Returning from a conference in Mexico, I witnessed an unusual scene. An American at Cabos airport was attempting to pay for his drinks with a (British) twenty pound note. The barman was polite, but refused. Mexican pesos were acceptable (this was, after all, Mexico). American dollars were acceptable. But the British pound was not.
The British pound has limited acceptability outside of the British Isles. However, this was not always the case. A century ago, the British pound was the only currency worth having for international transactions: It was the world's reserve currency. However, by 1948 the dollar had effectively replaced sterling as the global reserve currency. Now the reserve status of the dollar is in question.
What is a reserve currency? Most people think of reserve status as relating to the official, central bank managed foreign exchange reserves of countries. Of course, the foreign exchange reserves of Asia have grown substantially in size. Around two thirds of the world's official foreign exchange reserves are held in dollars -- a level that has been fairly constant over time.
However, official foreign exchange reserves are not the most important reserve. The private sector also needs foreign exchange reserves, to conduct international trade. In 1970 an Indonesian importer, wishing to purchase goods from a Japanese exporter, would have had to have conducted that transaction in dollars.
This meant that the Indonesian importer would have had to have had access to dollars, and the Japanese exporter would have (briefly) received dollars. There was a reason for both sides to hold a certain amount of dollar cash, to facilitate business transactions.
In the last few years, the private sector role for the dollar has been in decline. The private sector is increasingly looking to other currencies. In fact, an xxx importer seeking to business with a Japanese company today is far more likely to have to pay yen. Over half of Japan's exports to Asia are invoiced in yen.
Does it matter whether one is paying yen or dollars for the imports? Reserve status matters in three ways: It matters to the U.S. economy; it matters to the value of the dollar; and it matters to importers and exporters in the Indonesian economy.
The U.S. receives a benefit from being the world's reserve currency. Basically, foreign exchange reserves are an interest free loan -- a means of financing the U.S. current account deficit "for free". At the moment, the dollar's reserve currency status is worth around US$31 billion per year to the U.S. economy. As the reserve status of the dollar diminishes, this economic benefit to the U.S. economy will diminish.
Related to this, the dollar's value receives support from its reserve status. Assuming that the value of global trade grows each year, there is a "natural" demand for dollars to fund that international trade. If the dollar's reserve status continues to be undermined, the "natural" demand for dollars will decline and a support for the dollar's value will also diminish.
For Indonesian importers and exporters, the decline of the dollar' reserve status is complex and depends on the position of the Indonesian company. If the company is the dominant partner in the transaction then they will be able to demand that invoices are in Indonesian Rupiah. That means that the xxx company carries no foreign exchange risk. Clearly this is a benefit.
However, if the Indonesian company is not able to dictate the terms of the contract, then they will have to hold reserves in whatever currency their counterpart wishes to deal in -- yen, euros, dollars or even pounds sterling. Because they will end up holding reserves in more than one currency, the cost will increase.
The dollar's decline as a reserve currency is likely to be drawn out. However the growth in private sector use of the other currencies in international transactions means that Indonesian firms (and maybe even the Indonesian central bank) may need to reconsider the currencies that they hold.
As for the American tourist in Mexico -- as a British subject I was only too happy to purchase his pounds from him. As an economist I reflect the balance of global reserves, and I always carry dollars, euros, Swiss francs and pounds sterling in my wallet.
The writer is Managing Director of Global Economics, UBS Investment Bank. This is a personal view. He can be reached at paul.donovan*ubs.com.
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