The next reserve currency
By Toni Straka
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Oil prices seem to have reversed their recent correction, capital inflows into the United States are falling, and there has been no significant moderation of producer and consumer prices. Under these circumstances, questions are being raised about America's preeminent economic status. 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, here's some historical perspective about reserve currencies - a status that many say the dollar is perilously close to losing.
Time-traveling from the Greek to the Roman empire, the British empire, and the young history of the US, one notes that the most widely accepted (reserve) currency always had its home in the political powerhouse of its times. Political power rests on three determining factors: the productive capacity 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 origins 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, 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 at the edges - the need to prevent this resulted in the edge grooves still seen on many coins now in circulation - and then the purity of the coins was tampered with until they became pieces of lead covered with a thin coat of gold.
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 the content of precious metals - a system that continued till 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 for 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 stemmed from the custom of cutting 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 capacity to the colonies, where labor 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 economy in the world, a place it has held ever since.
Menzie Chinn of the University of Wisconsin and Jeffrey Frankel of Harvard look at the next 20-30 years and conclude, in their study entitled "Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?" 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. 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 along the way that are inherent with the growth rates that the country has been enjoying recently.
China is still some distance away from liberalizing its currency controls, not least for the reason that its financial sector is still in its infancy. But China will develop this sector and gain knowledge along the way. With a consumer base of probably more than 1.5 billion people by then, it will have a huge backyard on which it can rely for further growth to fuel its growing international importance. As the country has been on the path to a more liberalized economy for the last 15 years, taking one step at a time, its careful planning for 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 favor the euro as the preferred means of payment for the riches in their soil. Until now, commodities have been predominantly priced in dollars on the world markets, stemming from the fact that the US is the single-biggest buyer and consumer of energy and has been the biggest buyer of most other commodities. In an age of global redistribution, this might change as the US gives up its number one purchaser position.
Staying with dollar-based prices - which could mean using the currency of a third country that is primarily known for its huge amount of debt and no plausible recipe for a turnaround - could become too costly a way for others to conduct their bilateral trade. After outsourcing American production, an outsourcing of control of international trade could well be on the way. The race for financial dominance is on. And it will be decided in favor 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.
Toni Straka is a Vienna, Austria-based independent financial analyst and portfolio manager, who worked as a financial journalist for over 15 years and now evaluates global market trends. He runs a young blog, The Prudent Investor, where this piece first appeared.
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Rogue
