money again, and after the onslaught of the Covid-19 pandemic, the Fed balance sheet got bloated by nearly $2.8 trillion within a 3.5-month period between March 9 and June 15, 2020! Even as a percentage of the GDP, the size of the Fed balance sheet increased from around 6 per cent in 2007 to 31 per cent by August 5, 2020 (see Chart).
Implications for dollar
What does such a bulge in the Fed balance sheet mean for the dollar? First, since the dollar is a convertible currency, a large chunk of the Fed’s assets is held outside the US economy. In fact, in May 2020, out of the total government securities worth of $6.9 trillion, Japan ($1.3 trillion) and China ($1 trillion), were the top two holders. In this day and age of trade hostility, such huge US government securities holdings outside the country’s economy could have strategic implications. Illustratively, a trade war against China could induce China to shift the composition of its foreign exchange reserves away from the dollar.
Second, with the active pursuit of quantitative easing since the global financial crisis of 2008, the quality of the Fed’s balance sheet has undergone significant drop in quality. Assets of government-sponsored enterprises like Fannie Mae and Freddie Mac, as well as individual corporate papers — including junk bonds — have now entered the Fed balance sheet.
Third, although the US has been significantly affected by the pandemic and the economy is expected to contract considerably in 2020, the exuberance of Wall Street seems to have been generated by the presence of easy liquidity arising out of the bulging balance sheet of the Fed.
Suitable alternative
What do these possibilities imply for the near-term future of the dollar? As the oversupply of the dollar is leading to its rapid depreciation, the notion of stability associated with the currency is fading. Consequently, there is a distinct shift away from dollar-denominated assets among the central banks’ foreign exchange reserves. Data from the IMF suggests that central banks are diversifying their holdings away from US treasury bonds towards Euro-denominated assets.
However, despite its recent weakness, the dollar is still the overwhelmingly dominant currency for international transactions. Many non-US countries invoice their exports and imports in terms of the dollar.
In this respect, the dollar is far ahead of its closest competitor — the euro. Interestingly, more than 50 per cent of all goods imported into the European Union were invoiced in dollar terms in 2018. As historically, international trade has been dominated by one standard currency, it does not seem that there is a strong enough contender to replace the dollar as the new king of international exchange.
The success of an economy is often ascribed both to ‘good policy’ or ‘good luck.’ Perhaps despite non-so-good policies of the US economy, in terms of good luck, the ‘exorbitant privilege’ of the dollar is likely to continue as the world grapples with finding a suitable alternative.
The writers are Professors atIIM-Calcutta