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Is dollar era over ?

15 January, 2008, Yayati Tyagi

Former Federal Reserve Chairman Alan Greenspan said in September 2007 "It is "absolutely conceivable" that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency."

It looks that since the inception of euro, economists all around the world are speculating for the day when euro will replace the US dollar as global currency. In present days, when old champion is showing weakness against other major currencies, these speculations are popping up increasingly. But it will not be easy for euro to take lead on dollar as dollar still has strong presence in the international monetary system. Before we move on towards our assessment of fate of both currencies it is better to take a look back in time that how both currencies have progressed.

History of US dollar

Dollar ($) was adopted by the USA as official currency as on 6 July 1785 but it started assuming the position of global currency with the rise of USA as the world’s economic powerhouse after World War II. After introduction of Bretton Woods system in 1944, US dollar became principal reserve currency. While carrying highest purchasing power and after pegging with gold @ $35/ounce and backed by a promise from US government to pay gold in exchange of dollar, it was considered as good as gold. Moreover, IMF and World Bank adopted dollar as their official currency which further increased the demand of dollar. In 1971, US withdraw from Bretton Woods and made dollar directly convertible against gold, which led to collapse of Bretton Woods system and as well as devaluation of dollar. Besides, dollar became the standard unit of currency for petroleum and gold. As a result, dollar became so strong that it took the roll of unofficial second currency in a large part of the world. Even some countries like Panama, El Salvador and East Timor adopted the dollar as their official currency independently, this process was called dolorization. Some countries like Malaysia, Kuwait, Syria (and allegedly China also) pegged their official currencies with the dollar at a fixed exchanged rate. The journey of dollar has been phenomenal so far and it remained strongest currency for years.

History of Euro

Introduced in 1999, euro (€) is perhaps the newest currency in the world. It is the official currency of European Union’s Eurozone, which currently consists of 15 European countries (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain). Its history goes back to 1990 when exchange controls were abolished, making capital movements completely liberalised in the European Economic Community with an ultimate objective to have a single currency among its member countries. After that, while passing through many phases of discussions and events euro was launched on 1 January 1999 as an accounting currency. As on 1 January 2002, euro currency notes and coins were issued in market. Euro appreciated steadily over the years and soon became the place of second most preferable reserve currency.

War of currencies: Dollar vs. Euro

"So long as the dollar remains the dominant international currency the US can continue consuming more than it produces and, for example, build up its military strength while simultaneously affording tax cuts. Getting a share of this economic free lunch has been one of the motivations, and perhaps the main motivation, behind setting up the euro.. Were the euro to become a reserve currency equal to, or perhaps even instead of, the dollar, countries would reduce their dollar holdings while building up their euro savings."

-Coilin Nunan

Petrodollar or Petroeuro? A new source of global conflict

Even before the launch of euro, economists all around the world were speculating about euro replacing dollar as major global currency. In fact, the whole exercise of introducing euro was seen as an attempt by European Union to challenge the dominance of dollar in the monetary system and ultimately become economic powerhouse of world replacing USA. As soon as euro hit the markets it started claiming more share, in international trade and forex reserves of central banks, compared to previous number two currency. Besides this, the value of all euro notes in circulation worldwide has exceeded the value of total US dollars in circulation. Figures below give the clear picture:

Euro notes in circulation as on 1 January 2008

€679.822 billion

Dollar in circulation as on 2 January 2008

$829.078 billion

Exchange rate as on 2 January 2008

$1.4738 / €

Value of euro notes in dollar terms

$1001.821 billion

Sources: Fedreserve’s weekly bulletin, Fedreservenewyork website,

ECB’s weekly financial statements

Actually, since the inception of euro, dollar began to fall against it steadily. It can be seen in the table below:

Exchange rates between dollar and euro

Date

$ / €

Date

$ / €

4 January 1999

1.1807

2 January 2004

1.2614

2 January 2000

0.9415

3 January 2005

1.3489

3 January 2001

0.9484

3 January 2006

1.1934

2 January 2002

0.9042

2 January 2007

1.3283

2 January 2003

1.0456

2 January 2008

1.4655

Source: Fedreserve Newyork website, 10 A.M. spot rates

Threat from OPEC countries – Petrodollar or Petroeuro

"The Federal Reserve's greatest nightmare is that OPEC will switch its international transactions from a dollar standard to a euro standard. Iraq actually made this switch in Nov. 2000 (when the euro was worth around 82 cents), and has actually made off like a bandit considering the dollar's steady depreciation against the euro." (Note: the dollar declined 17% against the euro in 2002.)

-William Clark

U.S. Dollar vs. the Euro: Another Reason for the Invasion of Iraq

Won 2003 Project Censored award in 2004

For many years, the major strength of dollar has been it being the standard unit of currency of petroleum which keeps demand for dollar always high. This situation allows the USA to run large trade deficits without fear of devaluation of dollar as there is always demand of dollar from central banks. But this situation seems to be no longer sustainable as EU is trying hard to convince OPEC countries to accept euro as major currency for oil trade. This exercise has shown some positive results also. First of all, Iraq, one of largest exporters of petroleum, switched over to euro-denominated trade in November 2000, although after winning the war against Iraq, USA put back Iraqi oil trade from euro to dollar. Venezuela, another major oil exporter has started some of its oil bartering thus avoiding the use of dollar. Malaysian Prime Minister has also encouraged Malaysian oil exporters to switch over to euro. In June 2004, Iran announced that it was planning to start a euro based oil trading market for Middle East and OPEC countries. This move was an attempt to overcome the difficulties which might be came in way while switching over from dollar to euro. This oil bourse could be proved the major threat to London’s International Petroleum Exchange and New York’s Nymex. Although, that plan was deferred due to diplomatic pressure. Russia has also expressed its willingness to switchover to euro. And most importantly, OPEC secretary general had gave the hint long back that OPEC was also considering to switchover from dollar to euro.

Falling status of dollar as reserve currency

Economists like Alan Greenspan suggest that another reason of continueous fall in the value of dollar is its decreasing role as the reserve currency. Central banks, around the world, choose dollar as reserve currency due to its stability and also to ensure their country’s oil security. But the continuing devaluation of dollar, against other currencies, is forcing to all these banks to diversify their forex reserves from dollar to euro. Following table shows the decreasing share of dollar and simultaneously growing share of euro as reserve currency:

Currency composition of official foreign exchange reserves

Currency

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007*

US dollar

69.3%

70.9%

70.5%

70.7%

66.5%

65.8%

65.9%

66.4%

65.7%

63.8%

Euro

17.9%

18.8%

19.8%

24.2%

25.3%

24.9%

24.3%

25.2%

26.4%

German Mark

13.8%

Pound sterling

2.7%

2.9%

2.8%

2.7%

2.9%

2.6%

3.3%

3.6%

4.2%

4.7%

Japanese yen

6.2%

6.4%

6.3%

5.2%

4.5%

4.1%

3.9%

3.7%

3.2%

2.7%

French franc

1.6%

Swiss franc

0.3%

0.2%

0.3%

0.3%

0.4%

0.2%

0.2%

0.1%

0.2%

0.2%

Other

6.1%

1.6%

1.4%

1.2%

1.4%

1.9%

1.8%

1.9%

1.5%

2.2%

Source: Wikipedia, IMF: Currency Composition of Official Foreign Exchange Reserves (COFER), * Upto third quarter

This situation is putting more pressure on dollar to maintain its value. As banks are selling the dollar and buying the euro, the euro is appreciating steadily. China, which maintains the huge reserve of dollar accumulating about $ 1.53 trillion, has announced its intention to decrease the share of dollar in its reserves and to add more euros.

 Weak USA economy to push dollar downward

For some years, US economy is undergoing through economic slowdown and growth rate is going down. This scenario is expected to be same in 2008 also. Consequentially, the declining trend in dollar is also likely to continue in 2008.

"The projection for U.S. growth in 2007 as a whole is unchanged at1.9 percent, but has been lowered by 0.9 percentage point (relative to the July World Economic Outlook Update) to 1.9 percent in 2008. Ongoing difficulties in the mortgage market are expected to extend the decline in residential investment, while house price declines are likely to encourage households to raise their saving rate out of current incomes and thereby dampen consumption spending. Exports, however, are expected to grow robustly, benefiting from the continued decline in the dollar and solid growth in partner countries, and healthy corporate balance sheets should support business investment."

World Economic Outlook, October 2007

The economy of USA, which was already undergoing major weakness due to its internal deficiencies, was further hit by subprime crisis. Subprime crisis have melted the assets, worth of billions, and have been the cause of bankruptcy of many financial institutions. This crisis is not likely to cool down in near future. Some analysts estimate that total losses due to this crises may be more than $ 300 billion. Moreover, US economy has been trapped into the net of debt. As at 30 June 2007, the gross US external debt was $12 trillion (Source: World Bank) or 88% of the overall size of the U.S. economy. Further, IMF has warned USA to control its huge current account deficit at it has reached at dangerous level and may lead to crash of dollar. This economic weakness has put extra pressure on dollar in fighting against euro and other currencies.

Weak future outlook

The dollar is already touching historic low levels against other currencies and if it fails to keep its identity as petrocurrency or reserve currency that will lead to sharp decline in its value. These situations are creating difficulties for USA as further major devaluation of dollar will affect the national economy at large.

Due to these conditions, many analysts are expecting the dollar to loose its dominance. Legendary investor Jim Rogers declared that he quits dollar as he think its value will fall even further, especially against the Chinese yuan. Econometrical analysis suggests the euro may replace the U.S. dollar as the major reserve currency by 2020 if: (1) the remaining EU members, including the UK, adopt the Euro by 2020 or (2) the recent depreciation trend of the dollar persists into the future.

"No single economy can profit for long at the expense of the rest of an interdependent world. There is an urgent need to restructure the global finance architecture to return to exchange rates based on purchasing-power parity, and to reorient the world trading system toward true comparative advantage based on global full employment with rising wages and living standards. The key starting point is to focus on the hegemony of the dollar.
To save the world from the path of impending disaster, we must:

  • promote an awareness among policy makers globally that excessive dependence on exports merely to service dollar debt is self-destructive to any economy;
  • promote a new global finance architecture away from a dollar hegemony that forces the world to export not only goods but also dollar earnings from trade to the US;

-Henry C K Liu

US dollar hegemony has got to go

On the positive side, dollar is getting support from Federal Reserve which is trying to control devaluation of dollar through raising interest rates as and when required. US government is also keen about maintaining dominance of dollar in global economy. US government is taking hard steps to keep OPEC countries stuck with dollar. In any case, one should not forget that USA will not let dollar to loose its dominance easily and will try to defend it by all means, for example one may take the case of Iraq war and recent threats to Iran.

"The real reason the Bush administration wants a puppet government in Iraq -- or more importantly, the reason why the corporate-military-industrial network conglomerate wants a puppet government in Iraq -- is so that it will revert back to a dollar standard and stay that way"" (While also hoping to veto any wider OPEC momentum towards the euro, especially from Iran -- the 2nd largest OPEC producer who is actively discussing a switch to euros for its oil exports)."

U.S. Dollar vs. the Euro: Another Reason for the Invasion of Iraq

Conclusion

Although, there seems a difficult road ahead for dollar to survive against euro, it looks that it will take some time for euro to replace dollar as global currency. There is no probability of any sudden switchover by OPEC countries to opt for euro denominated oil trade or central banks to opt for euro as single major currency in their forex reserves, as that will lead to disastrous devaluation of dollar. Such a sudden change will have impact not only on US economy but on global economy as well due to wide presence of dollar in international monetary system. If all the major players start selling dollar for euro that will depreciate the value of other countries’ dollar reserves as well and it will not be possible for any country to make a sudden switchover. This situation may lead to global financial crises. So it is most likely that there will be gradual switchover and most probably there will be two dominating currencies balancing each other. That will be a better situation as no single player will be able to control global economy and ultimately a balanced economic environment will provide better options to all players to choose their way.

References:

    • Wikipedia
    • U.S. Dollar vs. the Euro: Another Reason for the Invasion of Iraq: by William Clark
    • Petrodollar or Petroeuro? Anew source of global conflict : by Coilin Nunan
    • US dollar hegemony has got to go : by Henry C K Liu
    -William Clark

    -International Monetary Fund

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