The Reserve: The Dollar, the Renminbi, and Status of Reserve

Part I - The Dollar Ascendant
When I was in elementary school, my family made regular trips to my parents’ birthplace of India. The journey would normally take us from our home in Iowa, to London, to Bombay (now Mumbai), and finally to Hyderabad. Upon arrival, we children would clamor for the local currency, rupees. These rupees were the key to making the summer trip tolerable: rupees purchased quantities of lassi, ice cream, and Indian fruit sodas. During our layover in Bombay, my father allowed us the luxury of room service. After the server made the delivery, he waited for the customary gratuity, and I realized that I had not a rupee on me. I reached into my pocket, but only found a crumpled dollar. I gave it to him with trepidation, but was relieved when he gladly accepted it. At the time, it struck me as odd that the US dollar, a foreign currency, would be accepted by a server thousands of miles away from the US. Now, many years later, that incident serves to remind me of the power and convenience of a reserve currency.1

For years, pundits and market participants have stubbornly predicted the demise of the dollar as the premier reserve currency in the world.2 The dollar has defied all skeptics. Even as chatter from market participants has grown louder with every contemporary financial crisis, the demand for dollars has become nearly insatiable.3 First the yen, then the euro, were predicted to become reasonable alternatives to the dollar. Despite these predictions, the demand for dollars has only increased in global financial markets. The Chinese renminbi (RMB), whose roll-out as a new international currency was patiently planned by Beijing’s policymakers, has been listed recently as a long-term viable alternative to the current status quo. So what are the prospects for the RMB, current market turmoil aside? And what is the likely fate of the dollar? GMO’s Asset Allocation team examines these questions in a two-part series. The first part, the rise of the US dollar and the key drivers and conditions that allowed it to attain reserve currency status, is meant to lay the groundwork for reviewing whether a currency is on its way to the status of reserve. Part I also serves as a supplement to work already completed here at GMO by James Montier in his “Market Macro Myths: Debts, Deficits, and Delusions” white paper. Part II, to be published later this year, will examine RMB, as well as several other currencies, to determine their progress toward reserve currency status.

We posit:

■ That the dollar as a preferred currency of exchange, transaction, and store of value is unlikely to be displaced in the near to medium term.

■ For RMB to meet the same type of acceptability as the dollar, an enormous amount needs to be accomplished in the areas of sovereign issuance, bankruptcy law, trade, and collateral usage, as well as the establishment of long-term credibility.

■ We do not mean to say that the dollar’s reserve status will remain unchallenged forever. Indeed, a singular reserve currency, driven by a central bank that is focused on domestic inflation and unemployment, presents a number of challenges to global financial markets and trade. However, to date, the yen and the euro have not proven to be up to the task of competing with the US dollar for reserve currency status.

■ The historically high debt levels of the US are not an impediment to maintaining reserve status, as the country issues its debt in its own currency. Indeed, the scale and liquidity of the Treasury market is a necessary condition to maintaining its reserve currency status.

For all involved in bond and currency markets, the concept of “reserve currency” status is nearly metaphysical and very hard to define. In this white paper, we attempt to define the meaning of reserve currency, briefly look at the modern history of reserve currencies, and then identify the necessary conditions required to be considered a reserve currency. Furthermore, we will discuss implications of the reserve currency status for investors, market participants, and policymakers.

The cross of gold
At the end of the 19th and through most of the 20th century, the concept of a reserve currency lay firmly anchored in that currency’s convertibility into gold. A country’s gold holdings determined its ability to expand the money supply. The dominance of gold, and its limitations, led to the now-famous speech by William Jennings Bryan. He demanded that the ordinary citizenry not be “crucified on a cross of gold” and demanded the US return to “bimetallism,” or the additional use of silver. That decision may have allowed the growth of the monetary base in parallel with economic activity. While it would take another 80 years for the gold standard to be completely cast aside, gold retained its preeminence as the specie of nations.

At the time of Jennings’ speech in 1896, if a currency had any inherent value it was given that value in accordance with the weight of gold each unit of currency brought to the table.4 And for years, the unit of currency that dominated that equation was the British pound sterling. The size of the British Empire, the amount of trade that took place on its sea lanes, the financial sophistication of the City of London as a place to raise capital, and the commitment of Her Majesty’s Exchequer to convertibility helped ensure the pound’s role as the paper currency of preference until 1914.5 While other currencies, such as the French franc and the German mark might have been used for reserves, it is hard to believe that they were a more convenient currency than the pound when used for global trade.6

Today, the dollar is the only serious reserve currency in the world. While there are other useful, or “transactional,” currencies, the dollar remains the universally accepted version of modern-day specie for merchants, financial institutions, and sovereigns.

Just over a century ago, the dollar was a secondary currency relative to the dominance of the pound. While a number of reasons may be given for the pound’s demise versus the dollar’s rise, three key reasons include:

■ The formation of the Federal Reserve in 1913, in order to alleviate the sporadic financial crises that plagued the US financial system, such as the Panic of 1907 following the collapse of the Knickerbocker Trust. The Federal Reserve was meant to add elasticity to the national currency and to serve as a lender of last resort.7

■ The enhanced credibility of the US Treasury, achieved by Secretary William McAdoo during the summer of 1914, by maintaining dollar/gold convertibility upon the outbreak of war in Europe.8

■ The dominance of the US, as the largest creditor nation, at the Bretton Woods conference, where it was able to make dollars and gold virtually substitutable for each other. Great Britain, ably represented by John Maynard Keynes, simply did not have the bargaining power at the conference to preserve the pound’s preeminence.

But why was the dollar not the preferred currency prior to the summer of 1914? The answer is not a mystery. First, prior to the formation of the Federal Reserve, the US was prone to numerous financial crises. In addition, a mere 50 years before the start of WWI, the US had been embroiled in civil war; this was not an encouraging state of events, nor did it inspire confidence in international investors. Second, prior to the summer of 1914, there had been little or no reason to question or doubt the pound’s convertibility into gold. Simply put, the British government had not given the world a reason to seek a new preferred currency.

The formation of the Federal Reserve, and the Treasury’s enhanced credibility during the summer of 1914, made the US dollar a tolerable substitute for the pound. However, it was the third event, the decisions made at Bretton Woods, which finalized the role of the dollar as the world’s reserve fiat currency, turning the de facto relationships of the war into the de jour relationships codified in the international monetary system. The decisions at Bretton Woods codified the dollar as a near substitute for gold, acknowledging the reality that had taken place over the long years of war.