The future of the dollar

“The reserve currency status of the U.S. dollar, for good and for ill, will erode neither quickly nor dramatically. But change it will.”

Barry Eichengreen, writing in The American Interest, on the future of the dollar as the world’s reserve currency:

The week between Christmas and the New Year is normally a quiet time for economic news. On December 25, 2011, however, headlines were ablaze with the news: China and Japan had reached an agreement to use their own currencies in trade and financial transactions. Their governments would establish a market for direct exchange of yuan and yen, avoiding the convoluted process in which a bank or firm in one country must first sell its national currency for dollars and then use them to buy the currency of the other. As part of the same agreement, Japan’s central bank agreed to hold more of its foreign currency reserves, most of which are in dollars, in yuan instead.

This historic accord was widely seen as a rebuke to the dominance of the dollar in international transactions. The dollar is involved in 85 percent of global foreign exchange trades. Fully 80 percent of all over-the-counter foreign exchange transactions involving the yuan and the yen are trades of those currencies for dollars. While neither China nor Japan divulges the share of its foreign exchange reserves held in dollars, educated guesses put that figure at more than 60 percent in both cases—even higher than the share of dollars in central bank reserves worldwide.

It is far from clear why the world’s second and third largest economies, both in Asia, should continue to utilize the dollar so heavily. The situation is probably best understood as a holdover from the past, when the two countries did little business with one another but traded extensively with the United States. Not so long ago, the United States was the world’s leading exporter and dominant foreign investor. The United States was the only country of economic consequence whose financial markets were fully open to investors, both private and official, from around the world. New York was the leading center for international financial transactions of all kinds. All this made it logical that firms, banks and governments should become habituated to a world in which the vast majority of international transactions were in dollars. And such habits, once formed, die hard.

This habit, however, in the view of the Chinese and Japanese governments, has outlived its usefulness.

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This entry was posted in 2007-2012, money and finance, the great contraction. Bookmark the permalink.

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