The US Dollar

I've been following doomsayer's comments for about a year now. They uniformly report the demise of the US Dollar. So I've been watching reports carefully and quietly, not blogging about them - but not slacking in my attention to the issue.

I don't see any evidence in a massive loss of confidence internationally in the US Dollar. The International Monetary Fund shows that 64% of all foreign exchange holdings are in Dollars. That's down 2 % from 66% before the financial crisis that swept the planet. (China doesn't report its holdings to the IMF).

There has been a shift in which dollar instruments foreign central banks are buying. They are currently accumulating US Treasury obligations (bonds) rather than securities of government agencies such as Fannie Mae and Freddie Mac. They also favor short-term bonds over long term notes, displaying caution - but still buying Dollars.

Why?

Many countries still trade and settle trading debts in Dollars (the rise of the Euro notwithstanding). It makes sense for those countries to hold the same currency they use to denominate their foreign debt. 

86 % of all foreign exchange transactions since 2007 has been in Dollars. The Euro accounts for 38%. (the total is 200% since there are two currencies for each potential transaction)

US Treasury Bonds are the single most liquid for trading on government bond markets in the world. This is reflected in the high turnover rate and narrow spread between buy/sell. The liquidity is a function of the size of the American economy. Foreign investors place their holdings in the US markets because those markets are liquid and high trading activity in turn makes them still more liquid.

Brief Comparison

The Swiss Franc accounts for less than 1% of foreign reserves. The Pound Sterling is about 3%. This has mainly to do with the small economies so they serve as a subsidiary reserve currency (a hedge). The Japanese economy is much larger (second largest in the world) but the Japanese government discourages use of the Yen internationally because doing so would undermine its ability to maintain a low/competitive exchange rate. I read an interesting piece on WAX LIPS' blog (CLICK HERE TO VISIT) today, "Is Japan a Dying Nation?" The very thing she discusses makes Japan a less attractive option to play an expanding role in world currency.

The Euro was instituted to offer a European alternative to the Dollar. Financial markets in Europe will naturally hold Euros. The Russian energy consumers, primarily Europeans, pay in Euros, so that will naturally expand Russia's holdings in that currency. Russia has expanded its Euro holdings from 42% to 46% of its foreign currency reserves.

China is trapped

China holds $2,000 for every Chinese person. 87% of all Chinese holdings are in Dollars. They have a tiger by the tail. Selling US Treasury securities in the quantities needed to significantly alter the composition of its reserve portfolio would make those securities tank. If the Chinese divested themselves of Dollars, the value of the Dollar would depreciate, causing further losses to Chinese financial holdings.

Special Drawing Rights

Last March, Zhou Kiaochuan (Bank of China) argued that the dollar should be replaced as a reserve currency by IMF's Special Drawing Rights (SDR's). The SDR is composed of a basket of four currencies: US Dollar, Pound Sterling, Euro and Yen. Russia immediately announced it would trade $10 billion for SDR's. The problem with the SDR is that they can only be used by governments to settle debts with other governments and the IMF. Previous efforts in the 1970's to commercialize SDR's never got off the ground. 

In order for SDR's to become any sort of international currency, the IMF would need to be able to issue additional SDR's in times of shortfall the same way as the US Federal Reserve issued Dollar swaps to insure liquidity in the second half of 2008.  Under present regulations, 85% of participating countries would have to agree in order for the IMF to act in that manner. IMF would have to act as a global central bank and that's not going to happen anytime soon.

Back to China

China would like to make Shanghai a world financial center by 2020, but it's unlikely to happen that quickly. The Chinese GDP is not large enough to support their currency, the Renminbi (RMB) a reserve financial currency. Even with optimistic growth rates that are largely unrealistic, by 2020, the Chinese GDP will still be less than half as large as the United States. The RMB is unlikely to be able to serve as more than a subsidiary reserve currency or regional reserve currency in the foreseeable future. Its prospects as a world currency are remote and distant.