The Reserve Currency Debate
By Ed Ponsi, President of FXEducator.com
Greetings from London! The Group of Twenty (G20) meeting is in full force just a few miles away, and the world is waiting to see if world leaders can come to a consensus on how to deal with the financial crisis. Some feel that at least part of the problem lies in the U.S. Dollar's status as the world's reserve currency. Lately there has been much talk about shifting the world's reserve currency away from the U.S. Dollar and toward a so-called "super currency."
First of all, what is a reserve currency? Reserve currencies are held by governments and institutions outside the country of issue and are used to finance international economic transactions, including trade and the payment of debts. A country might stockpile U.S. Dollars in case they may want to sell them and purchase their own currency, in order to boost the exchange rate. This is known as intervention, and it has happened recently in Australia, Brazil, and Mexico, among other places. Another reason to keep a supply of USD handy is because key commodities, such as oil and gold, are priced in U.S. Dollars.
Why do countries want to replace the U.S. Dollar as the world's reserve currency? If the U.S. Dollar becomes volatile, as it has recently, this can cause large swings in the value of financial holdings outside the U.S. A strong dollar makes it much more difficult for entities outside the U.S. to pay back loans that are denominated in USD. Critics also say that the United States enjoys an unfair benefit as the printer of the world's premier reserve currency.
And of course, haters like Venezuela's Hugo Chavez and Iran's Mahmoud Ahmadinejad would love to see the U.S. lose the prestige and influence that comes with possessing the world's reserve currency. "Soon we will not talk about dollars because the dollar is falling in value and the empire of the dollar is crashing," said Chavez on November 19, 2007. "Naturally, with the crash of the dollar, America's empire will crash." Ahmadinejad has led the charge for OPEC nations to price oil in currencies other than the U.S. Dollar, which he refers to as a "worthless piece of paper."
Please understand that any shift away from the USD toward either the Euro or a "super currency" would be devastating for the U.S. Dollar. To illustrate this, please consider the events of March 25, 2009. On that day, Treasury Secretary Timothy Geithner responded to a question from a reporter. The reporter asked Geithner for his thoughts about the proposal by the governor of China's central bank to replace the dollar with a new global reserve currency. Here is Geithner's reply:
"We're actually quite open to that suggestion – you should see it as rather evolutionary, rather building on the current architecture rather than moving us to global monetary union," he said. As word of these remarks reached traders, the greenback abruptly lost 180 pips to the Euro in just eight minutes, and suffered a similar plunge against other currencies (see figure 1).
Figure 1: Euro rockets higher vs. USD on 1-minute chart, and then reverses. Source: Trade Station
A few minutes later, Geithner furiously backpedaled on his comments by saying that there is "no change in dollar as world's reserve currency and likely to remain so for long time." As those words crossed the newswire, the buck reversed course and gained back most of the ground lost just minutes earlier.
I think Geithner is a bright guy, but am I the only one who is growing tired of his on the job training? For years, the U.S. Treasury Secretary has repeated one mantra, over and over. Here it is: "A strong dollar policy is in the best interests of the U.S." That's it. Mr. Geithner should commit those words to memory.
The scary part is that his comments seem very well thought out and articulate, so I don't think it was a gaffe. What if in his heart of hearts, his initial comments reflect his true feelings on the subject? What if he really believes that the USD should be replaced as the world's reserve currency, that such a move would be "evolutionary" as he put it? What sort of an impact would that have on the U.S. Dollar? Consider the damage that Mr. Geithner was able to do in eight minutes, and now imagine if that policy – to which he says he is "quite open" - was actually implemented. How far would the U.S. Dollar fall in eight days, in eight months, or in eight years? One can only hope that we never find out.
So what is this so called "super currency" that would replace the U.S. Dollar as the world's reserve currency if China and Geithner have their way? The likely choice would be an SDR. In 1969, the International Monetary Fund (IMF) created an international reserve currency called a Special Drawing Right, or SDR. An SDR is not an actual currency, but an artificial currency that is really created from a basket of currencies. That basket consists of the Euro, Japanese Yen, British Pound, and U.S. Dollar.
We in the U.S. take it for granted that the Dollar is the dominant currency of the world, but this was not always the case – the Great Britain Pound once held the title as the world's reserve currency. The U.S. Dollar was not always the reserve currency, and it will not remain the reserve currency of the world if we allow it to fall. Please keep in mind that the actions we take today have consequences for the future.
Ed Ponsi
