It is a well-established fact that the US$ position as the world’s reserve currency confer it many benefits that other countries yearn for. With China’s economy booming, many have highlighted that the China RMB may eventually pose a threat to the US’s position as the world reserve currency. They worry that the RMB will replace the US$ eventually much as how the US$ replaced the sterling gradually after the first world war. That still seems to be mere scare-mongering tactics with the closed financial system of the China’s economy.

However, the questions remains:

  1. What are the benefits of being a reserve currency?
  2. What are the lesson known complications of being the reserve currency?

 What are the benefits of the reserve currency?

  1. Currency Stability

The US$ constitutes almost 80% of world transactions. More than 60% of foreign reserves of central banks and governments are US$. Given the dominance of the US$ in world trade and financial transactions, the world is dependent on the issuance of US$ to sustain the economy. Investors typically will want to avoid currency swaps to reduce profit lost. As a result, they will pick the currency that serves as the most common medium of exchange or simply the reserve currency. When the sub-prime mortgage industry imploded in 2008, the US$ in fact appreciated for a short period of time. This reflect a general swamp to a safe haven both by government and investors even though USA was fundamentally at the center of the crisis. This differs significantly from other crises such as the Asian financial crisis in 1997 and more recently the Eurozone crisis, both of which the currency has significantly depreciated. This reliance on the reserve currency allows it to ensure currency stability which further boost the confidence of investors on its economy. Currency stability ensure stable expected rate-of-return for businesses and becomes useful to sustain economic growth.

  1. Increased Borrowing due to lower bond yields

Conventionally, when a nation runs high in government debt and lands itself in a recession, it increases the risk of defaulting on its loans. Thus, bond yields rise due to a lack of investor’s confidence and credit-rating agencies lower the investment grade of government bonds. This has been the case for Greece as high government debts and the inability to produce its own currency has increased its risks of default. Bond yields have spiked to nearly 7% and credit rating agencies(Moody/S & P) have deemed its bonds as junk status. However, this situation is inconceivable in the case of the reserve currency. As a result of the reliance on the reserve currency on monetary transactions and the inertia faced in any attempt to replace it, confidence in the US$ can be considered stable and indefinite. The demand for its government bonds and currency is so significantly high that it results in an unwavering advantage. Its government can typically borrow indefinitely from the world. As of 2015, the US government debt is nearly $18 trillion dollars, constituting around 102% of its GDP and it seems to be continuing to rise indefinitely. Admittedly, there seems to be no limit to its debt accumulation. The long-term result is that the US economy can produce and consume well above other countries since many will be willing to lend to its government.

In other words, the US benefited by paying for imports with costless dollars. In turn, the US’ main trading partners enjoyed robust demand for their products, creating employment and income growth.

This all seems like a good thing for the global economy. But, is it?

 What are the problems of a single world reserve currency – Triffin’s Dilemma?

Originally raised by Belgian born American economist Robert Triffin in 1960s as a reference to the instability of the Bretten Words system in view of the peg of the world currency to the US dollar, it still shows its relevance today. Robert Triffin notes that the US dollar’s position as a world reserve currency resulted in a clash of interest between domestic objectives and international obligations.

On one hand, the world needed the US$ for liquidity purposes but on the other, this made it easy for the US to run consistently large current account deficit. Thus, it is inaccurate to blame the US consistently large currency account deficit mainly on China or lowering export competitiveness. The US$ is thus severely undermined during good economic times which destabilizes the world economy and potentially result in an ability for market forces correction and thus an eventual larger implosion of the world economy.

In the period from 2000-2007, the huge deficits brought about by excess US massive consumption produced a massive amount of liquidity in the world economy. While Triffin’s dilemma would have predicted the collapse of the dollar, foreign governments sustain the value of the US$ by reinvesting its excess dollars back into the US asset markets for several years. However, this excess liquidity flowed towards the mortgage industry and led to the spike of asset prices. The result is an unstable creation of a massive financial bubble build on shaky fundamentals. In 2007, debt accumulation peaked and the collapse of the industry created the largest economic crisis in years.

In such a crisis, the US government will aim to depreciate its currency to gain a certain exchange-rate advantage. However, the US dollar in fact was the only currency to appreciate against the other currencies since it acts as a safe haven for investors. Moreover, much of the liquidity vapourized returned to their source, pushing up the value of the dollar. The point is that in a crisis, the world currency trades above its value although its economic fundamentals is as weak as other economies. The US government may want to pursue a depreciation to increase its net-exports but its status as a reserve currency prevents such economic tools.

Moreover, its position as a reserve currency encourages reckless policies in their attempt to provide global liquidity. The inherent conflicts in the global monetary system that led to the great financial crisis has not been addressed. In fact the massive rise of the US currency in recent months despite a weak economy is a clear reflection of the relevance of Triffin’s dilemma.

Thus, unlikely what many Americans may assume, perhaps China joining the party may not be as poisonous as it seems.

Questions to ponder about:

  1. What are Special Drawing Rights(SDR) that are maintained by the IMF? How could they play a part in resolving the Triffin’s Dilemma?
  2. What is the current status of the RMB? How close are they to challenging the US position as reserve currency?
  3. What role must the Chinese government play to improve the Yuan’s role in the world currency market?