Book review: 'Exorbitant Privilege'

Book: Exorbitant Privilege
Author: Barry Eichengreen

Experts and analysts have been questioning the ability of the US dollar to continue to act as an international currency, given the poor shape the American economy has been in the last few years.

Their doubts notwithstanding, the real evidence suggests that the dollar continues to be the leading international currency.

As Barry Eichengreen, a professor of economics and political science at the University of California, Berkley, points out in Exorbitant Privilege - The Rise and Fall of the Dollar “the most recent Bank for International Settlements survey showed that the dollar was used in 85% of foreign exchange transactions worldwide, down only marginally from 88% in 2004. Some 45% of international debt securities are denominated in dollars. Opec (the organisation of petroleum exporting countries) continues to price its petroleum in dollars.”

The foreign exchange reserves data also points out that dollar continues to be the leading international currency. “Data from the IMF (International Monetary Fund)...show the share of dollars in total identified foreign exchange holdings as of the first quarter of 2010 was at 61%, down only marginally from 66% in 2002-2003 If one goes back further, to the first half of the 1990s, the dollar’s share in total identified official holdings of foreign exchange was actually lower than recently,” points out Eichengreen.

So what continues to make the US dollar, the international currency of choice, despite the US being on a dollar printing spree to revive its moribund economy? First and foremost the incumbency effect is at work.

As the author writes, “consider an exporter deciding in what currency to quote the prices of his exports. Exporters want to limit fluctuations in their prices relative to those of competing goods in order to avoid confusing their customers.

If other exporters are invoicing and settling their transactions in dollars, each individual exporter has an incentive to do likewise.” Given that the dollar is the premier currency of international trade it makes sense for the central banks around the world tend to hold a major part of their foreign exchange reserves in the dollar.

What about holding foreign exchange reserves in other currencies? “Another factor favouring a continuing role for the dollar is that other candidates for international currency status have serious shortcomings of their own,” points out Eichengreen.
Take the case of the British pound and the Swiss franc.

“The US and Switzerland are simply too small for the pound sterling and Swiss franc to be more than subsidiary reserve and international currencies. Both lack the size to provide debt instruments (to invest the reserves) on the scale required by the global financial system. The UK is barely a sixth of the economic size of the US.

Switzerland is barely a thirtieth...Sterling accounts for less than 4% of identified global reserves, the Swiss franc for less than 1 %.”

What about the Japanese yen? “A decade of no growth and zero interest rates have made holding reserves in yen unattractive. The yen accounts for barely 3% of total identified holdings of foreign exchange. Going forward, Japan’s aging population and antipathy to immigration do not favour a rapidly expanding global role for its economy,” writes Eichengreen.

So that leaves us with the euro and the Chinese yuan (or the renminbi as it is popularly known as). Euro has various things going for it. It exports are nearly twice that of the US. It has a well functioning central bank and well developed financial markets. As Eichengreen points out “While currently it is fashionable to couch all discussions of the euro in doom and gloom, the fact is that the euro accounts for 37% of all foreign exchange market turnover.

It accounts for 31% of all international bond issues. It represents 28% of the foreign exchange reserve...It is second only to the dollar on all these dimensions of “international currenciness.”

But the major problem with the euro is the fact that it is a currency without a state. “It is the first major currency not backed by a major government, there being no euro-area government, only the national governments of the participating countries...This absence of a euro-area government is the main factor preventing the euro from matching the dollar in international importance. When Europe develops economic and financial problems, managing them requires cooperation among its national governments, which is far from assured,” writes the author.

China has plans of making the renminbi an international currency by 2020. But that is a long way off. As Eichengreen explains “the renminbi will remain inconvertible for the foreseeable future. Inconvertibility means that foreigners can only use it to purchase goods from China itself...Other central banks can’t use the renminbi to intervene in foreign exchange markets. They can’t use it to import merchandise from third countries or to pay foreign banks and bondholders.”

Also allowing convertibility of the renminbi would mean allowing the option of the Chinese savings to go out of China. “If foreign companies offered Chinese investors more attractive terms, their savings would not automatically flow to Chinese banks, to be lent out to enterprises that the government deemed worthy.”

So the moral of the story is that when it comes to the dollar, there is really no alternative.