Despite pressures, US dollar remains key currency

The US dollar remains the world's most accepted currency by most measures.
This position has been retained despite the growing acceptance of the euro since its inception in 1999 and its encroachment on the US dollar's share in certain markets, and despite recent depreciation in the US dollar vis-a-vis its chief competitor. The 'AAA' long-term issuer credit rating on the United States of America rests on this position of the dollar as a key international currency. Without this, the US would not have such ready access to external financing; interest rates would have to rise to attract higher domestic savings; and growth would slow well below potential. The US dollar did not attain this position by accident, nor does the US maintain it simply with inertia. This dominance is based on the US economy's fundamental strength - the causality does not run in the other direction. That strength comes from the economy's size, the flexibility of labour and product markets, and--relative to other large, developed nations - the prospect for higher productivity growth and favourable investment returns over the medium term. As long as inflation is moderate and stable, financial markets sound and unfettered, and government spending efficient and sustainable, Standard & Poor's Ratings Services expects the US to continue enjoying the benefits a key currency brings and to maintain the 'AAA' rating.

Dollar Market Share
One indication of the US dollar's continued primacy is that it dominates foreign exchange trading. Most foreign exchange contracts are quoted with one leg as the US dollar. Table 1 shows the survey of foreign exchange market turnover compiled triennially by the Bank for International Settlements (BIS). The US dollar has a commanding position, peaking in 2001 at 90.3% and retrenching only modestly to 86.3% in 2007. (The figures for the surveyed currencies add to 200% [rounding error aside], as both sides of a trade are recorded.) On the other hand, with the elimination of the predecessor currencies of the euro and thus their trading, the euro's trading volume fell to 37% in 2007 versus nearly 60% for the legacy European Monetary System currencies in 1995. Third place belongs to the Japanese yen, which has seen its share slip to 16.5% in 2007 from its recorded peak of 24.1% in 1995. The British pound sterling, whose share declined slightly, to 15.0% in 2007 from 16.9% in 2004, its recorded peak, is fourth. No other currency has a 10% mark (again meaning that no other currency attains a share of one-twentieth of foreign exchange transactions).

The US dollar is also a key unit of account for crossborder finance, although its importance has lessened. According to BIS data, the euro has increased its share of international debt securities outstanding since its 1999 inception, to 48% in first-quarter 2007 from 29% in 1999, while the US dollar's share fell to 36% from 47% in the same period (see chart 1). The euro's market share appears to have stabilized since 2004. The euro also challenges the US dollar in over-the-counter derivatives turnover, used significantly more in interest rate swaps, which is by far the most traded contract (see table 2). On the other hand, the US dollar is employed with greater frequency for interest-rate options, currency options, and currency swaps, and has also recently become used more often for forward rate agreements.

The US dollar plays a pre-eminent role in trade, as well. As table 3 shows, almost all imports and exports to the US are denominated in US currency, a privilege no other country enjoys. US dollar use in import and export invoicing has fallen since the euro came into use, but this decline is largely confined to euro-area and EU accession countries, and even for these countries, trade with the US remains almost exclusively invoiced in US dollars. For countries in Asia, Latin America, or Australia, a high percentage of trade is invoiced in US dollars. Moreover, for every country surveyed, the share of exports invoiced in US dollars exceeds the US share in the country's exports--and often by a wide margin. This reflects the decision of many commercial agents globally concerning the expected transaction costs and macroeconomic volatility associated with their invoicing currency of choice, relative to its alternatives (comments in this paragraph draw largely upon "Why a Dollar Depreciation May Not Close the US Trade Deficit," Linda Goldberg and Eleanor Wiske Dillon, Federal Reserve Bank of New York, June, 2007).

An additional indicator of the dollar's continued primacy is that the bulk of the foreign exchange component of international reserves remains invested in US dollars (see table 4). Through second-quarter 2007, the share of U.S. dollar reserves as a percentage of identified reserve holdings fell to 54% in 1991 (during the recession coincident with the turmoil in the savings and loan industry) from 58% in 1987 (one year after the Plaza Accord), and then rose steadily to 76% in 1999 (at the introduction of the euro) before sliding back gradually to 65% in the second quarter of 2007. As the euro's track record lengthens, as some central banks whose trade linkages are less tied to the US diversify their marginal foreign exchange holdings away from the US dollar, and as the dollar depreciates, its share of international reserves will fall further. The decline, however, will likely be steady and protracted, and recede only to levels maintained in the 1990s.

Why The Dollar's Role Remains Central

The US dollar is the world's key currency for several reasons, all ultimately related to the US economy's fundamental strength. The US is the world's largest economy, with 27% of 2006 global GDP, more than the next three largest national economies (Japan, Germany, and China) combined and still slightly greater than the entire Eurozone (at market exchange rates). The US is also one of the world's most important trading partners. Although the level of US exports (8.6% of global exports) is slightly below that of Germany (9.4%) and, more recently, China (10.7%), the gap between these three leaders and the next-largest exporter, Japan (5.4%), is large. The US is also easily the world's most important importer (15.7% of global imports), with a much greater share than China (9.2%), Germany (7.5%), Japan (4.7%) or any other country. Inflation remains modest (see chart 2), despite recent upticks. The dollar's recent depreciation versus the euro (almost 20% in nominal terms since November, 2005) has been the focus of much attention; but from a long-term perspective, the dollar has been as stable as other major currencies or more so in real, effective terms (see chart 3).

In addition, US banking and capital markets are dynamic and unfettered. The US's capital account is open. Unlike the euro, the government of a single, unified state backs the US dollar. Many Asian trading partners, to enhance their own export competitiveness, accumulate dollars to keep their bilateral nominal exchange rates in check. Many emerging market central banks maintain a high proportion of their reserves in dollars to match the currency composition of their country's commercial external debt. Many investors who hold their savings in offshore financial centres value their holdings in US dollars, and thus have a bias toward dollar assets.
Where The Dollar's Role Is Vulnerable

The international acceptance of the dollar as a unit of account, a medium of exchange, and a store of value has also enabled the US to develop a notable vulnerability. The US's external position is weak. Net external debt relative to current account receipts is among the highest of rated sovereigns (see chart 4). In 2006, 44% of US federal government debt held by the public was owned by foreigners, and this share has increased steadily since 2001, when it amounted to 30%. Moreover, in 2006 the increase in foreign holdings equated to 86% of total federal government borrowing, and this ignores indirect inflows via foreign deposits in US financial institutions which themselves hold federal debt. Of the federal government's external debt, foreign central banks hold two-thirds. Though entirely US dollar denominated, nevertheless external financing for the US government, emanating from a handful of principally Asian central banks (see chart 5), is more vulnerable to sudden stops in investment flows than external financing for the US private sector, based upon myriad different investor classes seeking to maximize their investment return.

To motivate external creditors to maintain their US dollar holdings, US policymakers are ever more pressured to pursue strong macroeconomic policies, particularly in light of the gradual but consistent depreciation vis-a-vis the dollar's chief competitor, the euro, since 2005. Any policy that exacerbates the imbalances would put the dollar's role as the key international currency more at risk. The greatest uncertainty pertains to the US fiscal deficit's trajectory. Although Standard & Poor's expects the general government deficit as a share of GDP to fall below 2.5% this year and to remain at or below this level through 2009, the dollar could face increased pressure if US fiscal accounts deteriorate or if investors come to doubt the government's willingness to address fiscal challenges that loom in the next decade. These challenges will become greater the longer they remain unaddressed (for more information, see "Poor Prognosis: Unfunded US Benefit Programs Could Cause Budget Pain"). Lesser risks emanate from rising inflation or protectionist trade policies (although recent trends in commodity prices and domestic politics make these risks more real than they seemed several years ago). Fiscal outturns, inflation figures, trade volumes, and foreign exchange volatility will be the leading indicators should the dollar's role diminish. In the medium term, such a worst-case scenario could even weigh on the 'AAA' rating on the US

(Please see "Sovereign Ratings History Since 1975" for ratings on all sovereigns mentioned herein.)
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