Welcome to the Currency War, Part 5

The Dollar Gets Serious Competition

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Not so long ago the dollar was the world’s only reserve currency. Everything else was one (or several) steps down in terms of safety and liquidity, and major financial institutions acted accordingly, accumulating dollars for the risk-free parts of their portfolios. Global demand for dollars was, as a result, effectively infinite, which meant the US could borrow whatever it wanted, secure in the knowledge that the Treasury bonds it created would find willing buyers.

But quietly, over the past couple of decades, the dollar has been joined at the top by the euro, yen, pound sterling and Swiss franc. And now the list of legitimate reserve currencies has expanded to include Canadian and Australian dollars:

Aussie, Canada dollars termed reserve currencies

LONDON (MarketWatch) — The Australian and Canadian dollars, the world’s leading commodity-rich currencies, are being formally classified as official reserve assets by the International Monetary Fund, marking the onset of a multi-currency reserve system and a new era in world money.

In a seemingly innocuous yet highly portentous move, the IMF is asking member countries from next year to include the Australian and Canadian dollars in statistics supplied by reserve-holding nations on the make-up of their central banks’ foreign exchange reserves. The technical-sounding measure, reflecting growing diversification of the world’s $10.5 trillion of reserves, is likely over time to exert wide-ranging impact on world bond and equity markets.

Expanding by two the list of officially recognized reserve assets from the present five — the dollar, euro, sterling, yen and Swiss franc — signals a new phase in the development of reserve money. For most of the past 150 years, the world has had just two reserve currencies, with sterling in the lead until the First World War, and the dollar taking over as the prime asset during the past 100 years.

Sterling — although still the world’s third reserve currency on IMF figures, just ahead of the yen — has been in relative decline since the Second World War. The birth of the euro in 1999 has turned the European single currency into the world’s No. 2 reserve unit, but it is now officially accepted that the dollar and the euro share their role with smaller currencies.

Enshrining in official thinking a development already evident among reserve managers and on private markets, in a sense, does no more than catch up with reality. However, the IMF step has both practical and symbolic importance and will likely promote further asset diversification among official and private asset managers.

The popularity among central banks of the Australian and Canadian dollars, which have been relatively strong even against the firm U.S. dollar during the past few years, reflect their stable economic growth and intact banking systems since the financial crisis, as well as the influence of Australian and Canadian commodity resources. On informal estimates, worldwide official foreign-exchange holdings in each of the two currencies probably are around $60 billion.

The Chinese renminbi, the Korean won and the Singapore dollar are being held by a relatively small number of central banks. There are no Asian currencies (apart from the yen) on the new IMF list, reflecting their still very low use as official assets.

The renminbi has attracted widespread attention as a possible future reverse currency. But it’s still some years away from attaining that status, primarily because it is not fully convertible. Although held in appreciable quantities by 10 to 15 central banks around the world, the Chinese money lags as a reserve currency behind not just the Australian and Canadian units but also some Scandinavian currencies.

People’s Bank of China Gov. Zhou Xiaochuan said at the weekend: “For the central bank, the next movement related to the yuan [renminbi] is going to be reform of convertibility … We are going to realize it, we are moving in this direction, we need to go further, we will have some deregulation.”

Zhou, who will have completed 10 years at the central bank next month, is widely expected to retire shortly. The focus will be on how much scope the Chinese Communist leadership gives his successor to pursue further financial liberalization.

The importance of the dollar has diminished, from a peak of 71.5% of declared reserves in 2001 to just under 62% by 2012. Outside the five standard reserve currencies, the importance of “other” currencies has risen, from a low of 1.3% in 2001 to 5.3% by end-June 2012, amounting to $310 billion.

Some thoughts

Categorizing Canadian and Australian dollars as reserve currencies makes sense when you view those countries in terms of gold, oil, sunshine and other resources per citizen. By that measure, each Canadian and Australian dollar is backed by a lot more real value than are the currencies of the paper-dependent societies like the US, Europe and Japan. If, as seems likely, we’re in the early stages of a shift away from financial assets and towards real things, the relative strength, and currency exchange rates, of the better-run resource-based economies will keep improving, making their currencies less risky and more profitable investments.

Note that the Chinese renminbi (aka the yuan) and Singapore dollar aren’t on the list. But they will be soon, with China now the second biggest economy (and an aggressive importer of gold) and Singapore becoming the preferred destination of global savings (especially gold storage) now that Switzerland has been cracked by the IRS and other tax authorities. See China’s next step in yuan overhaul is convertibility.

Gold, meanwhile, is once again being accumulated rather than dumped by central banks, and has already, arguably, replaced the dollar as the most coveted reserve asset. This, by the way, is simply a return after a 40-year absence to the place gold has occupied since the beginning of recorded history.

What does this mean for the dollar? First, a lot of central banks and trading firms will sell dollars to buy those other currencies and gold in order to make their portfolios reflect evolving financial realities. That selling pressure will, other things being equal, lower the dollar’s relative value, which is another way of saying that the US might not be able to borrow infinite amounts of money going forward, forcing us to either cut annual deficits far faster than is currently planned or pay a higher interest rate on future borrowings, which would increase future deficits.

The US, in short, will finally be subject to the same economic laws as lesser countries, with the same result: excessive debt and money printing lead to currency crisis which leads to depression.

Source: Dollar Collapse

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