01 Mar 2010 | Economy

Global Currency - Old Glory for the Dollar? 

David Smith debates whether or not the dollar can remain the world’s leading currency

Big economic events have lasting consequences and this crisis has obviously been a very big economic event. The enormous US fiscal hangover and the prospect of only a gradual return to health for America’s banking system has created what the historian Niall Ferguson describes as “an empire at risk”. History tells us that when empires fail, their currencies fade in global importance. It happened to Britain in the 20th century. Is it the fate of America and the US dollar in the early years of the 21st century?

The question is being asked, and by important people. Last March, in a speech unlikely in the absence of the crisis, China’s central bank governor, Zhou Xiaochuan, called for a reform of the international monetary system to enhance the role of the International Monetary Fund’s ‘basket’ of currencies – Special Drawing Rights (SDRs) – as an alternative to the US dollar. China is concerned that the American currency will not be strong enough in future to support the global economy, and others agree. “The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency,” said Robert Zoellick, president of the World Bank, in September. “Looking forward, there will increasingly be other options to the dollar.”

The dollar, it should be said, is still the global currency of choice. Since the late 1990s, emerging market economies, led by China, have increased their foreign exchange reserve holdings from $500bn to $4,500bn. Most of those reserves are in dollars. Over half of cross-border loans and 40 per cent of international securities are denominated in the US currency.

Could that change? Maybe to an extent. Central banks hold their foreign exchange reserves in a range of currencies. The dollar is the most important, followed by the euro, the Japanese yen and sterling. Already central banks have been diversifying their foreign exchange reserves away from excessive dominance by the dollar and into the euro. That, along with concerns about the US economy, contributed to the dollar’s weakness during the crisis. Middle East countries may also decide to diversify out of dollars for pricing oil. Some other countries have broken their formal currency links with the dollar.

There is a difference between that, however, and the dollar losing its status more fundamentally. That would require an alternative. When sterling fell from grace, the dollar was there to replace it. Is there anything to replace the dollar? The logical thing would be for China’s currency, the renminbi, to rise in importance in parallel with the Chinese economy’s continued climb. The fact that China’s central bank governor chose to champion the IMF SDR instead shows how reluctant Beijing is for that to happen. It has seen that having the world’s reserve currency can be an economic millstone. Somehow, however, though the idea has a long pedigree, having something as artificial as the SDR as the world’s reserve currency does not seem right.

So, while the idea of replacing the dollar will continue to be debated, investors should bank on the ‘greenback’ being around for quite some time yet. It may even be the case that as the world economy emerges from the crisis, and America recovers, the dollar will also do quite well in the short-term.

David Smith is economics editor and an assistant editor and policy adviser on The Sunday Times and visiting professor at Cardiff University. His latest book is The Dragon & the Elephant: China, India and the New World Order.

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