Conjecture is once again rife that we are reaching the end of the era of the dollar-centric global currency system. And while previous reports of the death of the dollar as the global reserve currency were greatly exaggerated, the system is showing signs of stress. Huge cross-border capital flows that only partly reflect economic fundamentals are resulting in exchange rates out of line with fundamentals for sustained periods. Volatility and uncertainly is hindering decision-making. Questions are being asked about the risks being placed by countries holding much of their reserves in dollars.
In response, there has been a rush of proposals from policymakers, think tanks, and non-governmental organizations for reform. Prominent calls have been made by the Governor of the People's Bank of China, Nobel Laureate Joseph Stiglitz, and others for a new reserve currency system based on the IMF's special drawing rights. Others have argued for a more coordinated approach to exchange rate policy involving target zones. And recently British Prime Minister Gordon Brown refloated the idea of a Tobin tax on all cross-border currency flows which could help dampen movements.
The corporate world has thus far been notably absent from these discussions, despite the fact that many businesses are taking a direct hit from current exchange rate misalignment and uncertainty. In a December 2009 survey by McKinsey & Co., more than 30% of manufacturing executives reported that exchange rate uncertainty has reduced their planned investment over the next two years. It is time for business to engage and shape the currency debate.
little benefit to the U.S.
Recent capital flows have been driven by a range of factors, but uncertainty over the commitment of the U.S. to supporting a strong dollar as a reserve currency is one of the major sources of future uncertainty. This is why new research from the McKinsey Global Institute (MGI) looks at the reserve currency issue from a new angle: What are the costs and benefits of being a reserve currency, and is the U.S.—or the euro zone—likely to continue supporting policies in line with being the issuer of the world's reserve currencies?
This may seem a no-brainer given the enduring assumption that, as a former French Finance Minister charged in the 1960s, the U.S. enjoys an "exorbitant privilege" from the dollar's reserve currency status. But the surprising result of MGI's analysis is that the U.S., in fact, enjoys hardly any net benefit at all. In 2007 and 2008, MGI estimates, the net financial benefit to the U.S. was between about $40 billion and $70 billion—or 0.3% to 0.5% of U.S. gross domestic product. And in the year to June 2009, when the dollar appreciated by about 10% due to its safe-haven role, the cost-benefit turned even less positive: We estimate a range between a net benefit of $25 billion and a net cost of $5 billion.
There are two main benefits to the U.S. as issuer of the main reserve currency. First is interest from seigniorage—the profit made on issuing additional currency to nonresidents who hold U.S. notes and coins—estimated at $10 billion a year. Second is the fact that the U.S. is able to raise capital more cheaply because of very large purchases of U.S. Treasury securities by foreign governments and government agencies. We estimate that these purchases have reduced the U.S. borrowing rate by 50 to 60 basis points over the past few years and are worth about $90 billion to the U.S.
The large downside to the U.S. is that the reserve currency is a magnet for the world's official reserves and liquid assets, and that these flows mean that the dollar exchange rate is higher than it would be without reserve currency status by 5% to 10%. This harms the competitiveness of U.S. exporters and companies competing with imports.
greater volatility ahead
These aggregate numbers mask some big differences. The benefits are received by borrowers—especially the U.S. government. Exporters and manufacturers that compete with imports lose out by up to $100 billion because of the strength of the dollar, reducing employment in these sectors by between 400,000 and 900,000.
The modest overall benefits—and the hit taken by U.S. exporters and manufacturers and American jobs—suggests the U.S. is unlikely to prioritize its reserve currency role over its domestic economic agenda, particularly given the economic challenges it faces. In particular, it seems likely the U.S. will continue with its relatively loose monetary and fiscal policies even if this comes at the expense of its implicit responsibilities to global exchange rate stability. Given the scale of the global imbalances and of cross-border capital flows, this may contribute to heightened exchange rate volatility and uncertainty.
But could a reluctant U.S. anchor be an opportunity for the euro zone to promote the euro as the new global currency?
We believe not. Our analysis shows that the small costs and benefits of the secondary reserve currency status of the euro broadly cancel each other out today. Euro zone economies can borrow slightly more cheaply, but there are costs associated with an elevated exchange rate. And if the euro were to become a more significant reserve currency over time, these costs would rise because the euro would appreciate.
Given that European policymakers are concerned about today's euro exchange rate, the prospect of a permanently stronger euro is likely to be unattractive. Perhaps unsurprisingly, in a November 2009 interview with Le Monde, European Central Bank president Jean-Claude Trichet said that the euro was not designed to be a global reserve currency.
If the world's two main reserve currency issuers are increasingly disinclined to pursue policies that are consistent with global exchange rate stability, we may de facto be in a period of an "unmanaged" reserve currency system with no firm hand on the tiller. There is indeed a growing consensus that the world will move away from the dollar as a reserve currency—fewer than 20% of executives surveyed by McKinsey expect the dollar to be the dominant global reserve currency by 2025—but there's also less clarity on where the world will end up. Businesses seem to be anticipating greater exchange rate volatility to result from this system in transition. Our survey shows that 70% of executives expect the current currency volatility either to remain or increase.
This is a worrying prospect for business. As policymakers begin to think in earnest about the new global financial architecture, it is vital that companies ensure that policymakers consider the impact on competitiveness of exchange rates out of line with fundamentals and on decision-making from exchange rate uncertainty. Companies may argue that grand schemes about global financial architecture are the preserve of politicians, but whether the world resolves the reserve currency issue or not is very much their business.