US Dollar Reserve Currency Status Not a Blessing, study says
By Aldo Caliari- March 2010
The US dollar reserve currency status has limited benefits, is one of the messages in the recent paper by
McKinsey Global Institute: “An exorbitant Privilege: Implications of reserve currencies for
competitiveness.”
The alleged “exorbitant privilege” the US derives from its reserve currency status has been referred late
last year in no less than an IMF staff paper.1 The McKinsey study, a Discussion Paper, contests the
assertion and uses this assessment to draw important implications for what the future of the world
monetary system will be.
Inertia is a powerful force keeping a currency’s reserve status, says the paper, because the factors that
make a currency the preferred reserve choice tend to change very slowly, and because of network
externalities –it is more efficient to use the same currency as everyone else. But, in spite of this, there is
historic evidence of changes in currency reserve status which allow to presume that such changes will
also occur in the future.
The study estimates the benefits to the US of its currency’s reserve status as ranging between USD 40 to
70 billion or a 0.3 to 0.5 of GDP in a normal year. This is a result of adding up:
. seignorage income (estimated in USD 10 billion),
. the capital advantage obtained by US borrowers –in other words, lower interest rate facilitated by the
excess demand for US dollars worldwide minus the disadvantage that US households and companies
suffer by having to earn lower interest on their USD-denominated holdings (net of the two estimated in
USD 90 billion)
But then the losses from competitiveness of US exports need to be subtracted. Assuming a US dollar
overvaluation of 7.4 % it estimates the net cost to be in the range of 30 to 60 USD.
While in the next few years the study projects that the benefits to the US will increase, the costs will
increase even further. The pressure for export-led growth will become more intense given high
unemployment levels in the US. Analysts have noticed that, in his State of the Union speech this year,
President Obama pledged to double exports—not trade-- in five years (a pledge that is expected to
support 2 million American jobs).
But factors such as the lack of benefits from a depreciation in relation to economies that peg their
currencies to the dollar, and the strong probability that there is continued high demand for dollars, will
contribute to make the net benefits from acting as a reserve currency issuer more modest.
The study acknowledges that another benefit of being a reserve currency issuer means the space for
running large fiscal deficits and a loose monetary policy, due to less subjection to market disciplines.
These are, for instance, the arguments put forward in the IMF staff paper mentioned above.2 But the
McKinsey Discussion Paper argues that, on the other hand, the fact that there is so much foreign-held
US debt creates its own constraints on monetary policy by forcing unsustainable current account deficits
and accumulation of debt. On such basis, it is likely that the significant costs may increasingly outweigh
the advantages and operate towards lower incentives for the US to maintain its reserve currency status.
The study considers the Euro to be the second preferred reserve currency and explores, with the same
methodology, the Eurozone advantages and costs from the euro’s reserve currency status. It concludes
that the Eurozone has even less incentives to push for a shift towards a Euro’s bigger role as reserve
currency.
The paper qualifies the impacts of sharp exchange rate fluctuations on companies as “substantial” and
having generated a significant redistribution of resources as companies change location and gain or lose
market share based on where they are located. It quotes the results of a survey of executives to argue
that the volatility of exchange rates has a large, and growing, negative impact on company profits and
investment decision-making. There is a strong relationship between exchange rates and competitiveness
that is more pronounced in trade-exposed companies and, geographically, in the Asian region, with
exchange rate volatility in the coming years expected to intensify such impacts.
While the report recognizes research –including some well-known IMF papers issued a few years ago3—
that point to a negative, but small, impact of exchange rate volatility on the level of exports, it contends
that companies’ experience and the survey imply that costs are higher than what such literature had
suggested. Likewise that currency instability has stronger impacts on variables such as investment,
market share, profitability and so on, than on exports directly. These findings are consistent with those
of UNCTAD experts that had established the impact on exports via, among others, the impacts on
domestic investment decisions, availability and costs of access to financial markets, domestic
productivity differentials and the value of market access concessions.4
In the concluding chapter, the authors say they expect that in the US and Europe, the impact of their
policies on the global exchange rate system will take a backseat to the domestic imperatives of a loose
monetary policy to keep growth and employment from worsening. While the prevalence of domestic
over external factors and an “unmanaged” system do not differ from the approach that has prevailed in
the past, the study suggests three ways in which the current conditions have evolved and that will
magnify the repercussions of such approach on exchange rate volatility.
First, the substantial increase in reserve accumulation. Part of this is reserves accumulated by foreign
governments that will tend, for that reason, to oppose movements to erode the value of the
denomination in which they have such substantial amounts of reserves.
Second, the substantial increase in cross-border capital movements, encouraging higher currency carry
trades that strongly contribute to exchange rate movements divorced from economic fundamentals.
Third, the emergence of plausible reserve currency alternatives that make a move away from the US
dollar –with consequent uncertainty-- more likely than when such alternatives do not exist.
Given the reduced benefits for either the US or Europe from acting as reserve currency issuers, it is
possible that we will see increased support for alternatives to the existing monetary system that more
broadly distribute burden and benefits.
The study highlights as evidence of such emerging shifts the discussions on more exchange rate
coordination in platforms such as the G20. It further refers to the recent initiatives on Special Drawing
Rights, while noticing that the amount issued so far is a very small proportion of global reserves and that
existing features of the SDR conspire against a more significant currency role. 5 The Tobin Tax proposals
to curb excesses in currency volatility are also mentioned in this regard.
The full McKinsey report is available at http://www.asiaing.com/an-exorbitant-privilege-implications-ofreserve-currencies-for-competitiv.html
1
IMF 2009. The Debate on the International Monetary System.
2
Ib. (“[the exorbitant privilege] is because this center country has more macroeconomic policy space by virtue of
the greater liquidity of its markets and ability to borrow in its own currency abroad at lower cost, as well as the
seignorage earned from issuing a global currency….”).
3
See Clark, Peter et al 2004. Exchange Rate Volatility and Trade Flows- Some New Evidence. IMF Working Paper.
May.
4
See Kotte, Detlef 2009. Presentation in Caliari and Yu (Ed.) “Trade-Finance Linkage for Promoting Development”
and UNCTAD 2004, Communication to the Working Group on Trade, Debt and Finance (WT/WGTDF/W/27).
5
Consistent with Caliari 2009. “Can the G20 have it both ways? Addressing Global Imbalances without Reform of
the World Monetary System,” available at http://www.coc.org/node/6441. (see also for a complete review of
implications that G20 decisions related to Special Drawing Rights up to date have for the reform of the
international monetary system).