The "exorbitant privilege" under threat: Will the US dollar remain the world’s main reserve currency?

Presumably, the phrase "exorbitant privilege" was coined in the Sixties by a then-very-young Valery Giscard d'Estaing, Finance Minister during the presidency of Charles de Gaulle, to denote the advantages derived by the United States under the Bretton Woods System. The latter, introduced in the aftermath of the Second World War, provided for fixed exchange rates backed by USD or gold reserves and required the US Government to convert USD into gold when requested by foreign central banks. The implied world demand for dollar reserves allowed the US central bank to "print" dollars in vast quantities, without fear of inflation, in the knowledge that they would be absorbed by foreign central banks. This was the "extraordinary privilege".

The system became the subject of serious criticism, especially from the French, in the Sixties partly in response to US inflationary policies implemented to finance the Vietnam War. Famously, de Gaulle requested the conversion of France's USD reserves into gold and sent the French navy to New York to collect it. Faced with the risk of depletion of the US gold holdings, President Nixon suspended in 1971 the convertibility of the USD into gold. Shortly thereafter, the Bretton Woods system collapsed and the world moved to a system of (sometimes managed) floating exchange rates. But - surprise, surprise - nearly fifty years later the USD remains the world's main reserve currency and the "exorbitant privilege" has largely survived.  

Statistics indicate that over 60% of the reserves held by central banks are denominated in USD. Only around 20% of world currency reserves are held in EUR, making it a very distant second. Furthermore, oil and other commodity prices are quoted in USD and an estimated 75% of world trade is invoiced in USD. Jean-Claude Juncker complained last year that Europe was paying for 80% of its energy imports in USD and deemed this situation unacceptable. What he was planning to do about it was less clear.  Even when it comes to cash transactions (occasionally for nefarious purposes) the USD is the world's favourite currency. An estimated USD 580 billion in US bills (65% of the total) circulate outside the US, including a surprising 75% of all USD 100 bills.

By contrast to the Bretton Woods days, nobody has decreed that the USD should remain the primary reserve currency or that international trade should be denominated mostly in dollars. This situation has developed spontaneously and efforts to reduce the dollar's role have largely failed. For example, in the late Sixties the IMF introduced special drawing rights (SDR) as a supplementary reserve asset. Following the oil-price crisis of 1973, a lot of ink was wasted to write articles advocating the pricing of oil in SDR. This, of course, came to naught as there were not enough SDRs to finance the global trade.

Economists have pointed out the many reasons for which the USD remains the main reserve currency.  Among them: the size of the US economy, a well-developed financial system, full convertibility and capital mobility, an independent central bank and strong banking regulations. Other countries may also meet some of these conditions, but not all. The Chinese economy is close in size to the US one, but does not fulfill the other requirements. The EUR is the only other serious candidate, but long-term confidence is undermined by the fact that the monetary union is not backed by a fiscal union as in the case of the US. One could say that the USD is the main reserve currency by default - no one else can do it.

Arguably, the main advantage deriving from the international role of the dollar, is the ease with which the US can finance its massive budget deficits. The world demand for US Government debt seems insatiable. Nearly 30% of the total US Government debt of USD 21.8 trillion is held by foreigners. This debt is USD-denominated and as such the US does not have any substantial debt denominated in foreign currencies. An international default is unthinkable because the US can "print" unlimited dollars to redeem its debt.

There are, of course, risks that the US is incurring in return. Its currency is subject to fluctuations (occasionally violent) that ultimately can affect the domestic economy. There is always the risk that, for a variety of reasons, foreign governments may decide to sell large amounts USD assets triggering a sharp rise in US interest rates and weakening of the dollar. This risk is, nevertheless, contained. First, foreign governments are likely to be cautious as they do not wish to suffer capital losses. China, with an estimated USD 3 trillion in reserves, is the largest foreign holder of USD reserves. Despite the current trade tiffs with the US, they have been very prudent in reducing the size of their dollar assets.  Second, even in the worst-case scenario, automatic stabilisers eventually kick in as a weak dollar leads to an export boom and strong economic performance.

Linked to the role of the dollar in international transactions is the effective control that the US can exercise over the international payments system. Most international payments take place through the SWIFT system. Legally speaking, SWIFT is a Belgian cooperative society owned by member banks. However, most transactions involve a US clearing bank and thus the transactions can be transparent to the US authorities. The ability to take punitive measures against financial institutions allows the US to deny the use of the system to certain participants. A case in point is the recent confrontation between the US and Iran. The US has withdrawn from the nuclear treaty with Iran and has imposed drastic economic sanctions on Iran. The sanctions have turned out to be very effective and have already had a devastating impact on Iran's economy. A key reason for this success is that Iran has been locked out of the international payments system.

This has infuriated America's European allies who want to remain part of the of the nuclear agreement with Iran.  They have announced steps to create an alternative payments system outside US control and reduce the role of the dollar in international transactions. Will they succeed in this effort considering that other previous attempts have failed? What is different this time is that the US is acting out of sync with its European allies. This makes the threat to the "exorbitant privilege" more serious than in the past. Restraint is not one of the characteristics of the Trump administration and they may go too far in weaponising America 's economic advantages. In response, efforts to create an alternative to the dollar and new payment systems could become more forceful and effective than in the past. Furthermore, the dollar’s role in international transactions may also be challenged by crypto currencies such as the just-announced Facebook’s Libra.  But, under any circumstances, given the enormous obstacles changes are likely to be slow and very gradual.

‍