Is the worlds’ beloved currency off for a downhill?

Summary

• Deteriorating economic conditions points to a weaker US economic outlook.
• Currency interventions in the past have not yielded the desired results.
• Economists have pitched for a new reserve currency.
• USD dominated global trade transactions & reserve currency.

Surmounting unemployment and loss of production, consequently, paints a bleak economic outlook for the United States. As the US economy is mostly tilted towards consumption of the US household; the rise in unemployment, wage loss and depleted wage growth together pose a threat to the US economic outlook.

With pandemic already racing through the veins of the nation, the recent social unrest in the country has caused more panic among the US households, forcing cities to impose curfew as violent protests take over the world’s number one country.

American tag line – where people live their dreams – has been imperative for many greats to immigrate to the country, including for Nikola Tesla and Elon Musk. American democracy and its epitome of liberty has been an inspiration for many nations.

The decade you must not forget – 1980s

Ronald Reagan took over the office in 1981. His policies emphasised on laissez faire, lower taxes, lower public spending and lower regulation. These policies helped him to achieve lower inflation and growth. When he took over the office, the state of the American economy was suffering the worst recession since the Great Depression.

At a time when music artists like Pink Floyd, Lionel Ritchie, Queen, Kenny Rogers, John Lennon, Paul McCartney were leading the Billboard charts, the American sentiments were extremely gung-ho for Japan. Bashing Japan was perhaps favourite American time pass aggressively followed by Buy American campaigns which were running in the US, especially in the auto sector.

Washington was concerned about the massive trade deficit it had with Tokyo. Japan was having sublime growth since world war II ended, inching closer to become a world power. Japanese indeed mastered the art of manufacturing, emerging as exporter nation.

US legislators accused Japan of dumping and damaging the domestic industry. But some say that Japan was making better than the US.

Japanese automobile companies opened factories in the US in response to the heat in the auto industry, thereby manufacturing in the US as well as supporting jobs. Yet all this Japan-bashing was ongoing when to say Tokyo was one of Washington’s most reliable allies, especially in the Asia Pacific.

In the 80s, the circumstances were somewhat similar to what they are today – a rising trade deficit and a stronger US dollar. During the early part of the decade, under the leadership of Paul Volcker, the US Fed rates were in double digit to hit as high as 20% leading to a hyper-sensitive monetary policy, which ended the decade at fed funds rate of 8.25%.

Interestingly, the decade also entailed Black Monday and Saving & Loan Crisis. Black Monday of 1987 led to collapse equity indices, primarily attributed to new bills that were being passed by Congress to regulate markets. It’s also believed that Treasury’s intentions to keep the dollar from falling further added to the woes; the idea was that a lower dollar would help to reduce the trade deficit.

Currency interventions in the ‘80s

In 1985, Germany, Japan, France, the United States, and the United Kingdom came together to depreciate the USD against Japanese and German currency. Likewise, Deutsche Mark & Japanese appreciated against the United States Dollar.

A rising USD was making it harder for the US companies to operate businesses, especially the ones with export driven business. Before FX rate intervention, the United States was experiencing economic growth and running a massive current account deficit, while Japan and European nations were having negative GDP growth and huge trade surplus.

Following a continued decline in the USD due to Plaza Accord, the large countries signed the Louvre Accord in 1987 to put the beaks on falling USD. Policymakers of the participating nations affirmed that USD is consistent with economic fundamentals. A lower USD also induced capital flows to move away from the country and US assets to be sold by the investors.

US Dollar is a reserve currency

US Dollar plays an essential role in the International Financial System. It is a prime choice for countries seeking to hold a reserve currency. Researchers have said that the US is the supplier of safe assets, and USD clears the market for dollar denominated safe assets.

Arvind Krishnamurthy and Hanno Lustig of Stanford University, in a paper presented at the Jackson Hole Symposium last year, noted that variation in dollar exchange rate, bond yields, and other financial variables is dependent on the changes in the demand and supply of dollar denominated safe assets. Moreover, the US monetary policy also impacts the dollar exchange rate.

What does a lower dollar mean for the rest of the world?

A lower USD could hurt the foreign exchange reserves held by most Central Banks around the world as they mainly hold FX reserves in USD. Another problem is that there are not many reserve currencies that are favoured by the world compared to the USD. The United States Dollar constituted approx. above 60% of the foreign exchange reserves, followed by Euro at around 20%.

Source: IMF, data as of 31 March 2020

Last year, Mark Carney, former Governor of Bank of England, pitched for a new global reserve currency. Referred to as Synthetic Hegemonic Currency (SHC), Mr Carney prompted a new currency to lower the dominance of USD as a reserve currency.

He reckoned that an SHC could help to lower the dominance of USD in the global trade system. A replacement of the USD may allow to lower the volatility of capital flows in the emerging markets and reduce the dominance of the USD in credit markets. Rising use of an SHC would mean that the underlying basket of currencies in it would appear as a reserve asset, prompting other safe assets holders to move away from the USD.

As far as Australian businesses are concerned, the companies that transact the majority of their revenues in USD may want to move away from the dollar to any other reserve currency. Businesses would be inclined to change their trading currency as export sales would become costly for the purchasing countries.

Alternatively, a lower USD means an appreciating AUD, which does not bode well for the businesses that are exporting goods to other countries and transacting in USD, thereby inducing such companies to scramble for other transacting currency/reserve currency.