(This column was published in DNA edition dated October 14, 2009.)
Last week, the global currency markets were rattled by the detonation of what some analysts saw as a monetary nuclear bomb of cosmic proportions. A report in a British newspaper claimed sensationally that Gulf oil-producing states were in secret talks with China, Russia, Japan and France to end the pricing of oil in US dollars and move to a basket of currencies.
Such a move, which would tie in with long-nursed concerns about a weakening US dollar and the pile-up of excessive US government debt, would (if confirmed as true) signal the beginning of the end of the dollar’s status as the preferred currency of global trade (or the global ‘reserve currency’). The report was denied by all the principal players, but given these uncertain times, it sounded plausible to many, and the dollar fell in response.
Countless other doomsday scenarios for the dollar abound, and not a day passes without some over-the-top hyperbolic pronouncement by ‘dollar bears’ about the ‘coming collapse of the dollar’. The perception that even the US administration, skating on thin ice economically and politically, appears to favour a weak dollar in order to rebalance its economy has amplified the bears’ growls.
Yet, the conspiracy theories about the imminent erosion of the dollar’s status as reserve currency and the emerging alternatives are wide off the mark and low on economic and realpolitik wisdom. ‘Reserve currencies’ do not come about as a result of political negotiation among a few players, in the way the British newspaper report implied; they come about organically over years, perhaps decades, on the strength and financial depth of the underlying economy, the convenience of using that currency, and the network effect of many others using it.
One economist likens it to using the Windows operating system for your computer; sure, it’s expensive and has bugs, and sure there are freeware alternatives, but it’s more convenient to use Windows because ‘everyone else is using it’. And like Windows, reserve currencies enjoy an ‘incumbency advantage’: unless a new currency can demonstrate that is offers vastly superior benefits, it cannot dislodge the entrenched one.
The choice of a reserve currency also comes with an implicit bargain: the underlying economy has to run trade deficits and current account deficits to provide liquidity to the rest of the world. It must also open itself up to the risk of seeing hostile governments or traders short-sell your currency for political or economic reasons, as is happening with the dollar today. Not everyone wants that responsibility and the headache: just ask China, which is clamouring the loudest for a change from the dollar standard.
Most of the ‘dollar bear’ growls you hear today are motivated by power politics or profits. In China’s case, its concerns over the dollar have forced US policymakers to tone down their rhetoric on China’s currency manipulation and its human rights record.
Similarly, among the most extreme ‘death to the dollar’ chants come from ‘bullion bulls’ who expect to gain from higher gold prices when the dollar weakens. Every uptick in the price of gold in US dollars is celebrated, despite the fact that against other currencies like the Australian dollar, gold prices have actually fallen over the past six months. Even in India, it’s true that gold prices have appreciated about 45% since their recent low in October 2008. But over the same period, the Sensex has returned 70%, which puts the ‘gold rally’ in perspective.
All this is not to say the dollar won’t weaken in the short term; it will. And over time, as other economic powers rise and US’ share of the global economy shrinks, other reserve currencies could organically emerge. But the only ones who are profiting from short-term volatility driven by market hysteria of a ‘dollar collapse’ are dollar bears and bullion bulls who are looking to make jackasses of us others.