decide which laws to enforce. This naturally means that the law most likely to be enforced is U.S. law.
It is completely reasonable for other nations to resent America’s enforcement of its rules. There is a classic quote from an unnamed official with Standard Chartered Bank, which was accused by the U.S. of violating sanctions against Iran. The official sputtered, “…you Americans…who are you to tell us, the rest of the world, that we are not going to deal with the Iranians?” However, given that no other nation wants to bear the burden of being the superpower, which includes not only the costs of providing the reserve currency but also providing global military security, then until something changes, the U.S. can enforce its rules on the world as it sees fit, if it has the power to coerce behavior.
The European media has been warning the U.S. that its “capricious” behavior, allowing prosecutors to bring foreign entities to justice under American law, will encourage foreign banks and companies to seek other reserve currencies. Presumably, that currency would be the euro. However, at the end of last year, S.W.I.F.T. reported that 81.1% of all letters of credit were denominated in U.S. dollars. Although this number is down from 85.0% in 2012, it clearly shows that, for international trade transactions, the dollar remains supreme.
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Will the dollar be replaced? Although it is possible, we doubt any other nation will be willing to accept the role of providing the aforementioned global public goods that the reserve currency nation is required to make available. For example, for the euro to become the global reserve currency, Germany would have to run persistent trade deficits, which would be a major change in behavior and policy.
What about the yuan? Although China may be more open to running trade deficits at some point, it will be a while before China will open its financial markets to allow foreigners to hold their debt and affect their interest rates. At present, China’s capital account is only partly open to foreigners and giving up these capital controls isn’t likely in the near term.
For the foreseeable future, the world is “stuck” with the dollar and the U.S. legal system. This gives the U.S. great power to implement financial sanctions against nations it opposes. Until another nation or group of nations is willing to accept the burdens of being a superpower, the dollar should continue to not only remain the reserve currency but also give the U.S. a significant tool in global geopolitical management. This factor will tend to support the dollar’s exchange rate even as the Federal Reserve engages in policies that would usually be expected to bring about currency weakness. Of course, when policy tightens, it may also mean that the dollar will become surprisingly stronger.
July 14, 2014