The US dollar experienced its worst devaluation in recent times after decades of complete dominance in the International Financial Market. The US dominance in global finance arises from the dollar’s status as an International Currency. The dollar is the main currency in International Trade, key commodities such as oil and gold just to name a few are traded in US dollars, a large share of equities in the world stock market is valued in dollars, most central banks around the world utilize the US dollar as the nominal anchor for their exchange rate and also hold a large share of their reserves in dollars. In this era of globalization, is the hegemony of the dollar threatened?
The introduction of FIAT currency in the early nineteenth century required that money issued by countries had to be backed by gold reserves. This was the era of the gold standard. In 1971, then US President Mr Richard Nixon dethroned the gold standard by allowing the Federal Reserve Bank to sell its stock of gold reserves. Concurrently, the US commitment to free movement of capital, the rule of law and price stability led to the dollar being elevated as an International Currency with a credible store of value. As a result, the gold standard was quickly replaced by the dollar standard. Today after more than four decades of the dollar standard its influence is being diluted.
The dollar is currently experiencing its lowest nominal value against the world major currencies. At the end of September 2007, the exchange rate of the Euro vis a vis the dollar was at 1 E=$1.40 the strongest since the Euro was launched, the dollar was two to one to the Pound Sterling, the weakest since 1981.
The Canadian dollar came on par with the US dollar value in late September for the first time in three decades. The dollar rallied a little better against the Japanese Jen at $1.16. However, in less than twenty-four months the dollar had lost more than 20% of its nominal value against the world’s major currencies.
There are a number of reasons that would have contributed to the decline of the dollar. Part of the dollar demise is cyclical reflecting lower than expected G.D.P growth in the US this year when compared to the Euro area, Britain and Canada according to the Economist’s monthly poll of forecasters. Figures of September 2007 showed that the American Economy lost 4,000 jobs in August rather than creating the 100,000. (Economist 14/09/2007) and the US unemployment rate at 4.7%.
Moreover, structural factors such as the widening US budgetary deficits and the rising Current Account deficit now estimated at 6.5% of GDP would have impacted negatively on the value of the dollar. Lastly, the problem with the delinquency of US sub-prime mortgages with its spill over impact on the financial sector is another of the reasons advanced for the declining dollar.
The theoretical assumption on the depreciation of the US dollar is supported by the empirical evidence and US data. For instance, Federal Reserve chairman Ben Bernanke (2007) pointed out that the US current account deficit got worse in the past two years from $640 billion in 2004 (5.5% of GDP) to $812 billion in 2006 (6.2% of GDP), he further argued that the deficit was driven by an increase in investment from 19% in 2004 to 20% of GDP in 2006 while overall savings showed a decline. In contrast, the current account surplus of developing countries driven by the growing Asian economies and the oil producing countries moved from a deficit of US$80 billion in 1996 to a surplus of over $643billion in 2006. The economic reality is that for some countries to accumulate such a large surplus others must run a deficit.
In recent years, however, a major threat to the stability of the world economy has been the issue of the global imbalance with the rising deficit of industrialized countries especially the US and the growing surpluses of emerging economies and now oil producing nations. The policy directive from the main multilateral financial institution, the OECD and the G7 is a careful rebalancing to prevent any downside risks to world stability. Adjustment of the exchange rate was a policy prescription for the rebalancing act.
However, unlike his contemporaries Bernanke (2007) saw no problem with the global imbalances which he argued is as a result of a “world saving glut” driven by the transformation of many emerging market economies and oil producing countries from net borrowers to net lenders in the International Capital Market.
Bernanke (2007) further pointed out that the US external imbalance is a financial market phenomenon reflecting the attractiveness of the US Capital market depth, liquidity and legal safeguard for investors.
This article focused mainly on the large US current account deficit as the main reason for the soft dollar while there are other reasons such as the US sub prime mortgage delinquency, weak economic performance, time and space do not permit further evaluation of their impact on the weak dollar.
Apart from investor expectations, the advent of the Euro has challenged the dollar hegemony in the International Financial Market. The experience of the Euro as an official reserve asset is instructive given that the fraction of the international reserves held in Euros grew from 18% to 24% while the dollar share dropped from 71% to 66% (W. Silbert 2007). Net issues in Euros have risen faster than any other currencies and comprised half the total global stock of bond and notes in the world economy by September 2006 (Finance and Development 03/2007).
The current trends of financial globalization, with Foreign Exchange transactions rising from $200B in the mid 80s to $1.9Trn in 2004 will give rise to exchange rate volatility. While the US dollar has experienced a steep nominal depreciation its real effective exchange rate (REER) is more or less stable which seemed to suggest that the nominal rate is adjusting to the economic fundamentals of the US economy. Also, the growing US Investment is a positive indicator for the future strength of the dollar.
Now is also a unique opportunity for large foreign reserve countries to diversify this asset base. The late Rudy Dornsbutch predicted a world dominated by a few strong supranational currencies. While the dollar will continue to be an important international currency, however, its hegemony and monopoly in the International Financial market will be tempered by more competition in the present epoch.
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Mr Rampersaud is the holder of two Masters Degrees, an M Phil in Monetary Economics and Finance from the University of Glasgow, UK and Msc in Economics from Moscow. He also did studies on Money and Capital Markets in Wall Street, New York.
