Dollar as the world‘s reserve currency – Is it helping ?

It was after the second world war that the UK sterling lost its power as the world‘s reserve currency and the world leaders convened at Brenton Woods, to decide on a new financial and monetary policy for international exchanges. It was here, in the Brenton Woods Summit, that the dollar was chosen as the reserve currency. Dollar was backed by gold , and 1 ounce of gold was worth $35 in 1944.

Since then, the dollar enjoyed a free run in the world markets and for nearly six decades. It was the currency which every nation in the world wanted to fill its forex reserve with. These dollar reserves created a hedge for them against their own presumably less stable currencies. As for America, it enjoyed having a currency which could be, and was over evaluated to buy assets in other countries and not needing to go to the other sources of borrowing. The dominating reserve currency also meant that every major commodity in the world market was traded in dollars, which helped to maintain constant demand for the American Dollar. Being the issuer of the reserve currency helped America greatly in becoming the largest creditor nation in the world and almost every country in the world had two-third of its forex reserve in US dollars.

But this was when everything was all hunky dory for America and it could do no wrong. Things have changed in the last 10 years and more so, in the last 2 years which also saw a major recession in the economies world over. In 1999, almost 71% of the world‘s official forex exchange reserves were denominated in Dollars; today the figure stands at 63%. US is also now the largest debtor nation in the world with the debt being almost 10% of its GDP standing at $10.6 trillion. The US government also has plans to double its debt in the next 5-10 years owing to its large bail out plans and the fiscal stimulus it has provided to various banks.

Most of the countries now are hesitant to accept dollar as the reserve currency in wake of the recent US borrowings and the economic turmoil in 2008 which is likely to depreciate the dollar further and increase its inflation. The recent happenings have also seen various countries raising demands/debates over the feasibility of dollar being the world‘s reserve currency with the BRIC nations even demanding that the dollar be replaced with a ?supranational? currency. Their demand is lead by a vociferous China which ironically is the largest holder of the US dollar with $1 trillion lying in its banks. It makes for an interesting study as to why China, will want the dollar to be replaced when it has its own fortunes intertwined with the dollar. Let us look at what might be China‘s concerns. To repair the economy in crisis, with US having a $1.75 trillion-fiscal-deficit for 2009, the Federal Reserve has already been printing money. The extra money supply may provide an abundance of liquidity and stimulate the economy to avoid a depression. Meanwhile, as the world‘s largest debtor, the US may also manage the pressure to repay foreign debts through the inflation brought by the extra money supply. This allows the US to pay back in dollars that are worth less in terms of what it can purchase.

The US Dollar will depreciate in this course and this makes other reserve currencies such as the Euro, Pound and Yen appreciate. In order to promote their own economy and exports, these countries may also start to print money. Finally, this will hurt two types of investors—creditors and savers. Creditors receive a relatively low interest rate if interest rates rise whereas the saver‘s holdings are devaluing day by day. As the biggest saver in the world and the biggest creditor of the US, China do have reasons to be worried.

China is also proposing the use of ?Special Drawing Rights? or the SDR as the replacement for the dollar. The SDR is an international reserve asset created by the International Monetary Fund in 1969 that has the potential to act as a super-sovereign reserve currency. A super sovereign reserve currency will not only eliminate the risks associated with a credit based currency like dollar, but also make it possible to manage global liquidity backed by gold. China‘s demand is also backed by other BRIC nations like India, Russia and Brazil. And considering that these countries form almost 12% of the world‘s GDP, it would be difficult for the world‘s financial authorities to overlook their demands.

Amidst all the hue and cry regarding the replacement of the US dollar, President Obama issued a statement saying ?

The dollar is extraordinarily strong right now and the reason the dollar is strong right now is because investors consider the United States [to be] the strongest economy in the world with the most stable political system in the world.

The US authorities are confident that the dollar will continue to enjoy its status as the primary reserve currency and they would do what is required to sustain confidence in the capital markets. No wonder, the United States is still the most preferred destination of the investors. Also the fact that almost every nation in the world has taken a hit in the recent financial meltdown, there condition is not much better than that of the States. In such a situation, they are looking up to the world leader for support and guidance and putting their faith in the surge of the dollar sooner than later.

Whether the dollar will be replaced or not, or whether SDRs will come into play or not, are not the primary question. The focus of the world should be on, in the world of globalization where every nation‘s fortune is dependent on every other nation, can we afford to put all our weight behind one single currency? Wouldn‘t it be better to distribute the risk/gains among the other currencies as well as the SDRs? But then, the world has ridden high on the back of the US dollar for 6 decades and it might surge again before we count it out!