Dollar bashing is a popular pastime right now. China wants a new reserve currency; the IMF thinks that its Special Drawing Rights international reserve asset would make a nice replacement; some suggest the Euro; still others promote the Chinese remnimbi. The coffers of the world's central banks are piled high with dollars, and the U.S. government is piled high with debt.
While economists disagree on the prospects or a timeline (maybe 10 years away) in a shift away from the dollar as reserve currency, it's a reality that if the dollar loses its preeminence, higher interest rates in the U.S. will discourage borrowing and hurt the domestic banking sector. But some economists say a shift away from the dollar could also make it easier for smaller and regional U.S. banks to do international business, because transaction costs would decline, leveling the playing field.
How did the dollar's top-dog status come under duress? U.S. deficits and trade surpluses didn't faze too many as U.S. consumers bought all those goods from around the world on credit. Sure German economic ministers and European Central Bank officials scolded Washington, and Chinese leaders cast worried looks at their growing pile of U.S. treasuries. But the scolding came with a wink - all that U.S. debt was employing workers around the world.
Then the housing bubble burst, spewing toxic asset-based securities in every direction. U.S. consumer can't mine their homes for credit any more, and there's a global fire sale with not enough buyers lining up at the checkout counter.
By the end of last year, China's leaders were frightened, and declared that the time had come for a new reserve currency. As 2009 progressed, they convinced Brazil, Russia, and India to sign on to a call for an undefined super-reserve-currency. Renowned economists touted the Euro; the IMF presented a paper to a meeting of the G10 extolling the virtues of the SDR. NYU professor Nouriel Roubini cheered on the Chinese remnimbi.
"A shift away from the dollar probably should happen, but it won't happen overnight," says Standard & Poor's chief economist David Wyss. He sees a 10-year process, with the dollar losing its dominant position to a basket of currencies. "You can't have a world currency before you have consistent global regulatory and fiscal policy," according to Wyss.
Others don't believe a brand new currency is likely, and doubt the remnimbi will be ready to take its place as a reserve currency anytime soon. "The remnimbi would have to be freely exchangeable and deliverable, and it's not," says Steven Pearson, head of G10 currency strategy at Bank of America Merrill Lynch. Brazil, Russia, China and India are pressing for an expanded SDR, Pearson adds, but there are few stable currencies that are broadly enough traded to merit inclusion. Today SDRs are a mix of the dollar (44 percent), the euro (34 percent), the yen (11 percent) and the pound sterling (11 percent). Instead, the most likely near-term scenario will be a rebalancing of central bank currency holdings away from the dollar.
"SDRs are an old saw raised perennially, but without a government and central bank behind them they cannot become important," observes Paul Bennett, a fellow of Columbia University's program in law and economics.
He gives the remnimbi another 20 years before it challenges the dollar. And Bennett predicts a gradual increase in the use of euros as reserve holdings, "but nothing dramatic."
Keith Leggett, senior economist at the American Bankers Association, says the dollar "will not be as preeminent but still will be a major component in these portfolios." Falling demand for the dollar will bring inflationary conditions, along with higher interest rates. Demand for credit will decline, and U.S. banks will be left competing for fewer customers at narrower margins.
A shift away from the dollar could take at least 10 years, according to Scott Anderson, vice president and senior economist at Wells Fargo. The relative decline of the dollar would raise the cost of business of U.S. big banks. "Many global bonds and commodities are priced and purchased in U.S. dollars," says Anderson, and large U.S. banks can take in low-cost dollar deposits and deploy them worldwide. And many foreign institutions must go to these U.S. banks for dollars when they want to deal in dollar-denominated markets, generating a reliable flow of fee and transaction income.
"If the U.S. dollar was no longer the global reserve currency, these advantages would quickly evaporate," Anderson says. Small domestic banks and even foreign institutions could compete on equal footing as the effective cost of funds for major U.S. banks increased, leveling the competitive playing field.
The dollar has been unrivaled in the post-World War II era. Change is in the air, and whether the dollar's dimming is gradual or sudden, it won't be easy for U.S. borrowers and lenders.