There is more and more discussion about the possibility of the U.S. dollar losing its status as the reserve currency of the world. In simple terms, the U.S. dollar has been the primary form of money used in international trade and it has been this way since the end of World War 2.
It is estimated that the U.S. dollar makes up 61% of the allocated reserves globally. But this is down from about 71% in 2001.
While many foreigners are tired of the U.S. government calling all of the shots in the world, other countries still depend on using dollars for international trade, particularly when it comes to oil. One problem is that there is no obvious replacement.
Some believe that the Chinese yuan is destined to take over as the reserve currency of the world. Particularly after executive order NCO1 or the “New Currency Order 1” was announced by China’s top brass. The intention of this is to provide an alternative reserve currency to the U.S. dollar.
At the very least, it could become a secondary reserve currency at this point.
Jukka Pihlman, of the Singapore-based Standard Chartered, has stated that 23 countries have declared at least some holdings of yuan. He also believes that there are at least 17 additional countries/ central banks that are holding yuan without publicly stating so.
While this could be for diversification, it is likely that other countries are holding the Chinese currency to enable them to trade with China, without having to resort to U.S. dollars.
The Problem with China
China is really an extraordinary story. It is still called a communist country, but it really hasn’t been for the last few decades. It is not an example of a free market either, but it has certainly improved. About 35 years ago, the government loosened restrictions on agriculture and slowly began allowing more business opportunities and stronger property rights, at least relatively speaking. China is still a centrally planned economy, but with some semblance of property rights and free markets.
The Chinese people, while still really poor by American standards, have benefited greatly. In the last 3 decades, there have literally been hundreds of millions of people lifted out of extreme poverty.
With that said, China still has a lot of issues. It has a bubble economy, particularly in real estate, and the Chinese people are about to experience their first major recession, unless you want to count the 20th century as one giant recession. They also have really high inflation.
China also does not have a freely floating currency. The yuan cannot be traded on the open exchanges in the same manner as the U.S. dollar, the euro, the yen, and many other currencies. It is going to be quite difficult to take over as the reserve currency of the world if it is not freely floating.
Why A Reserve Currency?
One thing I continue to preach is that nothing may replace the dollar as the reserve currency. This doesn’t mean the dollar will keep its status though.
Why do we need a reserve currency at all? In a global world with digital technology, countries can just trade in their own currencies and quickly convert them. There is becoming less and less of a reason to use the dollar as a middleman. Of course, I don’t say this from the perspective of a U.S. central banker or U.S. politician.
China and Japan can buy and sell goods and services using yuan and yen. There is no need to use the dollar. The same holds true with other countries, particularly those with major currencies.
One thing I don’t expect to happen is for certain countries in particular to abandon the dollar any time soon. Saudi Arabia comes to mind. The Saudi government gladly uses dollars in exchange for the political and military support it receives from the U.S. government. If you ever see Saudi Arabia abandon the use of U.S. dollars in international trade, then the world has changed significantly.
While some Americans fear seeing the dollar lose its reserve status, I don’t necessarily see it as a bad thing in the long run. American consumers are somewhat subsidized in that it means less expensive products. But the U.S. government is also subsidized, which is bad for our liberty and prosperity.
If China and Japan buy less in U.S. government debt and the Federal Reserve has to face higher interest rates, then the U.S. government will not be as easily enabled to run huge deficits. This might actually lead to less government spending and, ultimately, more prosperity for Americans.
Time will tell if the world abandons the U.S. dollar. But things seem to be heading that way. I expect it will continue to happen slowly and not with any one major announcement.