US academic explains greenback's dominance

[SINGAPORE] The US dollar's dominance as a reserve currency and a safe-haven currency has increased after the global financial crisis (GFC) of 2008 and is unlikely to be challenged anytime soon, not even by the Chinese renminbi, according to Eswar Prasad, Tolani Senior Professor of Trade Policy at Cornell University.

In a lecture last week sponsored by Singapore-based Tolani shipping group and organised by the NUS Business School's Centre for Asset Management Research and Investment, Mr Prasad summarised the main findings of his acclaimed new book, titled The Dollar Trap: How the US Dollar Tightened its Grip on Global Finance.

One of the key themes of the book is that, as Dr Prasad put it, "whenever there is financial turmoil anywhere in the world, even in the United States, investors seek safety in the US dollar".

This was underlined in the period after the GFC, which had its origins in the US. The crisis forced the US government to issue vast amounts of public debt - publicly-traded US government debt rose 5.8 times compared to the pre-crisis period. The US Federal Reserve also injected massive liquidity into the markets via three rounds of quantitative easing, the last of which is still in progress.

A number of commentators expected that with the supply of dollars having thus dramatically increased, the dollar would go down. But this didn't happen: in trade-weighted terms, the dollar is at about the same level as it was before the GFC.

Investors, as well as foreign central banks, sought safety in the dollar. Foreign central banks bought about 60 per cent of the US public debt issued after the GFC. "The irony was that people went into the US dollar for safety, even though the US was the main source of the global financial crisis," said Dr Prasad.

Something similar happened when the US was on the verge of a technical default on its public debt, as a result of the inability of the US Congress to agree on a debt ceiling in 2011 and again in 2013. The response of investors was to increase their dollar holdings. "Every time the US came close to defaulting, US bond yields fell," Dr Prasad pointed out.

The main reason for the dollar's increased attractiveness after the GFC was essentially a skyrocketing of demand for safe assets both from private investors and foreign central banks, who wanted to hold large amounts of reserves.

Commercial banks, which were badly bruised during the crisis, were also required to hold more safe assets.

Moreover, in the post-GFC world, the dollar faced less competition from other currencies that were traditionally safe havens in the past. Dr Prasad pointed out that both Switzerland and Japan discouraged large capital inflows, which would have strengthened their currencies, something they did not want. By intervening in the markets, they ended up adding to the demand for dollars.

The euro was not favoured either, because of the eurozone crisis and the fact that euro-denominated financial markets were not as deep and liquid as dollar markets.

However, Dr Prasad noted that the euro could yet pose more competition to the dollar if the eurozone were to achieve full economic and political union, including a fiscal and banking union - but that is still far off.

What about the renminbi? Could it challenge the dollar, as a reserve currency and a safe haven?

China's currency has a lot going for it, according to Dr Prasad, who previously served as head of the International Monetary Fund's China Division.

He pointed out that the Chinese economy is still growing rapidly and may become as large as the US economy within the next decade.

The renminbi is also gaining traction as a trade currency; many countries in Asia, Latin America and Africa already hold some of their reserves in renminbi because "it's a low-cost bet on a currency that is going to become more prominent", and these countries have strong trading links with China. Twenty one central banks have signed local currency swap deals with the People's Bank of China. The renminbi may therefore gain ground as a reserve currency. But a reserve currency is different from a safe-haven currency, he explained.

What safe-haven currencies (which in the past have also included the euro, the yen, and the Swiss franc) have in common are open and transparent systems of government; public institutions, including central banks, that command trust; and independent legal frameworks in which even the government is held to account.

China does not, as yet, have these characteristics, said Dr Prasad. "The US has the magic sauce that will keep the dollar as the dominant reserve and safe-haven currency for a long time to come," he added. "The renminbi will erode, but not challenge, the dollar's dominance."