In doing most introductory courses in economics you will have come across the four functions of money which are:
Medium of exchange
Unit of Account
Store of Value
Means of deferred payment
Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:
60% of the world’s currency reserves are in US dollars
50% of cross-border interbank claims
After the GFC, purchases of the US dollar increased significantly – store of value.
Around 90% of forex trading involves the US dollar
Approximately 40% of the world’s debt is issued in dollars
n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.
So why therefore is there pressure on the US dollar as the reserve currency?
The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:
Deposits in yuan = 1trn yuan = US$144bn
Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
China settles 15% of its foreign trade in yuan
France settles 20% of its trade with China in yuan
The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%
However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.
Source: The Economist – China wants to make the yuan a central-bank favourite 7th May 2020
The Washington Post recently reported that with the prospect of the Fed maintaining lower interest rates than its counterparts elsewhere, the US dollar is losing its status as the world’s safe currency in troubled times. The dollar is still dominant but when the European economy gets its fiscal issues resolved – could take a long time – that might lead to a shift away from the dollar to the euro. However on a positive side for the decline in the US$ is that it has been more systematic and not driven by foreign exchange speculators getting out of dollars but by sentiment that the euro, the GB pound, the Canadian dollar are a better buy at this stage. This is ironic as the US economy is starting to pick-up pace, albeit slowly, and the debt crisis in Europe seems to be getting worse – Portugal look as if they will need to be bailed out.
Remember that high interest rates attract foreign investment into a country which means that investors have to change their currency, in the foreign exchange market, into the currency of that country that they wish to invest in. Therefore the demand for that currency goes up which means that it will increase in value. Ben Bernanke has consistently said that he wants to keep short-term interest rates near to zero for an extended period – whatever that means.
From the Wall Street Journal – the state-controlled Bank of China Ltd. is allowing customers to trade the yuan, also known as the renminbi, in the U.S. The decision is the latest move by China to allow the yuan, whose value is still tightly controlled by the government, to become an international currency that can be used for trade and investment.
“We’re preparing for the day when renminbi becomes fully convertible,” Li Xiaojing, general manager of Bank of China’s New York branch, told The Wall Street Journal. He said the bank’s goal is to become “the renminbi clearing center in America.”
Bank of China’s move comes at a time of U.S. pressure on China to let its currency rise in value. America has blamed an unfairly valued yuan for exacerbating the U.S. trade deficit with China. But the preparations for convertibility are also a sign of Chinese strength, as China, now the world’s second-largest national economy, recognizes that as a global power it must have a global currency. In time, a globally traded yuan could emerge as a store of value on par with the dollar, euro and yen.