The Dollar Ain't Picture Perfect, But What's Better?

By Brad Zigler

Everybody's got an opinion on the dollar, ranging from its aesthetics (for the most part, people think greenbacks lack that) to its utility (we hear a lot from folks bemoaning its use as a fiat currency).

Voices were raised in recent months in favor of doing away with the dollar as a reserve currency, the most strident emanating from exporters of dollar-denominated commodities, such as Russia, and nations like China that hold large swatches of U.S. government paper.

So, what's a reserve currency and why should the buck get the boot?

A reserve currency is simply a store of value, held by a central bank and denominated in the legal tender of another nation, that facilitates international trade and foreign exchange. The modern notion of a reserve currency came about in the late 19th century along with the emergence of the international gold standard.

The U.S. dollar is the most widely held reserve currency, representing about two-thirds (10-year weighted average: 65.9%) of central bank foreign exchange holdings. The hegemony enjoyed by the greenback makes it easier for the U.S. to run and maintain high trade deficits, a consequence of the nation's debt-financed consumerism and low savings rate. The greenback's preeminence is eroding, though. Its allocation in central bank reserves has been chipped away at a rate of 70 basis points (0.7%) a year over the past decade.

Central Bank Currency Holdings: Percentage Of Allocated Reserves

	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008	Avg
US Dollar USD	70.9	70.5	70.7	66.5	65.8	65.9	66.4	65.7	64.1	64.0	65.9
Euro EUR	17.9	18.8	19.8	24.2	25.3	24.9	24.3	25.2	26.3	26.5	24.8
British Pound GBP	2.9	2..8	2.7	2.9	2.6	3.3	3.6	4.2	4.7	4.1	3.7
Japanese Yen JPY	6.4	6.3	5.2	4.5	4.1	3.9	3.7	3.2	2.9	3.3	3.8
Swiss Franc CHF	0.2	0.3	0.3	0.4	0.2	0.2	0.1	0.2	0.2	0.1	0.2
Other	1.6	1.4	1.2	1.4	1.9	1.8	1.9	1.5	1.8	2.0	1.7

Source: IMF

The euro, launched in 1999, now represents a quarter (a 24.8% weighted average) of allocated reserves and is the second-most commonly held currency in the world. Since its introduction, central banks have gradually added to their euro holdings, largely at the expense of the dollar, in recognition of the European trading bloc's growing influence and as a means of diversifying risk. Euro allocations are building at an 85 basis-point compound annual rate.

The British pound sterling comes in a distant third (weighted average: 3.7% of allocated reserves), having slipped from its former role as the world's most heavily banked currency. Though sterling makes up a small percentage of global reserves, holdings have nearly doubled over the past five years, largely because of the quid's higher yields. Vagaries in sterling's trend in the last decade have allowed commitments to grow an average 12 basis points a year.

The exact opposite scenario has prevailed for the Japanese yen (3.8% weighted average). As with sterling, the yen's importance as a reserve currency has been waning for decades, but in the wake of the Japanese asset bubble implosion, the yen's diminution accelerated. Allocations are falling at a 31 basis-point annual rate.

Owing to its relative stability, the Swiss franc is often referred to as a reserve currency, though allocations are, and have traditionally been, quite small. Commitments average only 0.20% and have actually been eroding by 1 basis point a year.

The Dollar Problem

China became the most vocal advocate for a global move away from the dollar this spring. There's plenty of reason for the Chinese to fret. Years of U.S. Treasury purchases and export trade by Beijing have produced a $2 trillion pile of greenback assets. If Washington's burgeoning budget deficit can't be reined in, any consequential weakening of Yankee paper could leave the Chinese holding the bag.

Alarmed by the U.S. response to the financial crisis in March, the governor of the People's Bank of China floated the notion of supplanting the dollar and the euro as global reserve currencies with special drawing rights (SDRs).

SDRs, introduced by the International Monetary Fund (IMF) in 1969, were originally created to replace gold and silver in large international transactions. SDRs are credits that nations with trade balance surpluses can draw upon nations with trading deficits. Since SDRs are ledger entries, their use eliminated the logistics of shipping bullion back and forth to settle national accounts.

SDRs essentially represent the value of a trade-weighted basket of currencies. That basket now consists of four currencies: the U.S. dollar, the euro, the Japanese yen and the pound sterling. SDR basket's makeup is determined every five years by the IMF Executive Board.

The Chinese proposal would enlarge the SDRs basket to include more currencies (read: the renminbi) and establish a settlement system that would make SDRs convertible and tradable.

And well it should, because the current SDRs are essentially a proxy for U.S. dollars. Price the greenback and SDRs in gold and you end up with an r² correlation of 99.6%.

SDR And USD In Gold

There'd be little risk shed by using the current iteration of SDRs as a reserve currency instead of the dollar. The other components of the SDRs basket are themselves strongly correlated to SDRs, ranging from a 91.7% coefficient for euro to an 87.8% coefficient for sterling and 81.6% for yen.

Still, adding other currencies to the basket and attempting to float the SDR as a currency introduces another set of risks and challenges.

First of all, there's no global banking support for widespread use of SDRs among private parties and businesses. Developing an infrastructure for SDR use would be many times more daunting than that required to bring the euro online.

Second, the Chinese proposal includes a provision for turning over a portion of each SDR's component nation's reserves for IMF management, an insult to the sovereignty of the nations involved.

Most important, though, is this: The Chinese renminbi isn't freely convertible. It's only being gradually de-pegged from the U.S. dollar. Making the currency convertible would require a lowering of trade barriers and an increase in foreign access to Chinese markets. That means fundamental political change in Beijing, something not easily achieved. There's no track record for the renminbi as a fully convertible currency and no track record for the bankers who'd be obliged to manage it in global markets.

Jawboning?

The proposal put forth by the People's Bank chairman as well as that offered contemporaneously by Russian President Dmitry Medvedev could just be the jawboning done before important economic summits in the hope of raising their visibility. Were they just attempting to kick the dollar down a notch or two? Or prod for some concession at the table?

Now, with some two or three months' distance attained, and some stability returning to the markets, other apparatchiks of the Chinese and Russian financial systems are actually pooh-poohing the notion of stripping the dollar of its reserve currency status.

Just this month, the chairman of the China Construction Bank and the former head of the country's foreign exchange administration, Guo Shuqing, announced in a Financial Times interview, "I don't think we can find another currency to replace the U.S. dollar. We've had SDRs for many years but everybody knows they don't work so well."

And, ahead of the recent G8 summit, Russian finance minister Alexei Kudrin chimed in by saying there was "no alternative" to the greenback as a reserve currency. Adding yet one more opinion to the mix, Kudrin said he felt confident that dollar was in "good shape."

See? EVERYBODY'S got an opinion.

Comments

[AuGod!:]

Any notion of the American dollar being a store of value in terms of practical Main Street applications is pure lunacy. As for its macro-use to facilitate international trade, it is still the tallest midget in the room. Going forward, if international trade is to continue, which it will, accomodations will be found. A sophisticated barter system is in the works among BRIC, nothing more; international liquidity still hinges on the USD. Now when push comes to shove (read deflation comes to inflation) those monetary phenomona, now in a dance of sorts, will come to roost squarely on the shoulders of the consumer. That is the fate of ALL fiat. Gold is gold.

Jun 19 12:39 PM

[dw57:]

we used to have private currencies printed by banks. that was a bigger failure than any thing else, mainly because banks wouldn't take each others currency


On Jun 19 09:38 AM JohnAl wrote:

> The history of money is the history of how those who control it -
> almost always governments - use that control to rob others of their
> wealth. In ancient times it was through debasement of the gold or
> silver coins. In modern times it's done via the printing press (real
> or electronic).
>
> It's a complete pipe dream of course, but in the best of all possible
> modern worlds, money would be privatized. As long as they maintain
> control governments won't let it happen, but there's no reason that
> privatized, electronic, PM or commodity backed currencies couldn't
> work as the world's reserve currency(s). All users of such a currency
> would need would be trust in it's future value, trust which could
> be built over time through regular audits by trusted entities.<br/>
>
> The current problem with the dollar (and to an extent it's always
> there with every government fiat currency) is that there is a growing
> lack of trust in it's future value. With good reason.
>
> Oh, and a privatized money would have one other effect. Some of
> us think it would a quite positive effect on most everyone's wealth.
> It would reduce government's ability to borrow, and without the ability
> to borrow government would be forced to downsize to a size that the
> citizenry were willing to support through current taxation.

Jun 19 12:41 PM

[Boxed Merlot:]

On Jun 19 07:01 AM Moon Kil Woong wrote:
…That is why the framers of the constitution gave these powers to Congress so they rested under the command of the people's will. They never intended it to be held in the hands of private interests like the Fed which operates primarily for the interest of its members (the banks)…

Article One
Section 8. The Congress shall have power to… borrow money on the credit of the United States…to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;…and…To establish…uniform laws on the subject of bankruptcies.
Evidently the only “money” Congress is allowed to possess is “borrowed on the credit of the US”, which would necessitate the pre-existence of such outside its current ownership, or it would have to “coin” it’s own. These seem to me to be the controls our framers had in mind. As for the handling of the recent bankruptcies, it appears the “uniform laws on the subject” have been sorely missing.

Jun 19 12:45 PM

[Canadian Re...:]

I think we are in transition time. In the short term, US$ will still be the reserve money or currency for trade setlement. In the long term, who knows. Of all probability, US$ will become less and less dominant. There may be more bilateral agreements. I believe that's what the Chinese government is doing now. I know of a few major projects where the Chinese contractors were getting paid in commodities, totally bypassing US$.

When I purchased materials for a couple of projects in China, the suppliers insisted on being paid in Deutch Marks. We also bought steel in RMB (yuan). If this trend keeps up, it will not be good for USA. USA may find itself not able to buy as much as they used to when suppliers asked to be paid in any currency other than US$. That will be interesting days for all concerned.

Jun 19 01:35 PM

[Vuke:]

Whatever is chosen to hold safe value should be portable and compact, near indestructible and impossible to counterfeit or debase.

As currency it should be attractive, brightly shining and easy to recognize by others. Above all, it should inspire confidence.

Jun 19 02:12 PM

[Boxed Merlot:]

Sounds like a perfect description of a Federal Reserve Note to me.


On Jun 19 02:12 PM Vuke wrote:

> Whatever is chosen to hold safe value should be portable and compact,
> near indestructible and impossible to counterfeit or debase.
>
> As currency it should be attractive, brightly shining and easy to
> recognize by others. Above all, it should inspire confidence.

Jun 19 03:01 PM

[TinyTim:]

hard to feel bad for the Chinese, they manipulated their currency against the USD to stimulate the imbalance of trade that jacked up their reserves.

good article and comments.

I'd been wondering about SDR's

Jun 19 05:39 PM

[Kinabalu:]

"China became the most vocal advocate for a global move away from the dollar this spring... The Chinese proposal would enlarge the SDRs basket to include more currencies (read: the renminbi)"

If China really wanted their currency to play a bigger part in global trade they have the perfect weapon to do that. They can eliminate the crawling peg. Of course, that would have some other consequences that they wouldn't be so happy about.

Jun 19 05:56 PM

[Boxed Merlot:]

I apologize for being so naïve about such things, but are you saying they could barter their treasury notes for a place at the table of “legitimate currencies” but with the future cost being the participation with the rest of the world on,(a more or less), equal footing?... If so, then that's pretty interesting and almost kinda obvious.
Who would / could determine their value? I believe our, (the US constitution), system puts that responsibility, (from the US perspective), on our Congress. That’s very spooky to me at this point in time. In addition to the familial relationships with our representitive member(s) and /or their spouse(s), I doubt they're up to the task. Especially given their blatant disregard for “too big to fail” status of recent bankruptcies.


On Jun 19 05:56 PM Kinabalu wrote:

> "China became the most vocal advocate for a global move away from
> the dollar this spring... The Chinese proposal would enlarge the
> SDRs basket to include more currencies (read: the renminbi)"
>
> If China really wanted their currency to play a bigger part in global
> trade they have the perfect weapon to do that. They can eliminate
> the crawling peg. Of course, that would have some other consequences
> that they wouldn't be so happy about.

Jun 19 06:45 PM

[Brad Zigler:]

Check your math.

Yes, SDRs are weighted 63.2% in favor of the dollar. That's 63 cents of the SDR's present $1.54 value. Yes, that's 41%.

But, the euro, the second-largest component in the SDRs basket, is base-weighted at 41%. Converted to dollars, that puts the euro's effective weight at 57 US cents, or 37% of the SDRs total.

The yen and sterling collectively make up the 12% weighting balance.

While the buck doesn't make up the MAJORITY of the SDRs weighting presently, its PLURALITY makes it the most influential. That's made clear when you view the price movements of the SDRs and the dollar in gold terms. SDRs, remember, were meant to replace gold.

The chart in the article shows the value of the dollar and SDRs over a multi-year period when currencies vigorously bobbed up and down in gold terms. And still, the greenback's movements explain 99.6% of the SDRs value fluctuations.

None of the other currencies correlate so well to SDRs.

That says "proxy" to me.



On Jun 19 09:29 AM Living4Dividends wrote:

> Hard Assets Investor, you said "the current SDRs are essentially
> a proxy for U.S. dollars."
>
> This is not true.
>
> SDRs represent the value of a trade-weighted basket of four currencies:
> the U.S. dollar, the euro, the Japanese yen and the pound sterling.
> According to the IMF's website, the dollar proportion of the SDR
> is 0.632000 / 1.541617 = 41%
>
> The dollar makes up only 41% of the SDR, since the dollar makes up
> less than half of an SDR, the SDR cannot be considered a proxy for
> the Dollar.
>
> True, you have shown that the SDR and dollar have been strongly correlated,
> but if the dollar were to significantly decline or appreciate against
> the other major currencies, the SDR would no longer track the dollar.

Jun 20 01:01 PM

[Brad Zigler:]

"When I purchased materials for a couple of projects in China, the
suppliers insisted on being paid in Deutch Marks"

Must have been a project done a while back. Deutsche marks were replaced by euros in 1999. Are you saying that the Chinese wanted non-dollar payments a decade ago?


On Jun 19 01:35 PM Canadian Red Neck wrote:

> I think we are in transition time. In the short term, US$ will still
> be the reserve money or currency for trade setlement. In the long
> term, who knows. Of all probability, US$ will become less and less
> dominant. There may be more bilateral agreements. I believe that's
> what the Chinese government is doing now. I know of a few major projects
> where the Chinese contractors were getting paid in commodities, totally
> bypassing US$.
>
> When I purchased materials for a couple of projects in China, the
> suppliers insisted on being paid in Deutch Marks. We also bought
> steel in RMB (yuan). If this trend keeps up, it will not be good
> for USA. USA may find itself not able to buy as much as they used
> to when suppliers asked to be paid in any currency other than US$.
> That will be interesting days for all concerned.

Jun 20 01:08 PM

[Brad Zigler:]

Checking MY math again ...

The SDRs basket is 22%, not 12%, weighted to yen and sterling.


On Jun 20 01:01 PM Brad Zigler wrote:

> Check your math.
>
> Yes, SDRs are weighted 63.2% in favor of the dollar. That's 63 cents
> of the SDR's present $1.54 value. Yes, that's 41%.
>
> But, the euro, the second-largest component in the SDRs basket, is
> base-weighted at 41%. Converted to dollars, that puts the euro's
> effective weight at 57 US cents, or 37% of the SDRs total.
>
> The yen and sterling collectively make up the 12% weighting balance.
>
>
> While the buck doesn't make up the MAJORITY of the SDRs weighting
> presently, its PLURALITY makes it the most influential. That's made
> clear when you view the price movements of the SDRs and the dollar
> in gold terms. SDRs, remember, were meant to replace gold.
>
> The chart in the article shows the value of the dollar and SDRs over
> a multi-year period when currencies vigorously bobbed up and down
> in gold terms. And still, the greenback's movements explain 99.6%
> of the SDRs value fluctuations.
>
> None of the other currencies correlate so well to SDRs.
>
> That says "proxy" to me.
>

Jun 20 01:52 PM

[buddhabill:]

What is the US percentage of global GDP (GGP) over the past 10, 20, 30 years and projected over the next 10, 20, 30 years?

I'm too lazy to do the research because I'm making a big picture point here: The United States IS losing it's global economic dominance. We WERE the market in the past, and we MADE the market in the past. But we have exported so much of our wealth and are COMMITTED to exporting even more (i.e. oil) for the foreseeable future.

But as the title of the article states, there are no viable alternatives on the immediate horizon. Lucky us, else the dollar would be synonymous with the Lira.

Jun 20 05:25 PM

[one eye:]

The USD is the Primary Reserve Currency, It Is not the Only Reserve currency.

The USD is not a Currency onto itself. It is based on a basket of currencies one of which, the Euro, Is based on an even larger Basket of Currencies.

Can an Intrinsic value be found? How can we know what it is actually worth?

And with the Destruction of Wealth that has occurred coupled with the Massive Debt created and about to be created, Is It worth anything at all?

Jun 20 05:59 PM

[Brad Zigler:]

No one posited the dollar as the ONLY reserve currency. As the article points out, it's simply the most widely held.

If you're looking for intrinsic value, why not price the dollar -- or any other currency -- in gold as was done in the article's graph?


On Jun 20 05:59 PM one eye wrote:

> The USD is the Primary Reserve Currency, It Is not the Only Reserve
> currency.
>
> The USD is not a Currency onto itself. It is based on a basket of
> currencies one of which, the Euro, Is based on an even larger Basket
> of Currencies.
>
> Can an Intrinsic value be found? How can we know what it is actually
> worth?
>
> And with the Destruction of Wealth that has occurred coupled with
> the Massive Debt created and about to be created, Is It worth anything
> at all?

Jun 20 08:17 PM

[one eye:]

Brad: none of the other Reserve Currencies is Based on Gold, so there wouldn't be a comparison. And how would you price the USD in Gold except by Fiat, some arbitrary figure?

I am not questioning the Article or the attempt to get the USD back under the Gold Standard.

What I'm asking for is Help to determine what the Value of the USD would be if it were not priced as a Basket of Other currencies, a standalone Currency right now. Compared to the Pound, Yen, whatever.

After all, Britania Ruled the Waves and was the Primary Reserve Currency until the USD supplanted it. As such it had a value before that change. What would that value be assuming it never became The Reserve Currency and it wasn't on A Gold Standard?

Jun 21 12:50 AM

[Brad Zigler:]

I'm not talking about central bank "pricing" of the currency. The foreign exchange markets provide real-time pricing through cross-rates.

The amount of currency in private hands, too, exceeds central bank stashes, so intervention in the forex markets tends to provide only short-term bumps in cross-rate trends. Forex speculators can, and do, often outgun central bank open market operations.

If you're looking for a currency's "intrinsic value," why WOULDN'T you use gold as your benchmark? The valuation is global, instantaneous, transparent and subject to arbitrage.

That, to me, makes gold a pretty good metric.

Jun 21 10:21 AM

[one eye:]

Just answer the question, instead of asking more questions.?

If you align the USD to Gold and all other currencies at the same time to Gold, you haven't accomplished anything. The same ratios are maintained.

What would be the Point of the Entire Exercise?
Other than one of Futility?

Don't like the Questions? Don't set them up?

Jun 21 01:33 PM

[one eye:]

BTW, Just in case you don't understand.

The USD Is a "basket of currencies", if the USD is aligned to Gold, So Are All of The Currencies within that Basket.

Jun 24 02:29 AM

[Canadian Re...:]

The supplier was German manufacturer with local representation. I presumed they did not want to take the foreign exchange risk.


On Jun 20 01:08 PM Brad Zigler wrote:

> "When I purchased materials for a couple of projects in China, the
>
> suppliers insisted on being paid in Deutch Marks"
>
> Must have been a project done a while back. Deutsche marks were replaced
> by euros in 1999. Are you saying that the Chinese wanted non-dollar
> payments a decade ago?

Jun 25 06:47 PM