The Prudent Investor - seeing too many bubbles: What will be the next big reserve currency?
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What will be the next big reserve currency?
Amidst oil prices who seem to have reversed the correction of the last two weeks, lower inflows of capital into the US and no significant moderation of first producer and today consumer prices - which rose 0.5 percent month-on-month - Washington steps up its attacks on China in an effort to see a revaluation of the Yuan rather very soon than later (see also this post). Taking into account the slowing in US industrial production, worsening demographics in all western industrialized nations and the general expectation that the global economy will slow in the second half of 2005 and reflecting on David Altig's thoughts at macroblog whether the Euro can overtake the US dollar as an international reserve currency I want to add some historical perspective.
Time-travelling from the old Greeks to the Roman empire, to the British empire and then the young history of the USA one notes that the most widely accepted (reserve) currency always had its homebase in the political powerhouse of its times. The political power always footed on three determining factors: The productive capacities of that nation, its international trade relations and its capability to defend itself.
While there were several denominations of silver coins in circulation in the Greek empire that had their origin in the provinces of Byzantine, Macedonia and Peloponnesia, to name just a few, the Roman empire first introduced the silver drachmae in order to facilitate trade with the Greeks. The drachmae was followed by the golden aureus, the silver denarius and the bronze sestertius. One aureus was equivalent to 25 denarii or 250 sestertii.
Inflation was the beginning of the end
The aureus had a respectable lifespan of more than 400 years before inflation diminished its reputation. Nothing has changed since: Whenever a currency loses its value, so does its popularity.
First the Roman emperors started chipping away on the edges - this resulted in the grooves on its edges, still seen on many current coins in circulation - and then the purity of the coins was tampered with until they became pieces of lead covered by a thin coat of gold plating. As the Roman empire declined, so did the Roman money as a means of tangible form of payment for goods and services. In medieval times all forms of money and their respective strength were mainly tied to its content of precious metals. A system that held up to World War I. One Swiss gold franc had the same value as one Austrian gold crown or a Dutch gold coin of the same weight. There was no need of a Bretton Woods agreement in these times.
The reserve currency of the 18th and 19th century was undoubtedly the British pound sterling. As the name says, a one pound note could at any time be redeemed against one pound of sterling (pure) silver at the Bank of England or before that at the treasury of the king. The sixpence stems from the custom to cut a silver penny in six equal pieces for small purchases.
With the demise of the British empire which went hand in hand with the outsourcing of its productive capacities to the colonies where labour was cheap, the pound was replaced by the US dollar in the early 20th century when the US ascended to the throne of the biggest producing economy in the world, a place it has held since.
Menzie Chinn's and Jeffrey Frankel's paper looks at the next 20 to 30 years and concludes that "under any plausible scenario the dollar will remain far ahead of the euro and other potential challengers for many years."
I wonder whether this western approach will still be valid in 30 years from now. Under the assumption that the European Union with its strong productive base and its highly developed financial markets - especially once Britain joins the Euro - will come back to the path of stronger growth again the Euro could climb to the number one spot in the line-up of international currencies.
But this might be for a transitory period only. Most forecasts see China becoming the biggest economy on the globe by 2020, give or take some setbacks on the way to there that are inherent with such growth rates that this country has been enjoying recently.
China still buys time on the way to a liberalization of its currency controls, not least for the reason that its financial sector is still in its infancy, China will also develop this sector and gain knowledge on that way. With a consumer base of probably more than 1.5 billion people by then it has a huge backyard on which it can rely for further growth for its growing international importance. As the country has been on the path to a more liberalised economy for the last 15 years, taking one step at a time, its careful planning of the future will lead to a more prominent role in the capital sector. Those who produce can save too and therefore become a supplier of capital needed elsewhere.
Of course it is premature to speculate about the Yuan becoming the reserve currency of the world.
But it is not premature to speculate when the resource-rich countries will begin to favour the Euro as the preferred means of payment for the riches in their soil. Until now commodities are predominantly priced in dollars on the world markets, stemming from the fact that the US are the single biggest buyer and consumer of energy and have been the biggest buyer of most other commodities. In an age of global redistribution this might change as the US have given up their number one rank as a purchaser of other commodities. Staying with dollar based prices could become a too costly way for others to conduct their bilateral trade with the currency of a third country that is primarily known for its huge amount of debts and no plausible recipe for a turnaround of this situation. After outsourcing its production an outsourcing of control of international trade could be well on its heels.
The race for financial dominance is on. And it will be decided in favour of the country or region that manages to maintain a lead in production which will inevitably be located in proximity to the world's largest base of consumers.
If you want to read more about the transitoriness of currencies, follow this link.
