Despite the decline in the US share in world production and trade, the role of the dollar in the global financial system continues to grow. This is facilitated by the development of international supply chains, the dollarization of corporate lending and the growth in demand for reliable assets.
Oleg Yitzhoki
We are on an interesting stage in the development of the international financial and monetary system. On the one hand, the role of the United States and the European Union in world production, trade and GDP is naturally decreasing, as catch-up growth in developing countries – primarily in China, India and other Asian countries – exceeds the average growth rate of developed countries. Surprisingly, this trend began relatively recently – in the 1990s, before which the share of developed countries in the world economy was overwhelming and relatively stable. China has already overtaken the United States in terms of industrial production and its share in international trade and, obviously, will soon surpass the United States in aggregate GDP (at the current exchange rate), nevertheless still significantly inferior to developed countries in terms of per capita GDP.
On the other hand, the role of the US dollar in the global economic system has never been stronger: it dominates in all its fields – both in the private and public sectors – and in all three functions of money (measure of value, medium of exchange and means of accumulation) . The dollar is the main currency in international trade in goods and services and in the international financial system – when borrowing in the form of loans or issuing bonds in the banking and real sectors. From the point of view of states, the dollar is the main reserve currency and anchor currency for the full and partial fixation of exchange rates.
Paradoxically, the long-term role of the dollar increased after the collapse of the Bretton Woods system in 1973, when developed countries abandoned fixed-to-dollar exchange rates and fixing the dollar to gold. Now we live in a system of floating exchange rates, but at the same time a large number of countries, including China, prefer to partially fix their exchange rates against the dollar. In addition, China’s increased role in international production and trade since the mid-1990s. also, at this stage, led to a significant strengthening of the dollar in the global financial and monetary system. The role of the dollar in the global financial system has not decreased with the formation of the eurozone. The euro has become a significant regional currency, taking a significant role in regional international trade, debt crisis in Europe .
What mechanisms led to an increase in the role of the dollar, despite a decrease in the share of the United States in the global economy? First, globalization and the growing role of global value chains, which played a much smaller role in the 1970s. Now countries are much more involved in international trade , which consists not so much in exporting the final product as in adding value to complex production chains in which many companies from different countries participate. For settlements in such chains, it is preferable to use one currency – and the dollar plays this role, and its stability relative to many currencies strengthens its role in pricing in international trade. In turn, many central banks stabilize exchange rates against the dollar in order to strengthen the position of national firms in international competition.
Secondly, the globalization of the financial system, in which both banks and real sector companies increase the share of financing in the international financial market in US dollars, contributes to the strengthening of the dollar. At the same time, local financing takes place in national currencies, but plays an ever smaller role in the overall financing structure of large firms. This is primarily due to the size of the dollar financing market, which significantly exceeds the markets of all its closest competitors, including the euro and the yuan. Interesting trendIt consists in the fact that sovereign state borrowings, on the contrary, are increasingly switching to national currencies, but their volume is inferior to borrowings in the private sector, in which the role of the dollar has grown significantly. In turn, dollar borrowing in the banking and real sectors forces central banks in many countries to smooth out currency fluctuations against the dollar in order to avoid negative effects on national firms and their balances. In particular, for this, central banks maintain substantial dollar reserves, strengthening the role of the dollar as a reserve currency.
Thirdly, and probably this is the main trend, the value of the dollar increases with the global growth in demand for safe financial assets (safe assets). Rapid economic growth in developing countries, primarily in China and other Asian countries, has led to the fact that the volume of world industrial production, incomes and the need to save them have grown significantly faster than the ability of the international financial system to offer new reliable mechanisms for saving. In other words, the role of developing countries in the production and trade of goods has grown significantly faster than their financial markets. The only asset in the world that stably demonstrates reliability and has a sufficient market size.Are US Treasury bonds. Neither the national bonds of Germany or Japan, nor the assets of China, are able to even partially replace US bonds.
These trends have pronounced implications for the international monetary system and policy. As a result of the dollarization of international trade and financial flows, the ability of countries to stimulate their economies by devaluing the national currency is significantly reduced, since a weak currency does not allow for efficient export growth and negatively affects firms borrowing in dollars. The growth in demand for reliable assets leads to a long-term drop in interest rates to almost zero, narrowing the space for monetary policy around the world. Crises increase the outflow of capital from developing countries towards US reliable assets, strengthening the dollar, which makes American assets truly reliable in terms of hedge against the risk of global recession. However, this leadsadditional negative consequences for international trade due to rising import prices in the national currency while the dollar is strengthening. From the point of view of the global economy, the United States should increase the supply of reliable assets in order to at least partially satisfy the growing demand, while increasing US national debt, which in the long run increases the risks of US treasury bonds.
On the one hand, such an equilibrium with the central role of the dollar is very stable in the short and medium term. On the other hand, the diminishing role of the United States in world production and trade is likely to lead to a transition to a new equilibrium in the long run, where other global and regional currencies, such as the euro and the yuan, will play a large role. At the same time, an increase in the role of the euro and the renminbi in regional and global trade, as well as a possible increase in the international borrowing market in the renminbi with China’s active lending policy for developing countries around the world, looks more likely in the medium term. But neither the euro nor the yuan can become a potential replacement for the dollar as the currency of reliable assets.
Oleg Yitzhoki, Professor of Economics and International Relations, Princeton University and the University of California, Los Angeles.
The article was originally published on Econs.
Views in this article are author’s own and do not necessarily reflect CGS policy.
