Journey to Never-Never Land: Questioning the Dollar’s Reserve Currency Status

Two hours before the US Treasury Department was to run out of its authority to borrow, Congress passed a bill to reopen the government and to suspend the debt ceiling until 7th of February next year. Along with ‘extraordinary measures’ (i.e. accounting manoeuvres), the Treasury may be able to avoid reaching the debt ceiling until April next year.[1] While immediate financial disaster has been averted, the events last week had posed real danger to world financial stability, and have called into question the suitability of the US dollar as a reserve currency.

Image courtesy of Gage Skidmore, © 2013, some rights reserved.
Image courtesy of Gage Skidmore, © 2013, some rights reserved.

At the end of the Second World War, the US Dollar replaced the Pound Sterling as the world’s reserve currency. US Treasury Bonds are considered to be the safest and most liquid asset in the market, and thus play a pivotal role in the functioning of the global economy. In fact, US treasury bonds are considered so safe that, in August 2011, when Standard and Poor’s agency downgraded the US federal government’s credit rating from AAA (outstanding) to AA+ (excellent), the prices of US Treasury Bonds actually rose. The total current amount of US treasury bonds (i.e. national debt) outstanding is US$ 14.8 trillion, of which US$ 10.1 trillion (roughly 1/7 of world output in 2012[2]) is held by parties other than the US federal government[3]. US treasury bonds fulfil myriad roles, one of the most important being acting as a high quality asset underpinning the fractional reserve banking system. Simply put, banks only keep a small part of their deposits and lend out the rest. How much banks can lend is determined by the amount of high quality (i.e. liquid) assets it holds. If the US government defaults on its national debt, US treasury bonds would no longer be considered ‘safe’ assets, and banks would have to recall loans to shore up reserves. Meanwhile, the market for short-term loans between banks would also freeze up, as banks can no longer be certain of each other’s financial sustainability. This, in turn, would set off a financial crisis and a recession.[4]

Given the scale of the potential calamity, the remarks of some republican politicians make for Kafkaesque reading. In an interview with the Washington Post this month, Ted Yoho, Tea Party freshman congressman from Florida, quipped that a US default would bring stability to world markets, as it would show US commitment to curbing its national debt[5]. Republic senator Tom Coburn from Oklahoma simply denies the possibility of default. He reassured voters on television that the US would still be able to pay interests on its bonds and issue new debt without suspending or raising the debt ceiling. The aforementioned remarks speak to widespread ignorance (not to mention innumeracy) of some US politicians and their constituencies, and their willingness to play with fire and hold the world economy hostage for domestic political gain.

Implicit in dollar’s reserve currency status is a contract between the US and the rest of the world. On one hand, the US enjoys the privilege of borrowing at low interest rates, and the ability run persistent current account deficits. The other end of the bargain is that America is responsible for maintaining a stable and liquid market for US treasury bonds and the US dollar. However, there is now a growing perception among the nation’s debtors that the US government is no longer interested in holding its end of the bargain. In an editorial this month, Xinhua, China’s official mouthpiece, criticised Washington for jeopardising the world’s dollar-denominated assets[6]. That Song Hongbing’s ‘Currency War’, a Chinese book expounding a conspiracy theory of Zionist control of world currencies (especially the US dollar), sold 200,000 copies, points to deep-seated doubts in China on the wisdom of using the dollar as a reserve currency.

While the US dollar is not without its supporters (which include, ironically, the chief executive of Hong Kong’s Monetary Authority[7]), recent developments indicate that central banks around the world are planning to reduce reliance on the US dollar as their reserve currency. In 1995, 74.5% of the world’s official foreign exchange reserve was in US dollar; in 2013 the figure has dropped to 54.5%[8]. In the past few years, the People’s Bank of China, the Chinese central bank, has signed currency swap deals with its counterparts in Korea, Hong Kong, Australia, Singapore, the UK, and most recently, the EU. The deals enable these economies, to a certain degree, to bypass the US dollar when trading with China. The deals would also ensure adequate supplies of Chinese Yuan in a crisis.

 In the short term, there is no credible alternative to the US dollar as the global reserve currency. The Eurozone crisis has ruled out the Euro’s prospect of becoming the dominant reserve currency for at least a generation, and the Yuan is far from ready to take centre stage. When asked if Hong Kong should peg its currency to the Yuan instead of the US dollar (in effect, using the Yuan as the territory’s primary reserve currency), Hong Kong’s central bank vigorously refuted the possibility, stating that it would not be able to obtain enough Yuan for its requirements. Of all the currency swap deals the People’s Bank of China signed, that with Hong Kong, at 400 billion Yuan, was the largest. Despite its relatively small economy and unrivalled access to the Chinese central bank, Hong Kong could not satisfy its reserve needs with the Yuan. This indicates that larger economies would have an even harder time adopting the Yuan as their reserve currency. It seems that, for the foreseeable future, the world is stuck with the US dollars and Washington’s dysfunctional politics.




[4] One could argue that global investors would not have considered a US default to be temporary and therefore would not have reacted strongly. However, according to New York Times blogger Annie Lowrey, banks’ computer systems do not take ‘common sense’ into account – a default is a default, whether it is initiated by inability or unwillingness to pay. For more, see





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