#forex #dollar This note is related to concept of internationalisation of currency. It can also be well understood by analyzing the primacy of dollar in the global market. However, here we just focus on what would be the U.S. Consequences of a Declining Dollar Status? We have not discussed in detail what has led to dollar's supremacy. ==It is based on the research article by "The international role of the dollar: Does it matter if this changes?", written by Linda S. Goldberg, Federal Reserve Bank of New York and NBER, July 21, 2011 (revised October 3, 2011).== ## Internationalisation of U.S. Dollar 1. An international currency has to be capable of playing roles of 1. store of value, 2. unit/medium of exchange, 3. unit of account for both residents and non-residents. 2. ==More specifically, it can be used for:== 1. private purposes such as 1. **currency substitution** (use of a foreign currency by residents in place of the domestic currency), and 2. **trade and financial transaction invoicing and denomination in international trade** (use of the currency as a transaction currency in foreign exchange markets for capital and current account transactions). 2. public purpose such as 1. being held as primary currency in official forex reserves, 2. acting as vehicle/primary currency for foreign exchange intervention and 3. also serving as an anchor currency for pegging. 3. ==Many factors influence currency choice like == 1. country size, 2. openness in international trade and international capital flows, 3. creditworthiness, and 4. institutional and policy soundness and stability (strong economic fundamentals). 4. These above factors determine the currency’s liquidity and convertibility, which in turn make it attractive for international use. 5. US has satisfied these factors since World War II, which had led to dollar’s primacy in international economic transactions. 6. So even if there reduced dollar role in international markets because of growing strength in other economies, it may not be a concern for US as long as the United States maintains the strong economic fundamentals and the types of institutional strengths that have supported the dollar’s international roles. 1. 2008 crisis is an example of a reduced dollar role associated with less auspicious U.S. policy and institutions. 2. Before the 2008 crisis, many non-US banks borrowed heavily in dollars, but no one thought it was risky. When the crisis struck and dollar funding sources collapsed, those banks suddenly faced serious stress, revealing how dependent they had been on the dollar. 7. Roles of US dollar. It has been the primary/central currency in 1. ==international reserve holdings of central banks== and 2. exchange rate arrangements - that is the US dollar being used as the main reference point for setting/stabilizing their exchange rate. 1. Here 4 categories of countries are: 1. countries that have adopted US dollar as its official currency like Ecuador and El Salvador 2. have formed currency boards using the dollar like Hong Kong which keeps its own currency, but 100% backs it with US dollars (or another foreign currency) held in reserve, 3. pegged exchange rate against the dollar, or 4. maintain managed floats with the dollar as a reference currency 3. leading transaction currency for trade and financial invoicing and denomination in international markets. the dollar clearly dominates global financial and trade transactions as of October 2011. 1. It has an estimated 85 percent share of global foreign exchange transaction volume, more than twice that of the next leading currency (the euro), as of October 2011. *Here 85% means the US dollar is on at least one side of 85% of a foreign exchange transaction, which could be either current account (trade) and capital account transactions (financial). 2. Capital Account - ==Choice of currency for external funding/foreign currency financing==. This is another key measure of presence in international finance. 1. Debt - Of all securities sold outside the issuing country and in a currency different from that of the issuer’s country, share of dollar is nearly 50%. They are called international debt securities. 2. Loans - Around 60% of all loans made across borders, whether to banks or to companies, are denominated in dollars. 3. ==In other words, most global borrowers owe money _in dollars_, not in their local currencies.== 8. One must also remember that exchange rates can move substantially without immediately having bearing on the international roles of currencies 9. Chinn and Frankel (2008) project that the dollar status has been based mainly on the growth trajectories of different regions and argue that, in the next decade, the euro could potentially rival or surpass the dollar. 1. The potential for China’s currency, the renminbi, following on the Chinn and Frankel arguments about country size, is due to because of the spectacular economic growth of China over the past two decades. China’s historic rise as a global economic and trading power will continue to profoundly reshape the global economic system. 2. China’s removal of restrictions on international capital flow is also promoting the RMB internationalization in recent times 10. Likewise, Eichengreen (2011) forcefully argues that the world is evolving toward a multi-currency regime, without the continuing dominance of the U.S. dollar. 11. Euro-In the aftermath of the Great Recession and during the period of European sovereign debt stresses, EURO does not seem to be the choice for international currency ## What would be the U.S. Consequences of a Declining Dollar Status? *Consequences mean negative implications.* 1. If rupee were to become the international currency, policy-makers would have also consider what would happen this status declines. Hence it is very important also understand the consequences of a declining status. 2. Let us analyze it in context of US dollar as explained in [Goldberg, Linda S. (2011)](https://www.newyorkfed.org/medialibrary/media/research/economists/goldberg/int_role_of_the_dollar_changes.pdf) 3. **Seignorage returns: Lower returns** 1. Seignorage gains on currency outstanding can be approximated by the difference between interest earned on securities acquired in exchange for bank notes and the costs of producing and distributing those notes. 2. As on Sept. 2025, the total value of U.S. cash dollars in circulation was approximately $2.41 trillion. With yields in range of 50-400 basis points, returns for U.S. Treasury would be between $12bn-$96.4bn. *The vast majority of the Fed’s assets are U.S. government securities (like Treasuries and mortgage-backed securities). This not the case for India. 3. By some estimates, in excess of 60 percent of U.S. dollar notes are outside of the United States. *Much of the cash is in Russia and the former Soviet Union, Central and South America, and the Middle East.* 4. If the usage dollar declines in these countries, it will lower the holdings of dollar notes and reduce these gains. 4. **Funding costs: Increase in the funding cost if demand for US treasuries decline** 1. One of the misunderstood yet fascinating parts of international finance: the so-called **“exorbitant privilege”** of the U.S. dollar - U.S. investments abroad have had higher returns than what the U.S. pays to foreign investors. 2. This gap is a privilege that other countries don’t enjoy. 3. This "exorbitant privilege" is per se disputed. Here per se means in itself. So those who dispute mean that the advantage in returns might not be _because of the dollar’s international role itself_ buy could simply be due to what kinds of assets the U.S. and foreigners invest in. 1. The outward US investment is mostly in riskier and higher returns investments like FDI, while inward US capital flows is mostly in safer and low-yielding assets like bonds or bank deposits. 2. Hence the return gap is due to different asset composition, not necessarily because the dollar is special. 4. Adjusting for asset types, there _is_ a still a small advantage as the U.S. still borrows at slightly lower interest rates than others. But that’s likely because of lower country risk premium, tax differences, safe and stable investment returns. 5. Some may argue this insurance premium paid by the rest of the world to the United States for its exorbitant duty in giving the world a stable anchor and for providing other countries lender of last resort resources. 6. Regardless of one’s stance in this exorbitant privilege debate, it is certainly possible that funding costs for US debt will surely rise, that is there will be higher returns for foreign investors on their US investments, if the appeal of the dollar assets declines. 1. We can analyze this scenario as follows: 1. Imagine if the assets of other countries emerge as stronger alternative investment vehicles to U.S. Treasuries, OR if the safe haven role of the dollar is perceived as eroded. 2. This could potentially reduce the demand for U.S. government debt relative to the non-dollar denominated assets purchased by private and official sector investors 3. A reduced demand for U.S. official sector debts could increase the debt financing costs for the United States, 4. This would then lead to higher fiscal burden of U.S. debt 5. A rising US treasury yield will also lead to an increasing crowding out of domestic public and private sector spending. 6. A reduced demand for the U.S. assets also could lead to U.S. dollar depreciation, making imports expensive. 5. **U.S. insulation to foreign shocks:** 1. The dollar’s primacy in global trade and capital market transactions have traditionally provided the United States with a degree of insulation from shocks that originate in foreign markets. This type of insulation is discussed in Goldberg and Tille (2006). 2. **Loss of protection to imports by US:** 1. **More pass-through of weakening of dollar into import prices:** 1. The relatively low sensitivity of U.S. import prices to exchange rate changes results in less expenditure switching between home and foreign goods when the dollar value changes. 2. *In other words, even if the dollar weakens, the prices Americans pay for imported goods (in USD) don’t change much. Hence Americans do not have buy fewer imports and more domestic goods. There is less switching of expenditure. They continue to buy foreign goods, and more burden of adjustment is borne by exporters. 3. The low import-price sensitivity is partially attributable to the use of dollars in trade invoicing 4. With increased use of other currencies in invoicing trade and in borrowing and lending activity, the insulation could decline. It could raise exchange rate pass-through into domestic import prices, and ultimately make U.S. prices more sensitive to foreign fluctuations. Thus, when the dollar exchange rate moves, more of the expenditure switching burden is felt in the United States and less by our foreign trading partners. ==In short, a greater invoicing in other currencies could shift the adjustment burden more to the United States. == 3. **Large currency mismatch risks on their balance sheets.** 1. U.S. entities are able to issue their debt in U.S. dollars due to the global predominance of the dollar. 2. This has been helping the U.S. government and private entities avoid the “original sin” of large currency mismatch risks on their balance sheets. 3. Original sin - countries are unable to borrow in their own currency. 4. **Policy-making:** - If dollar's status declines , that is there is an increased use of other currencies in place of the dollar, in international roles such as trade invoicing and lending and borrowing activity could lead to 1. Facing more international transmission of shocks and stimuli. 2. The United States and its range policy decisions for its economy being influenced more by the external factors like decisions and economic cycles of foreign markets, and 3. This is like loss of a protection. 6. **Dollar valuation:** 1. **Weakening of US dollar:** 1. *A currency’s value is supported by its status as the primary global reserve currency* *to the extent* that U.S. dollar assets are demanded by public and private sector entities worldwide. 2. So, for example, if there is withdrawal of demand (by public sector) of US dollars as foreign exchange reserve demand, this occurrence could be associated with a depreciated U.S. dollar relative to whichever currency gets an enhanced role. 3. The potential economic consequences of a weaker dollar are mixed. 1. **Nominal value of debt remains unchanged:** The U.S. debt burden does not increase in dollar terms since U.S. liabilities are denominated in its own currency-the US dollar- regardless of the size of external debt of the United States. *Now Indian rupee is not an international currency. So India borrows in US dollars. As Indian govt. has external liabilities (dollar denominated debt), if rupee weakens against the dollar, the value of these US dollar liabilities in terms of rupees will increase. Though external debt of govt. of India is small compared to its internal debt + other internal liabilities. However if we rupee becomes the international currency, it would enjoy the same privilege as the dollar does now.* 2. **Yield may rise:** ==But if further dollar further dollar depreciation is expected, investors will seek higher yield, and thus leading to higher costs of carrying the debt. % returns. *Similarly, if rupee is expected to weaken, investors will seek higher yield on Indian sovereign debt*.== 3. **Trade Competitiveness will be impacted:** Changes in the value of the dollar will impact the competitiveness of U.S. exporters and importers. It will also impact the countries that use the dollar on their foreign trade. 4. <span style="background-color: #ecf9ee">Summary - Fall in demand for US dollars -> Weaker Dollar -> Nominal debt value remains same as U.S. debt is denominated in dollars -> Higher bond yields if further depreciation is expected -> Imports costlier/Exports cheaper</span> 7. **U.S. global influence:** 1. If the status of dollar declines, a potentially more significant could be a loss of global prestige and policy influence for the United States due to a shift towards a multi-polar currency world. 2. This loss of influence could come in following ways: 1. It would lose its influence on the IMF and World Bank, that firmly supports the current international economic and financial order. These institutions are one of the key ways U.S. exerts its global influence in the modern economic system. 2. A second way by which U.S. may lose its influence is by growing international use of other currencies in international negotiations and transactions. This could further strengthen the reach of other countries in ways that could differ from U.S. preferences and interests. 3. Sanctions will also become less meaningful. Now the dollar's dominance gives the U.S. significant financial and political power, allowing it to impose sanctions and dictate economic policies. But there is also an undesired consequence for US when it imposes sanctions on countries. The sanctioned country has no choice but to adopt other currencies for transactions, thereby leading to reduced demand for dollar. It impacts the hegemony of US dollar. ==Dollar dominance → ability to impose sanctions → reduced dollar dominance.== Many economists describe this as weaponization paradox or sanctions paradox of the U.S. dollar. ## Related Notes 1. [[Internationalisation of INR OPEN]] 2. [[Exchange Rate Policy]] 3. [[Foreign Exchange Management]] 4. [Forex Reserves](Forex%20Reserves.md) ## References 1. Kenen, Peter (1983) “The Role of the Dollar as an International Currency,” Occasional Papers No. 13, Group of Thirty, New York. 2. <span style="background-color: #fff9ae">Goldberg, Linda S. October, 2011. The international role of the dollar: Does it matter if this changes?</span> [Link](https://www.newyorkfed.org/medialibrary/media/research/economists/goldberg/int_role_of_the_dollar_changes.pdf)