A number of sites are commenting on a Bloomberg video in which El-Erian, PIMCO Co-CEO says “Dollar could lose its reserve currency status”.
Bloomberg: “Mohammad what does a weak dollar signal to you, a dollar that can’t jump up here on a day like we’ve seen today?”
El-Erian: “It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S. They are starting to worry about the level of debt. They are starting to worry about what they hear about states and municipalities. So, I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past.”
Reserve Currency Definition
Before we can debate whether or not the US will lose reserve currency standing, we must first define what it means.
Investopedia defines Reserve Currency as follows.
“A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate.”
I accept that definition. Unfortunately Investopedia rambles on with nonsense about the implications: “A large percentage of commodities, such as gold and oil, are usually priced in the reserve currency, causing other countries to hold this currency to pay for these goods.”
That sentence is a widely believed fallacy. The reality is no country is obligated to hold dollars to buy goods denominated in dollars.
Currencies are Fungible
Currencies other that illiquid currencies with low or no trading volume (think of Yap Island stones or the Cuban Peso) are fungible. It is a trivial process to switch from one currency to another.
You can buy gold or silver in any country, and I assure you those transactions do not all take place in dollars. Thus, just because a commodity is widely priced in dollars does not mean it only trades in dollars.
That holds true for oil as well.
I keep pointing this out, unfortunately to no avail, that oil trades in Euros right now. There is no selling of Euros to buy dollars on the front causing the oil producers to trade dollars for euros on the back end. The oil states simply sell oil for a price in Euros and then hold Euros in their Forex reserves.
Fact and Fantasy
The first part of what El-Erian said is factual. Here it is again for convenience. “People are starting to worry about the fiscal situation in the U.S. They are starting to worry about the level of debt. They are starting to worry about what they hear about states and municipalities.”
Those are true statements. Unfortunately, his “warning shot” regarding reserve currency status is fallacious.
To understand why, let’s return to the definition of reserve currency: “A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate.”
Foreign Currency Reserve Factors
- Trade Volumes
- Trade Deficits
- Currency Manipulation
- Hot Money
Trade Volumes and Trade Deficit
The US happens to be at or near the top of nearly every country’s trading partners. The US runs a trade deficit with most of them. Those trading partners accumulate dollars as a simple function of math. We run a deficit, someone else runs a surplus.
Some wonder why the surplus countries do not buy oil or commodities with their accumulated dollars. OK, what does Saudi Arabia, Iran, or Venezuela do with the dollars then?
Does Iran or Venezuela even hold dollars now? Think of the implications of that answer in light of the widely viewed fallacy that one needs dollars to buy oil.
Regardless, of where the dollars end up, those US dollars will eventually return home. Recall that Dubai tried to buy a US port and China tried to buy Unocal. Both were rejected for security reasons. However, those dollars will return home, with China, Japan, and the oil states buying various US assets.
Most US trading partners do not want their currencies to rise, especially China and Japan.
Consider the Yuan which does not float. To suppress the value of the Yuan, China takes US dollars and exchanges them for Yuan at a pegged rate. China does this hoping to create job and boost exports.
The US calls this currency manipulation and it is. However, it is no more manipulative than Bernanke flooding the markets with US dollars hoping to weaken the US dollar and stimulate growth.
Hedge funds and other speculators have moved money to China banking on currency appreciation.
China needs to maintain currency reserves to allow for the repatriation of those US dollars. Michael Pettis at China Financial Markets points out that most of the hot money inflows into China are done by Chinese businesses that understand how to get around rules and regulations regarding currency inflows.
That argument make perfect sense, but the math remains the same regardless of where the hot money comes from.
Global Beggar-Thy-Neighbor Policies
It is pretty pale to suggest the end of the US dollar as a reserve currency when countries hold dollars as a function of math, then hold still more dollars to suppress their currencies, hoping to keep their exports up to “stimulate growth”.
Another mathematical relationship says the dollar, the pound, the Yen, and the Yuan cannot all be weak at the same time (relative to each other). Yet that is precisely what every country wants. It’s mathematically impossible.
You can see the effect in rising commodity prices.
If commodity prices were a function of the US dollar alone, then they would be rising in US dollar terms alone. Instead there is upward pressure on commodities in all currencies.
At some point the desirability to hoard commodities will peak.
Zero Hedge Comments
Zero Hedge commented on reserve currency status about a week ago.
Regarding El-Erian’s statement: “I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past”
Zero Hedge quipped:
That’s a given – the question however remains, which fiat currency, if any, is willing and ready to step in and replace the USD? With all eyes continuing to be look at the CNY, how long before China finally takes the plunge to find out just who is the real reserve currency in the world?
Will Another Fiat Currency Replace the Dollar?
For starters, Zero Hedge ignored the essential trade deficit math. The US runs a trade deficit, someone else must run a trade surplus.
Second, Canadian dollar and the Swiss Franc do not have enough trading volume. More importantly, there are not enough Canadian Dollars or Swiss Francs to go around. Look at what happened to Iceland when too many plunged into the Icelandic króna.
The Canadian and Swiss economies are simply not big enough for them to be global reserve currencies. In regards to the Euro, is Europe in a better fundamental situation than the US? Would it matter even if it was? To answer the second question, please remember trade deficit math.
As for the Yuan, it is complete silliness to suggest the currency of a command-economy dictator-led country that will not even float its currency will be some sort of major reserve currency.
To the extent that China trades with Russia, South Korea, etc., local reserves in varying currencies can happen (and are happening already), but the global significance of it is wildly overstated. The amounts in question are tiny, as a simple function of math.
Will the dollar remain the global reserve currency forever? Of course not. However, it is highly unlikely any of the presumed leading Fiat candidates including the Yuan and the Keynesian wet-dream IMF SDRs (Special Drawing Rights), will take the dollar’s place. SDRs are essentially a basket of currencies.
The concept of trading in baskets of currencies backed by nothing is even more ridiculous than the existing setup. People do not buy goods and services in baskets of currencies.
What can replace the dollar?
Gold, or a mechanism like gold that would impose a hard restrictions on perpetual deficits is what its takes to restore sanity. However, we may not see a significant move towards gold until there is a massive currency crisis or revolt against fiat currencies in general, not just the US dollar.
Mike “Mish” Shedlock
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