Observations: As Washington Fiddled

Moody's

As the U.S. media focused on the political dance between President Obama and Congress during the 16-day government shutdown, America was taking a beating overseas—and so was the dollar.

For more than 70 years, the greenback has served as the world's reserve currency, accounting for 87% of the $5.3 trillion in foreign exchange transactions daily and 60% of the reserves held in vaults around the globe. The dollar is also the currency used to settle trade in crude oil, regardless of where it takes place.

Governments, banks and multinational corporations aren't the only ones that depend on the dollar: The $100 bill is the favored currency for black-market transactions and is hoarded in countries with shaky local currencies. C-notes account for the value of about 80% of U.S. currency in circulation, up from 50% in 1990.

A "de-Americanized" world

The dollar's clout has long generated resentment, which revealed itself this month when President Obama skipped two important Asia meetings to deal with the budget impasse at home. Seeing an opening, China's leaders called through the official Xinhua News Agency for nations to consider "building a de-Americanized world."

The world has been "Americanized" since the Bretton Woods conference near the end of World War II, when global leaders created an international monetary system with the dollar at its core, replacing the British pound as the favored currency for trade.

Although the Bretton Woods system arguably led to decades of relative stability, the dollar's hegemony has left big developing economies such as China's in a precarious position—holding $1.3 trillion in U.S. assets and thus exposed to enormous losses if Congress does anything to jeopardize the dollar's status or value.

Greenback loses value

Indeed, the greenback and those who hold it in their portfolios got pummeled during the debt-ceiling showdown. From October 1 until October 16, the dollar slid 1.5% against the yen, 1.1% against the British pound, and 0.5% against the Swiss franc. Against the euro, which has had its own troubles recently, the dollar fell only 0.07%. U.S. Treasuries also experienced more volatility than normal.

China renewed its call, first made in 2009, for the world to create a "super-sovereign reserve currency" to reduce dependence on the dollar. Such a unit of exchange would not be the currency of any single country, but rather a mechanism for exchanging payments that might be controlled by an organization such as the International Monetary Fund.

Meanwhile, China, which holds 23% of the U.S. debt held overseas and about 8% of the total debt load of $16.74 trillion, has been taking steps to promote trading in its own currency, the yuan, which unlike the dollar or yen is not freely convertible. Largely because China closely regulates and manages it, the yuan accounts for just 2.2% of daily forex trading.

China fills the gap

With President Obama absent from the recent APEC meeting in Bali and ASEAN summit in Brunei, Chinese President Xi Jinping took center stage. Among his agenda items was an alternative to the Trans-Pacific Partnership, a free-trade agreement the U.S. has been pushing. Elsewhere, China also reached a currency-swap pact with the European Central Bank. It previously signed similar agreements with England, Hong Kong, Australia, Turkey, Brazil, South Korea and Malaysia.

The opening of China's capital markets is welcome, but it was unfortunate that the U.S. was so distracted by its domestic problems that it wasn't able to make its voice heard as a new trade landscape was being shaped in Asia. Secretary of State John Kerry attended the Asian meetings, but the U.S. presence didn't carry the same weight as it would have with President Obama there.

A re-run in 2014?

Since the debt-ceiling deal only runs through February 7, calls for the dollar to be replaced as the world's reserve currency are likely to be renewed if another showdown takes place in 2014. What sort of system might replace the current one remains unclear, however, and likely will be as much a product of politics as of economics.

One idea that deserves further investigation is the expansion of special drawing rights, an international reserve asset created by the IMF based on a basket of four currencies—the euro, yen, pound and dollar. The wider use of SDRs was advocated by a United Nations commission led by economist Joseph Stiglitz and China's central bank governor, Zhou Xiaochuan, exploring reforms in the wake of the 2008 financial crisis.

Creating a supranational currency

However, the SDR, which floats along with its underlying components, must first have deep and liquid markets that could be tapped by banks and multinational corporations before it can be a real global currency. (It would not be used for local transactions or by consumers.) Another potential stumbling block: The G-20 nations would have to agree to transform the IMF into a global bank.

Unfortunately, reforms of the world financial system usually occur in the wake of a war or a major financial crisis such as when the first Bretton Woods regime was reworked after the U.S. went off the gold standard in 1971. But if brinkmanship continues in Washington, a financial crisis greater than the one in 2008 may arrive, forcing international policymakers to scramble to build the post-American financial order that China dreams of.


Monica Gagnier is an Economics Writer at Moody's Analytics.


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