Tracking the US dollar as the key international currency

The 'AAA' rating of the US rests on the position of the US dollar as a key international currency. Without this status, the US would not have such ready access to external financing; interest rates would have to rise to attract higher domestic savings; growth would slow well below potential.

The US dollar did not attain this position by accident, however, nor is it simply maintained by inertia. It derives from the fundamental strength of the US economy - the causality does not run in the other direction. That strength derives from the size of the economy, the flexibility of labor and product markets, and - relative to other large developed nations - the prospect for high productivity growth and favorable investment returns.

As long as inflation is moderate and stable, financial markets sound and unfettered, government spending efficient and sustainable, Standard & Poor's expects the US to continue to enjoy the added benefits a key currency brings and to maintain its 'AAA' rating.

The US dollar 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, which peaked in 2001 at 90.3% and only modestly retrenched to 88.7% in 2004. (The figures in the table sum to 200%, 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 volume of euro trading fell to 37.2% in 2004 versus nearly 60% for the legacy European Monetary System currencies a decade earlier. The third position belongs to the Japanese yen, which has seen its share slip to 20.3% in 2004 from 24.1% - its recorded peak in 1995.

The British pound sterling, whose share rose to 16.9% in 2004 from 13.6% in 1992, is in fourth position. No other currency attains 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 cross-border finance, although its importance is lessening. According to BIS data, the dollar registered a 42% share of cross-border bank assets at year-end 2004, down from the 1984 peak of 75%.

The dollar has lost market share to the euro and its predecessor currencies (see Chart 1). From 2000 to 2004, the euro increased its share of international bond and note issues to 47% from 30%, while the US dollar's share fell to 37% from 50% (see Chart 2).

The US dollar enjoys a preeminent role in trade. As seen in Table 2, almost all imports and exports to the US are denominated in US currency.

The share of Asian imports and exports denominated in dollars is also high, exceeding two-thirds in the sampled countries. In Europe, the component of U.S. dollar-invoiced imports is partly explained by US-dollar invoicing of oil imports and of other commodities, but the US dollar also commands a healthy share of European exports outside the Eurozone.

The bulk of the foreign exchange component of international reserves remains invested in US dollars. The figures are compiled by the International Monetary Fund (IMF) and released only with a 16-month lag (see Table 3).

Through 2003, they show the share of US dollar reserves as a percentage of identified reserve holdings falling 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 rising steadily to 74% in 1999 (at the introduction of the euro) before sliding back gradually to 69% in 2003. As the track record of the euro 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 US dollar depreciates, the US dollar share of international reserves will fall further.

The decline, however, is likely to be steady and protracted and will likely only recede to levels maintained in the 1990s.

The US dollar enjoys this position as the key currency for several reasons. The US is the world's largest economy, with 21% of world GDP on a purchasing power parity basis, and the world's largest trading partner, with 15% of world trade.

Inflation is under control (see Chart 3) and the dollar is as stable as other major currencies or more so in real effective terms (see Chart 4).

In addition, US banking and capital markets are dynamic and unfettered. The capital account of the US is open. Unlike the euro, a government of a unified state backs the US dollar.

Many Asian trading partners, to enhance their own export competitiveness, accumulate dollars to keep their bilateral 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 that hold their savings in offshore financial centers value their holdings in US dollars, and thus have a bias toward dollar assets.

However, the international acceptance of the US dollar as a unit of account, a medium of exchange, and a store of value has also enabled a vulnerability to develop. The external position of the US is weak.

Net external debt relative to current account receipts is among the highest of rated sovereigns (see Chart 5). Official institutions hold much of the US public sector external debt.

External financing for the US public sector, emanating from a handful of principally Asian central banks (see Chart 6), is more vulnerable to sudden stops in investment flows than external financing for the US private sector, based upon a myriad of different investor classes seeking to maximize their investment return.

To motivate external creditors to maintain their holdings of US dollars, US policymakers are ever more pressured to pursue strong macroeconomic policies. 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 trajectory of the US fiscal deficit. Although Standard & Poor's expects the general government deficit as a share of GDP to fall below 3% this year and to decline steadily through 2007, the dollar could come under renewed pressure if the US fiscal accounts deteriorate or if investors came to doubt the government's willingness to address the fiscal challenges that loom in the next decade.

Lesser risks emanate from rising inflation or protectionist trade policies. Fiscal outturns, inflation figures, trade volumes, and foreign exchange volatility will be the leading indicators should the dollar's role begin to diminish. In the medium term, such a worst-case scenario would even weigh on the 'AAA' rating of the US.

[The article is an abstract from RatingsDirect, Standard & Poor's Web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]