The dollar may be down, but it's far from snuffed out

Within minutes of rating agency Standard & Poor’s decision to downgrade US sovereign rating from the highest-rung AAA to AA+ the question of whether this meant the “ death of the dollar ” went out, right on cue.

China condemned the “short-sighted” political wrangling in the US over its debt problems and said the world needed a new and stable global reserve currency. China’s official news agency Xinhua noted that China, as America’s largest creditor, “has every right now to demand the US address its structural debt problems and ensure the safety of China’s dollar assets.”

It argued in favour of introducing “international supervision over the issue of US dollars” and the adoption of a “new, stable and secured global reserve currency” as an “option to avert a catastrophe caused by any single country.”

It’s a familiar chant, which we’ve heard with an increasing vigour over the past three years, ever since the 2008 financial crisis, with its epicentre in Wall Street, showed up the infirmities of the US financial markets and its underlying economy.

In 2009, a British newspaper even reported sensationally that Gulf oil-producing states were in secret talks with China, Russia and Japan to end the pricing of oil in US dollars and move to a basket of currencies. It then fancifully suggested that this would be the first step towards ending the dollar’s reign as the global reserve currency.

In fact, over the past three years that China has been demanding an alternative reserve currency mechanism , it actually increased its dollar holdings, even masking its sales through other financial centres to cover its tracks. It did it as part of its mercantilist policy to push its exports by devaluing its currency, and until that old habit changes, crying itself hoarse about the dollar trap it’s caught in, is a fruitless exercise.

It isn’t any surprise that the S&P downgrade has brought out the dollar bears in full force. For sure, the downgrade is a blackmark that sullies global perceptions of the US as worthy of the trust that investors in its assets have reposed thus far. The partisan bickering that preceded the shotgun debt ceiling deal reached by Congress earlier this week epitomised everything that’s broken about the American political system, which in turn is dragging down the US economy and compounding its long-term structural debt problems.

A kick in the pants

Yet, once you weed out the hype from the shrill rhetoric, it’s clear that for all the challenges that the dollar faces over the long term, today’s downgrade won’t change the currency landscape overnight. In fact, if anything, the downgrade may be just the kick in the pants that the hyperpartisan and ideologically rigid US political establishment needs to fix its structural debt problems. After all, nothing focusses the mind so wonderfully as the prospect of a hanging in the morning.

There’s evidence to establish that the debt downgrade won’t set off a short-term flight of capital from US Treasuries. As the Economist noted ,US money-market funds, which hold $684 billion of government and agency securities, “are allowed to hold government paper that has been downgraded a notch. Other investors, such as some insurers, can only hold top-rated securities but their investment boards are likely to approve requests to rewrite their covenants, especially if a lower rating looks temporary.”

The National Investment Company of the US confirms this, noting that money market funds “would not be affected by any change in the AAA rating” on US long-term debt, which is what S&P’s has downgraded now.Even a downgrade in the short-term credit rating - which hasn’t been done yet - would not force money market funds to dispose of their holdings of US government debt, the agency noted.

So, for all the grim headline news , it’s unlikely that we’ll see an immediate stampeding out of funds from US Treasuries. If anything, as this chart establishes , S&P’s record of AAA sovereign downgrades shows that its downgrade action has the effect of triggering a purchase of government securities.

Even the debate over the need for an alternative reserve currency overlooks the fact that reserve currencies emerge not by diktat but organically, over time. One economist likens the dollar’s continuance to the widespread use of Windows operating system for computers. Sure, Windows is expensive and has bugs, and sure there are freeware alternatives, but it’s more convenient to use Windows because of the network effect of having ’everyone else using it’. And like Windows, reserve currencies enjoy an ‘incumbency advantage’: unless a new currency can demonstrate that it offers vastly superior benefits, it cannot dislodge the entrenched one.

The dollar is, as this blogger notes , also like the English language. People may consider French to be better or the grammar easier, but in emerging markets, people are clamouring to learn English, not French. That’s not because of some shared affinity with the UK or the US but because English is the most convenient language to use - because it is widely spoken.

That could change over time, and over the next decade the dollar could lose relative marketshare in the marketplace of reserve currencies. Perhaps more people will learn to speak Chinese; perhaps a currency note with Mao Zedong will nestle alongside the one with Mahatma Gandhi in your wallet. But for that to happen, the Chinese yuan has to become fully convertible, which would require he Chinese Communist Party to give up control over its command economy, and perhaps even embrace an open political system, with an independent judiciary. That’s not about to happen anytime soon.

The choice of a reserve currency also comes with an implicit bargain: the underlying economy has to run trade deficits and current account deficits to provide liquidity to the rest of the world. It must also open itself up to the risk of seeing hostile governments or traders short-sell your currency for political or economic reasons, as is happening with the dollar today. Not everyone wants that responsibility and the headache: certainly not China.

All things considered, intimations of the dollar’s imminent death, or its displacement as a reserve currency in the near future, are greatly exaggerated. Not because the dollar deserves to live, but because those who grudge it its longevity won’t let it die.