Why the US dollar still rules the world

Kotak Mahindra Bank chief Uday Kotak recently called the US dollar “the biggest financial terrorist”. Such a comment from one of Asia’s pre-eminent and very successful bankers was bound to go viral, which it did. Before the bouquets and brickbats could begin, Kotak also clarified via a tweet that his language was inadvertent. It wasn’t clear whether he regretted saying it. The word “terrorist” cannot and should not be used loosely, at least from the high podium.

Kotak said that he meant to point out the disproportionate power enjoyed by the almighty dollar, as the world’s reserve currency. But that skirts the point that none of the 145 countries holding dollar reserves are under any compulsion, let alone terrorised, to hoard their reserves in US dollars. They are doing it of their own volition. Some 60 per cent of the nearly $13 trillion in global reserves are held in dollar-denominated securities.

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The biggest pile of dollar reserves is with China, now America’s biggest strategic challenger. Another 20 per cent of all global reserves is in euros. The rest are in British pound sterling, and Japanese yen (5 per cent each).

A small 3 per cent of reserves is held in Chinese yuan, presumably by those countries involved in trade or indebted to China.

The US dollar is the strongest it has been in 50 years. So those countries whose imports are invoiced in dollars are feeling the pressure of higher import costs. That is adding to their inflation, which is already high, thanks to higher commodity and oil prices, which are also denominated in US dollars. Those countries which have foreign debts in dollars are unhappy too since their debt servicing cost has gone up, as the dollar strengthens. The dollar is getting stronger because all the global capital is flowing “uphill”, from less developed countries into America. That is because the yield on the US government bond has gone up steeply. During recessionary times, a safe place for investors to park their funds is in US bonds. Hence the demand for the dollar is strong.

Another great anomaly is not only that many countries keep their foreign exchange assets in dollars mostly, but their trade invoicing is also in dollars. For instance, Sino-Indian trade is nearly $120 billion, and is almost totally invoiced in dollars. Only 15 per cent of India’s exports go to the US, but 85 per cent of the exports are invoiced in dollars. So, the US dollar enjoys hegemony not just as the dominant reserve currency, but also the invoicing currency of choice between any two random trading partners.

The reason the dollar is the currency of choice is because of the implicit trust in its stability. A third big privilege enjoyed by the US dollar is called seigniorage. This is actually the profit made by the currency issuing authority. More than 90 per cent of the dollars in circulation as cash are in 100-dollar denominations, and the bulk of it circulates outside America. So, all those foreigners holding that currency are implicitly paying a tax to the US government even though they are not US taxpayers. This is the essence of seigniorage.

Calling the US currency a terrorist would be sweet music to the ears of Russian President Vladimir Putin. That’s because the US unilaterally turned off the payment settlement system called SWIFT to block payments to Russia. It also blocked Russian funds lodged in US banks. The US has been trying rather unsuccessfully to persuade other countries to stop buying Russian oil. Even friends like India and Korea are not complying. India has found a way to bypass dollar payments for Russian oil with bilateral trade arrangements denominated in rupees. The Chinese too have struck a deal whereby they can bypass dollar invoicing and clearing. India recently signed a deal with 18 countries, including six from Africa, to start rupee-denominated trade and try to diversify from the dollar route. All this points to efforts to reduce the vulnerability caused by an over-dependence on the dollar. As a former Secretary of Treasury during the Nixon administration of the 1970s, famously said: “the dollar is our currency but your headache”.

Suffering a dollar-driven headache or being under the hegemony of the world’s dominant reserve and invoicing currency does not make it a terrorist. Kotak, as he clarified later, was also alluding to the US power to shut down Nostro accounts. These are accounts where foreign banks hold their money in US accounts in dollars. Blocking Russian funds is one thing, but abruptly shutting down the Nostro accounts of other countries is quite another. This would amount to a breach of international conventions. The discomfort is not because of any terrorising power of the US currency, but in fact because of the increasing and voluntary migration of many countries to using the dollar as a safe option.

That the US behaves in irresponsible ways, often bordering on breaking international conventions, is well-known. For instance, the IMF long ago agreed to reduce the voting share of the US, which has still not been ratified by the US Congress. Or the US single-handedly blocked the dispute settlement mechanism at the WTO by stonewalling appointments to the crucial panel. Under President Trump, the US resorted to tariff hikes which went counter to the principles of the WTO (market access and national treatment principles). The US walked out of the Paris accord after signing it, and also the Pacific Partnership. These are just a few examples of behaviour which shows scant regard for international conventions. But it still does not make the dollar a terrorist. Not even if that was a misplaced metaphor.

The adoption of the US dollar as the preferred currency for reserves amounting to 60 per cent of all reserves is an act of choice. The world is struggling to break away from dollar dependence. But eight countries have adopted the dollar as their de facto currency, and another 22 have pegged their currency to the dollar. Argentina may once again go to a dollar standard. Dollar addiction may be troublesome, but terrorist it is not. The decline of the dollar is still a long distance away.

(The writer is a noted economist)
(Syndicate: The Billion Press)