Dollar dominance and Donald Trump

Topics US Dollar

America’s share of global output has fallen sharply since the Second World War but its currency has retained its supreme position. The US dollar (hereafter ‘the dollar’) remains the currency of choice for trade invoicing, denomination of external debts, foreign exchange intervention by central banks, anchoring of exchange rates, and accumulation of foreign exchange reserves. In each of these uses, the share of the dollar is 60 per cent or more. The euro is a distant second. Currencies such as the Japanese yen, the pound sterling, the Swiss franc, and the Chinese renminbi are even further behind.


In the 1960s, Giscard d’Estaing, the then finance minister of France, coined the term “exorbitant privilege” to describe the advantages that currency dominance brought to the United States. The world economy has changed much since then (for example, many advanced countries have floated their currencies) but “exorbitant privilege” persists. It has three main features. Firstly, the US faces a softer balance of payments constraint than other countries. It can borrow more easily to cover current account deficits because the whole world wants to hold dollar assets.  And since America can thereby avoid or postpone balance of payments adjustment, it also enjoys greater leeway in monetary and fiscal policy. This process has provided a cushion for American standards of living in the face of external shocks. It has also come in handy for fighting external wars, for example in Vietnam in the 1960s, and more recently in Iraq.


Secondly, “exorbitant privilege” translates into hard cash. Global demand for dollar-denominated loans creates extra business for US banks: Since dollar lending carries no exchange risk for American banks, they can offer cheaper services than competing banks. In addition, as noted above, currency dominance means that the US can borrow more cheaply than other countries. What is more, this benefit is compounded by the opportunity to reinvest the cheaply borrowed funds in high-yield foreign assets, real and financial. In consequence, as Helene Rey’s careful research has demonstrated, the US has earned an annual excess return of around 2 per cent a year on its net external assets over several decades. Part of this return has its origin in the striking phenomenon that a depreciation of the dollar increases US external wealth. The reason is as follows: When the dollar depreciates, US external liabilities, which are mostly dollar-denominated, remain unchanged in dollar value, while US external assets, which are mostly denominated in foreign currencies, rise in terms of dollars. As a result, the increase in US external debt over the years has been considerably less than the cumulative sum of annual US current account deficits.


The third source of “exorbitant privilege” is that dollar dominance gives the US significant leverage in foreign policy. The main reason is its ability to impose a financial stranglehold on a target country. The example of the moment is Iran. The US has walked out of the Iran nuclear deal and imposed primary and secondary sanctions on Iran, and potentially on all companies, including non-American companies, trading with Iran. But the effectiveness of these sanctions is vastly increased because the US can disrupt Iran’s foreign receipts and payments which, like many countries, are mostly in dollars. Even if Iran were to make and receive dollar payments through European banks, these banks would be unable to carry on for long without dollar support from their American correspondents. And the US government, via the Federal Reserve, can proscribe any American bank from doing business with an Iranian bank or with any bank that does business with an Iranian bank. Circumvention of these prohibitions, though not impossible, would be highly tortuous and inefficient. The EU, which wishes to maintain the Iran nuclear deal, has set up a special purpose vehicle (SPV), called Instex, to trade with Iran. The idea is that companies importing from Iran could pay companies exporting to Iran via the SPV, without any money leaving or entering Iran.  Not surprisingly, these efforts have gone approximately nowhere so far.


The main reason for dollar dominance, apart from pure inertia, is that US government securities are regarded as safe assets par excellence, and the market in which they are traded is unmatched in depth and liquidity. Trust in American laws and institutions has contributed in the past to the perception that the US is a safe haven for money even when the world is in crisis. Moreover, there are currently no suitable alternatives to the dollar and dollar securities. The Chinese renminbi is not fully convertible. The euro lacks a market, let alone a deep market, for safe euro-bonds; and the currency has the reputation of being crisis-prone.


Even so, dollar dominance is not immutable. Its future depends on whether America continues to offer security and stability in dollar assets. This is where Trump comes in. He is erratic in his pronouncements and behaviour. As noted above, he has tried to weaponise the dollar with scant regard for alliance partners. He has also said that he may unilaterally devalue the dollar in order to promote American exports and manufacturing employment. If other countries feel that their dollar assets are not safe, they will jump ship and, slowly but surely, develop mechanisms to replace the dollar payments system. If Trump wins a second term and continues on his merry way, the decline of dollar dominance will gather force. New Delhi and Mumbai should watch carefully. Uncomfortable choices may be in the offing.

 The writer is Emeritus Fellow of Merton College, Oxford                




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