The Reserve: The Dollar, The Renminbi, And Status Of Reserve by Amar Reganti, GMO

Part I – The Dollar Ascendant

When I was in elementary school, my family made regular trips to my parents’ birthplace of India. The journey would normally take us from our home in Iowa, to London, to Bombay (now Mumbai), and finally to Hyderabad. Upon arrival, we children would clamor for the local currency, rupees. These rupees were the key to making the summer trip tolerable: rupees purchased quantities of lassi, ice cream, and Indian fruit sodas. During our layover in Bombay, my father allowed us the luxury of room service. After the server made the delivery, he waited for the customary gratuity, and I realized that I had not a rupee on me. I reached into my pocket, but only found a crumpled dollar. I gave it to him with trepidation, but was relieved when he gladly accepted it. At the time, it struck me as odd that the US dollar, a foreign currency, would be accepted by a server thousands of miles away from the US. Now, many years later, that incident serves to remind me of the power and convenience of a reserve currency.1

Dollar, The Renminbi, And Status Of Reserve

Introduction

For years, pundits and market participants have stubbornly predicted the demise of the dollar as the premier reserve currency in the world.2 The dollar has defied all skeptics. Even as chatter from market participants has grown louder with every contemporary financial crisis, the demand for dollars has become nearly insatiable.3 First the yen, then the euro, were predicted to become reasonable alternatives to the dollar. Despite these predictions, the demand for dollars has only increased in global financial markets. The Chinese renminbi (RMB), whose roll-out as a new international currency was patiently planned by Beijing’s policymakers, has been listed recently as a long-term viable alternative to the current status quo. So what are the prospects for the RMB, current market turmoil aside? And what is the likely fate of the dollar? GMO’s Asset Allocation team examines these questions in a two-part series. The first part, the rise of the US dollar and the key drivers and conditions that allowed it to attain reserve currency status, is meant to lay the groundwork for reviewing whether a currency is on its way to the status of reserve. Part I also serves as a supplement to work already completed here at GMO by James Montier in his “Market Macro Myths: Debts, Deficits, and Delusions” white paper. Part II, to be published later this year, will examine RMB, as well as several other currencies, to determine their progress toward reserve currency status.

We posit:

  • That the dollar as a preferred currency of exchange, transaction, and store of value is unlikely to be displaced in the near to medium term.
  • For RMB to meet the same type of acceptability as the dollar, an enormous amount needs to be accomplished in the areas of sovereign issuance, bankruptcy law, trade, and collateral usage, as well as the establishment of long-term credibility.
  • We do not mean to say that the dollar’s reserve status will remain unchallenged forever. Indeed, a singular reserve currency, driven by a central bank that is focused on domestic inflation and unemployment, presents a number of challenges to global financial markets and trade. However, to date, the yen and the euro have not proven to be up to the task of competing with the US dollar for reserve currency status.
  • The historically high debt levels of the US are not an impediment to maintaining reserve status, as the country issues its debt in its own currency. Indeed, the scale and liquidity of the Treasury market is a necessary condition to maintaining its reserve currency status.

For all involved in bond and currency markets, the concept of “reserve currency” status is nearly metaphysical and very hard to define. In this white paper, we attempt to define the meaning of reserve currency, briefly look at the modern history of reserve currencies, and then identify the necessary conditions required to be considered a reserve currency. Furthermore, we will discuss implications of the reserve currency status for investors, market participants, and policymakers.

The cross of gold

At the end of the 19th and through most of the 20th century, the concept of a reserve currency lay firmly anchored in that currency’s convertibility into gold. A country’s gold holdings determined its ability to expand the money supply. The dominance of gold, and its limitations, led to the now-famous speech by William Jennings Bryan. He demanded that the ordinary citizenry not be “crucified on a cross of gold” and demanded the US return to “bimetallism,” or the additional use of silver. That decision may have allowed the growth of the monetary base in parallel with economic activity. While it would take another 80 years for the gold standard to be completely cast aside, gold retained its preeminence as the specie of nations.

At the time of Jennings’ speech in 1896, if a currency had any inherent value it was given that value in accordance with the weight of gold each unit of currency brought to the table.4 And for years, the unit of currency that dominated that equation was the British pound sterling. The size of the British Empire, the amount of trade that took place on its sea lanes, the financial sophistication of the City of London as a place to raise capital, and the commitment of Her Majesty’s Exchequer to convertibility helped ensure the pound’s role as the paper currency of preference until 1914.5 While other currencies, such as the French franc and the German mark might have been used for reserves, it is hard to believe that they were a more convenient currency than the pound when used for global trade.

Today, the dollar is the only serious reserve currency in the world. While there are other useful, or “transactional,” currencies, the dollar remains the universally accepted version of modern-day specie for merchants, financial institutions, and sovereigns.

Just over a century ago, the dollar was a secondary currency relative to the dominance of the pound. While a number of reasons may be given for the pound’s demise versus the dollar’s rise, three key reasons include:

  • The formation of the Federal Reserve in 1913, in order to alleviate the sporadic financial crises that plagued the US financial system, such as the Panic of 1907 following the collapse of the Knickerbocker Trust. The Federal Reserve was meant to add elasticity to the national currency and to serve as a lender of last resort.7
  • The enhanced credibility of the US Treasury, achieved by Secretary William McAdoo during the summer of 1914, by maintaining dollar/gold convertibility upon the outbreak of war in Europe.8
  • The dominance of the US, as the largest creditor nation, at the Bretton Woods conference, where it was able to make dollars and gold virtually substitutable for each other. Great Britain, ably represented by John Maynard Keynes, simply did not have the bargaining power at the conference to preserve the pound’s preeminence.

But why was the dollar not the preferred currency prior to the summer of 1914? The answer is not a mystery. First, prior to the formation of the Federal Reserve, the US was prone to numerous financial crises. In addition, a mere 50 years before the start of WWI, the US had been embroiled in civil war; this was not an encouraging state of events, nor did it inspire confidence in international investors. Second, prior to the summer of 1914, there had been little or no reason to question or doubt the pound’s convertibility into gold. Simply put, the British government had not given the world a reason to seek a new preferred currency.

The formation of the Federal Reserve, and the Treasury’s enhanced credibility during the summer of 1914, made the US dollar a tolerable substitute for the pound. However, it was the third event, the decisions made at Bretton Woods, which finalized the role of the dollar as the world’s reserve fiat currency, turning the de facto relationships of the war into the de jour relationships codified in the international monetary system. The decisions at Bretton Woods codified the dollar as a near substitute for gold, acknowledging the reality that had taken place over the long years of war.

Starting from the 1960s onwards, US monetary liabilities held by foreigners began to exceed US holdings of gold.9 The paradox of being the world’s reserve currency required the US to supply the world with an adequate number of dollars. However, the more dollars it supplied the world, the more the US diminished its credibility regarding its ability to convert those dollars to gold on demand. This paradox is known as the Triffin paradox after Robert Triffin, who identified the problem in the 1960s. From 1965 onwards, in part for political reasons, France demanded its gold and the continuation of this “on-demand” conversion process precipitated in the ending of the gold standard in 1971. Coming off the gold standard, the dollar stayed the reserve currency. However, that did not occur without a substantial devaluation. Indeed, if one reads the minutes of the conference call of the FOMC in 1973, one can sense the palpable alarm among the participants regarding the dollar’s depreciation.10 Nevertheless, the dollar continued to be the world’s reserve currency for lack of any other substantial alternative.

Defining a reserve currency

“I know it when I see it…” uttered Justice Potter Stewart in the famous ruling of Jacobellis v Ohio.11 While that case involved possible conflict between the First Amendment and public decency laws, that particular phrase is illustrative of the ambiguity of the concept of a reserve currency. The line blurs between currencies that are considered “international” and those that are considered “reserve.” A reserve currency needs to be an international currency. An international currency requires that the currency be used in a significant portion of invoicing/trade transactions, and used in the financial markets. In other words, an international currency is really a transaction currency, one that is easily accepted by a number of market and trade participants. A reserve currency goes a level above that and becomes the currency of choice during flight-to-quality scenarios.

Dollar, The Renminbi, And Status Of Reserve

There are two necessary, but not sufficient, conditions for a currency to be considered an international or transactional currency, both of which are associated with capital account convertibility.

Condition #1 – A Trading and Invoice Currency. Trade and invoicing must take place in a currency for it to be considered international. Goods and services must be purchased with these currencies. The reason is obvious: Fiat money exists to facilitate some type of exchange between counterparties. A primary invoicing currency determines which currency is used when a good or service is exchanged between two countries.

As noted earlier, during much of the 18th and 19th centuries, the British pound was the world’s reserve currency. The power and expansiveness of the British Empire allowed the pound to be used for trade and invoicing in a convenient manner. The pound was also convertible into gold. A member state of the Empire needed the pound to purchase finished goods and materials produced in England. Raw materials were shipped to England, higher-valued finished products came back, and England financed the difference for her colonies.

The invoicing currency of tradeable goods is an important component of an internationalized currency. Grassman’s Law posits that goods are invoiced in the currency of the exporter. However, today, invoicing is usually determined by whether goods are destined for the US, in which case they are usually invoiced in dollars. This is one way in which the world acquires dollars. Yet why do countries still want dollars? My colleague Phil Pilkington would note that this is almost a “hangover” of Bretton Woods. The concept of hangover refers to the echoes of a codified system that made dollars the most convenient currency to hold in order to manage a nation-state’s liabilities. One can surmise that the countries require dollars for several reasons:

  • As a liquidity reserve or risk insurance (consistent with flight-to-quality or a specie that allows exchange rate management).
  • Mercantilist reasons, meaning that the accumulation of dollars is an output of creating an export-driven economy.
  • The requirement to purchase certain goods that are invoiced only in dollars (such as oil).

Condition #2 – A Liquid and Investable Currency. To invest in a currency, one actually needs a deep and liquid marketplace for securities.12 A short-term, high-quality securities market is critical to the development of an “investable currency.” There are several criteria for a currency to be considered “liquid.”

  • Short-term, high-quality commercial paper and bills market. The importance of this market cannot be overstated for the functioning of a reserve currency. It allows investors to purchase securities that they consider “cash-like” with limited credit risk. For banks, this market creates a liquid place to deposit cash as an alternative to depositing cash in a central bank account (remember, until recently, the commercial banks did not earn a return on their excess central bank deposits). For a central bank, self-liquidating notes offer the ability “to furnish an elastic currency, and to afford means of discounting
    commercial paper.”13 A high-quality commercial paper market, in conjunction with a functioning market for interbank lending, such as the fed funds market, allowed banks that were flush with reserves to lend to banks that needed more reserves.14
Commercial paper, where a lender has a predictable bankruptcy recovery process, has been a diverse and readily available place to hold cash that is not expected to change in value. A.O. Greef ’s magnum opus, The Commercial Paper House in the United States, provides an extraordinarily comprehensive overview of short-duration activities in US financial markets. Indeed, the development of an open market in commercial paper allowed bank reserves to move from parts of the country that were flush with reserves to parts of the country where reserves were scarce.15 Here the Federal Reserve served as a monetization agent, turning some of these short-term papers, such as bankers acceptance notes, into a liquid form of tender. This ability to convert high-quality paper into cash is a key part of a stable fractional reserve banking system.

Dollar, The Renminbi, And Status Of Reserve

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