Predictions for the Dollar as the Reserve Currency

Governments hold foreign currency reserves to help deal with issues such as depreciation in their currency. At the moment, the world’s biggest foreign currency reserve is the US dollar; about 64% of the World’s foreign currency reserves are currently denominated in dollars. This is because, historically, the US economy has been the most secure and powerful economy. However, with the continual decline in the dollar, many countries are fearing that the dollar is no longer the best currency to use and increasingly countries are switching to other currencies such as the Euro.

Pricing of Commodities in Dollars

A separate, but related issue, is that most commodities, e.g. oil prices, are also priced in dollars. Oil prices are denominated in dollars because currently, the dollar is the most common currency. If the dollar was to be replaced by the Euro as the world’s currency reserve; it is more than likely that we would see commodities priced in Euro’s. In fact, some countries are already starting to use the Euro rather than the dollar

Will the Euro Replace the Dollar as the World’s Reserve Currency?

• Since 1999, the Dollar’s share of the world’s currency reserves have fallen from 70.9% to 64%
• In the same period, the Euro has increased from 17.9% to 25.8%
• (the 3rd biggest reserve currency is the Pound sterling 4%
• (the 4th biggest reserve currency is the Japanese Yen 2.8%)

Why the Euro May soon Replace the Dollar

• The Dollar has been very weak in the past 8 years. Against the Euro, the Dollar has fallen by over 30% since 2001. The Dollar has also fallen against the Yen and other currencies. This means that countries holding reserves in dollars are seeing a decline in their value. For example, China has over $1,400 billion of dollar reserves. A 20% devaluation represents a significant loss for them. Therefore, the rational step is to diversify out of the dollar.
• Countries dropping the Dollar Peg. Many middle eastern Countries such as Saudi Arabia, Kuwait and Syria used to maintain a dollar peg. However, there are signs that they no longer want to keep a peg against a devaluing dollar. Kuwait and Syria have dropped their peg and Saudi Arabia recently decided not to follow the US in cutting interest rates.
• Dollar’s weakness may continue. The US economy is continuing to slow down as it remains hard hit by the housing slump. US interest rates have fallen and may continue to fall by more than the Eurozone. As interest rates in the US are low it becomes less attractive to buy US dollars so the devaluation will continue.
• US Trade Deficit (current account deficit of 5%). In recent years, the US has built up a large current account deficit. This has caused an outflow of currency and is a factor in maintaining the weakness of the dollar. (although the recent devaluation though has helped reduce the deficit from over 6% to 4.7%)
• The Euro is a real alternative. The Euro economy is now as large as the US. The Euro may also be seen as more politically desirable. European countries were less willing to get involved in Iraq and many accuse the US of an ‘imperial overreach’ with too many foreign bases and interference around the world. The European Union, by contrast, provides greater diversity and is politically more attractive, especially to middle eastern countries.
• Better inflation performance of the Eurozone to the US. There was a marked contrast in response to the recent credit crisis. The US slashed rates to 2.25%, the ECB barely cut rates at all. The lower rates and devaluation of the dollar makes future inflation in the US more likely, this will only make the US less attractive.

Changing the world’s reserve currency is something that doesn’t happen very often. The US has enjoyed a hegemony really since the end of the First World War. However, that is no reason to suggest that the dollar’s influence will continue. Sooner or later, economic fundamentals are likely to cause people to shift out of the dollar and into alternatives. I will look at the consequences of this potential change in future essays.

Related

• Effects of a falling dollar
• Why do foreigners hold US dollars?
• Will the Euro Replace the Dollar at Economist's view
• Why the Euro will soon replace the dollar as the world's reserve currency