Why Dollar Dominates World Trade

Dollar is ruling world's most preferred currency in the international Trade since 1920 after replacing British Pound Sterling. Many efforts have been made from time to time to replace dollar with other options. Birth of  European Union and Euro posed a threat to it. Despite the Euro being in existence for close to twenty years now, it had only a small impact on the dollar dominance, in fact it has replaced dollar in a limited way, mostly in the trade transactions among the  European Union countries .And before the Euro, it was the Yen. Yet there never seems to be any real, tangible shift in the global trading system. The dollar’s share of allocated currency reserves, or those reported to the IMF, rose to a record $5.05 trillion in the October-December 2016 period, or nearly 64 percent,  , the dollar remains the world’s reserve currency.

In March 2009, China and Russia called for a new global currency. They want the world to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies."China was concerned that the trillions it holds in dollars will be worth less if dollar inflation sets in. This could happen as a result of increased  US Deficit spending and printing of U.S.Treasurys to support US Debts. China called for the International Monetary Fund (IMF) to develop a currency to replace the dollar. In the fourth quarter 2016, the Chinese RENMINBI (RMB)became another one of the world's reserve currencies. As of Q2 2017, the world's central banks held $99.36 billion worth. That's a small start, but it will probably grow in the future. That's because China wants its currency to be fully traded on the global foreign exchange markets. It looks China's intention that yuan to replace the dollar as the global currency. To make it a reality,China has to work very hard to reform its economy and also make it more transparent.

From a layman's  perspective, why a country should try to trade with other countries  in it's own currency ? There is no harm in trying, but the country on the other hand want minimum risk from the possible devaluation threat from its trading partner. Why most country prefer to trade in dollar because of its track record, stability and free from the threat of devaluation. India's almost 100% international trade is conducted in non domestic currency.  

It is often tempting for economists to point out the most intriguing trends and predict the most extreme destruction and doom scenarios. Remember when the Japanese economy was set to overtake the US? Japan spent the next decade with GDP and price level growth of about 0 percent. Sometimes, it is difficult to state a continuation of the status quo.

The data on currency reserves is less than comprehensive. The IMF Currency Composition of Official Foreign Exchange Reserves (COFER) provides some level of detail but has a number of sources missing. (The report analyzes the currency composition of assets—so a US Treasury Bill denominated in dollars counts as dollars). But there are some interesting takeaways from the data. The US dollar constitutes 61 percent of all reported reserves. While this is certainly far from its peak of 72 percent in 2001, it is similar to the levels seen in the mid-90s. In 2013, the data-set covered 53 percent of official reserves—down from a peak of 79 percent in 1997. In other words, the data does not suggest an end to the dollar’s run as the predominant reserve currency. Granted, the 47 percent of reserves labeled “unallocated” could be hiding something, but it is unlikely they are hiding anything momentous.

It is worth understanding how the US dollar won the role of reserve currency in the first place. Though the exact timing is debated (and in this debate time is denominated in decades, not years), the best evidence—from Eichengreen and Flandreau—is that the dollar overtook the pound sterling somewhere in the mid-1920s, lost it briefly, and then regained it in 1929. The Great Depression saw the pound

sterling regain its prominence only to lose its status again to the dollar soon after. France, the China of its day in terms of foreign currency reserves, largely tipped the scales towards dollar dominance.

There is no clean shift from one currency to another. In considering how the dollar could lose its reserve status someday, it is necessary to understand what the shifts look like. It is a slow process, typically accompanied by a crisis. We might reasonably ask why the Great Recession did not have more of an effect on the dollars dominance. The simple answer is that there is, at the moment, no viable alternative. The RMB is heavily manipulated, the Euro has the overhang of its possible dissolution hanging over it, and the Yen is impaired by the Bank of Japan’s relentless easing. Granted, the US Dollar has not performed ideally for a reserve currency, but no currency ever will.

It takes economic stability and the ability to hold value across time to seize and maintain the mantle of reserve currency. The era of quantitative easing could have brought the dollar’s durability as a store of value into question. But it didn’t. The US dollar lost value—but it was never at risk of dissolving. And the only currency with markets liquid enough to challenge the US dollar—the Euro—had deep, idiosyncratic issues of its own. In essence, there was no alternative to the dollar during the crisis, and there remains no alternative now.

Any potential replacement must have enough debt and a large enough economy and a liquid enough market to support it. After all, other countries need to place tremendous amounts of money into the currency—in 2013 official foreign exchange reserves reached just under $11.7 trillion. In other words, being a country with a strong economy and stable currency is not enough. It must have deep and reliable debt markets and be able to support tremendous amounts of asset purchases. The Euro is the only currency with a market of similar depth to the dollar. China does not have the open system necessary for the RMB to be a reserve currency, and would require significant liberalization of currency movements. It may be able to develop a deep market in RMB—we simply do not know. These are not steps China is keen on making while attempting to avoid a slowdown of its own economic growth.

The first is being a medium of exchange. 

 For private sector payments, we already saw that the RMB’s share is minuscule compared to the euro and dollar. Even the RMB’s use in trade with and investment into China is relatively small and no longer growing, according to the report.Public

sector payments between governments and central banks are conducted via central bank swap lines. They allow central banks of different countries to issue money that is not their own. For example, during the financial crisis of 2008, the Federal Reserve provided the world’s central bank with as much as $620 billion in liquidity. China’s swap lines amount to $430 billion, but are hardly ever used.

The second function is being a store of value,so that private players can invest their money in yuan assets like stocks and bonds and preserve their purchasing power. Also here, foreign ownership of Chinese equities is not very large, at around 0.8 percent, and for Chinese bonds, only slightly larger at 2 percent. Foreign bank deposits and loans into China have also been falling since 2014. For the public sector store of value, that is, global central banks’ holding of foreign currency, the yuan’s share is 1 percent, despite the admission to the International Monetary Fund’s (IMF) special drawing rights (SDR) basket late in 2016. The dollar still takes the lion’s share at 64 percent.

The third function is the so-called unit of account. This means that trade invoices, for example, are issued in RMB and then paid in RMB rather than dollars. Also here, even for Australia, one of China’s biggest trading partners, only 0.5 percent of exports to China are invoiced in RMB. For the official unit of account, another country would need to peg its currency to the RMB, but given China’s relatively closed capital account, this hasn’t happened yet. At least the RMB is now part of the SDR, which functions as a unit of account for the IMF, but it only has a 10.9 percent weight.

Lastly, the currency needs to have developed fixed income markets where payments can be parked in the form of bank deposits or bonds. And while local Chinese corporate bond issuance is strong, foreigners aren’t buying into it, and the Chinese government bond market remains small in comparison to those in the United States and Europe. Furthermore, bank deposits in RMB in the so-called global clearing centers are also falling. In Hong Kong, for example, only 5 percent of all bank deposits are in RMB and 37 percent in dollars.

Yesterday, Gita Gopinath, Professor at Harvard Uniiversity was keynote speaker at Commencement Day Celebrations  of Exim Bank of India. When I spoke to her and ask about Yuan replacing dollar , she was also of the view that in the near future there is no threat for dollar dominance. It also seems that China is not in a hurry to push its agenda  but of course, working very seriously.