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The Dollar's Drift


Economics: CURRENCIES

THE DOLLAR'S DRIFT

The U.S. dollar has finally rebounded on foreign exchange markets, buoyed by apparent progress in curbing the budget and trade deficits--and possibly by a sudden reversal in market sentiment. But its rally is unlikely to be long enough or strong enough to reverse the slow and steady

erosion in the dollar's status as the key reserve currency.

As something to lose sleep about, the dollar's reserve status--that is, the willingness of foreign central banks to hold dollars in their coffers--may seem fairly marginal. Stanford University economist Paul R. Krugman believes that concern over the issue is "98% mysticism--people get frantic about it when they have no idea what it means, which is not very much."

HISTORY LESSON. Economists who take the foreign exchange market's pulse daily aren't quite so sanguine. "The world could be lurching toward a multipolar currency system where the mark and yen serve as regional international currencies," William Sterling, international economist at Merrill Lynch & Co., wrote in a recent market letter. Along the way, there could be currency crises and panicky dumping of dollars. "History teaches that major transitions in currency systems are unlikely to proceed smoothly," he warns.

The numbers themselves are irrefutable. The dollar has for years been the predominant foreign currency that central banks hold; it still accounts for more than 60% of official reserves. But over the past decade, there's been a gradual slippage in the dollar's share as central banks accumulate more German marks and Japanese yen. Today, a mere 9% of worldwide official holdings are in yen, up from 6% a decade ago. Global holdings of marks stand at about 16%, up from 13% a decade ago.

Central banks obtain foreign exchange in a variety of ways. As nations run trade or current-account surpluses, those surpluses are deposited locally, and reserves are set aside with the central bank. Then dollars, yen, marks, and other currencies are bought and sold through central bank intervention and trading. Most of the time, currencies are held in short-term government securities, which earn interest, also adding to reserves.

Perversely, the dollar's recent weakness may have raised global dollar reserves. The Bank of Japan, for instance, is estimated to have purchased $10 billion a month to support the dollar and undercut the yen's climb this year. Nonetheless, many smaller central banks in Asia may have been net sellers of dollars.

What is the significance of the dollar's loss of reserve status? First, there is the intangible but important geopolitical effect. The dollar's loss of prestige may undermine America's role as a superpower, observes Jeffrey Frankel, an economist at the Institute for International Economics in Washington, D.C. A more tangible effect, though, may be a reduction in what economists call seignorage, or the income or benefit a country receives from its ability to get its currency accepted in exchange for goods and services.

EXTRA PENNY. When the Japanese sell Toyotas to the U.S. and take dollars in return, for instance, they are accepting paper that represents a future claim on U.S. assets--in effect, an interest-free loan. For the U.S. government, the billions of dollars in circulation outside America means that a portion of government spending has been financed by an interest-free loan, noted Federal Reserve Board governor Lawrence B. Lindsey in a speech last year.

Lindsey quantified the benefits by noting that in 1981, following two rounds of inflation in 10 years, the ratio of dollars in circulation to U.S. GDP had fallen to just over 4 cents of currency per dollar of GDP. Twelve years later, after a painful disinflation, there were slightly more than 5 cents for every dollar of GDP. That extra penny amounted to an extra $64 billion in seignorage, says Lindsey. A strong reserve status also means that the government probably pays less on Treasury bills than it otherwise might.

Such benefits will accrue only as long as the dollar continues to be seen as a store of value. What worries some economists, though, is that periodic bouts of dollar-dumping on forex markets will prompt central bankers to reduce their holdings--and that economic fundamentals may hasten the process. The U.S. now accounts for about 25% of global output, compared with about 50% after World War II, and is a net debtor rather than a net creditor.

Still, despite the mark's and the yen's elevation in reserve status, they will not soon displace the dollar. For one thing, neither Germany nor Japan has a market for short-term cash instruments nearly as broad or deep as the market for U.S. Treasuries, which investors can hop in and out of on a 24-hour basis around the globe. "Any currency, if it is to become an international currency, must have an efficient market," says Toyoo Gyohten, chairman of the Bank of Tokyo Ltd. and adviser to the Finance Ministry on currencies. Gyohten favors reducing Japan's dependence on the dollar, which accounts for 75% to 85% of the central bank's forex holdings.

MISMATCH. The yen doesn't even have the regional status that the mark does in Europe, since many Asian countries still link their currencies to the dollar, and most Asian trade is still denominated in dollars. But with more debt owed in yen than ever before, Asian nations such as Indonesia and Thailand are experiencing a big mismatch between export revenues and debt service. They will "probably want to change their profile of foreign reserves to more closely resemble their liability profile," says James Lister-Cheese, an analyst at London's Independent Strategy, a bond and equity research firm.

As a reserve currency, pound sterling outlasted Britain's preeminence in the global economy, and the dollar's reserve role may well outlast the U.S.'s. Indeed, observes David Hale, an economist at Kemper Financial Services Inc., it is surprising that dollar holdings are as high as they are. The dollar remains the lingua franca of international trade and finance. Oil and other major commodities are priced in dollars, most international debt is still dollar-denominated, and the dollar is widely used as a "street" currency--though the mark is gaining in Eastern Europe. None of that will change quickly. Nor, with no good substitute at hand, will the dollar suddenly be unseated as the key reserve currency. Slowly but surely, though, its once lofty status is being chipped away.By Karen Pennar in New York, with Brian Bremner in Tokyo and Bill Javetski in Paris


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