Long-term Alternatives to the U.S. Dollar

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

Both China and Russia have discussed publicly viable, long-term alternatives to the U.S. dollar. Both have also publicly expressed their intentions to reduce exposure to the greenback and hold more of other currencies in their foreign-exchange reserves. Last year, the Chinese central bank’s governor, Zhou Xiaochuan, went so far as to predict that the U.S. dollar could one day be replaced as the dominant currency on the world stage. Perhaps not replaced with another single currency, but with a basket of “super-sovereign” currencies, the selection of which would depend on their respective reserves held with the International Monetary Fund’s in-house accounts.

After the initial shock of Xiaochuan’s statement had worn off, many economists interpreted this statement as an attempt to give the yuan, China’s currency, a more prominent role on the global stage; one reflecting China’s growing economic influence on that same stage. Of course, this is not something that can happen overnight, but it is also not entirely outside the realm of imminent possibilities either.

China is already putting its money where its mouth is. It has quietly set up currency swaps worth approximately $95.0 billion with central banks all over Asia, Latin America, and Eastern Europe. This would allow China to export its products somewhere else other than the U.S. and receive payments in the yuan instead of in the U.S. dollar.

Besides the yuan, the next currency in this selection process for supplanting the greenback is the euro, which, like the yuan, is tied to an economic area where there are no inherently common political or fiscal policies. This is partly the reason why solving Greece’s debt problems is so complex and difficult. The only problem with the “Eurozone” is that it lacks the breadth and depth of a bond market to match the depth and liquidity of the U.S. Treasury market.

Regardless of which currency on its own is able to supplant the U.S. dollar, if any, the fact remains that capital markets of emerging economies are opening up and their currencies constitute growing portions of world central banks’ reserves. However, as long as the U.S. manages to maintain sound macroeconomic policies and makes sure its markets are open and liquid, the unseating of the U.S. dollar will have to wait.

That is, of course, part of the problem, too. The state of the U.S. public finances is indeed a sorry matter and very likely the dollar’s ultimate undoing. In February, the White House said that the budget deficit for 2010 was going to reach $1.565 trillion, which represents nearly 11% of U.S. GDP, also the largest deficit since World War II.

Of course, the situation was further exacerbated with America running large trade and budget deficits before the financial and credit crisis struck. Going into the Great Recession, the U.S. economy was already weak and could only have weakened more trying to get out, and recover from, it.

Some economists believe that this is not the end of the road for the U.S. dollar. U.S. finances are in bad shape, true, but are not completely unmanageable. This implies a weaker dollar for the near future in order to advance exports and thus reduce the trade deficit and eliminate several decades of reckless spending.

To help the economy recover, the U.S. needs to invest in education and the country’s infrastructure, at the same time keeping a high level of economic output and productivity. The latter will not happen, however, without fixing the labor market, which is facing serious, perhaps even insurmountable, challenges.

Potentially undermining the U.S.’ economic might and, by extension, the U.S. dollar’s supremacy in currency markets, are the coming higher interest rates, higher taxes, and the resulting slower economic growth. On the other hand, there is also the strange love-hate relationship between China and America. Although the U.S. depends on China’s kindness to keep on financing its deficit, while China also depends on reckless U.S. consumers to keep on buying Chinese goods and services.

That said, according to some analysts, factoring in China’s massive economic growth produces an awkward result, which is the yuan remaining undervalued versus the dollar by as much as 40%. Therefore, although China’s economy is in a much better place than the U.S. economy has any chance of achieving ever again, the yuan still has a long way to go before it may supersede the U.S. dollar. In fact, currently the yuan is trapped, because the Chinese have so
many U.S. dollars they simply cannot diversify, at least not easily. However, if the rebalancing of world economic powers continues, the dethroning of the U.S. dollar could happen sooner than later, just as it happened to the British so many decades ago.