With the US dollar indices at record lows, there is much concern over whether the currency will lose its reserve currency status. However, as Stephen Jen points out in Morgan Stanley's latest Global Economic Forum, when assessing the merit of the US dollar as the dominant international currency, it is important to distinguish between these three uses of international money: a store of value, an international unit of account and a medium of exchange. While Jen believes that the US dollar has maintained its status in the latter two, it has deteriorated significantly as a store of value. Does that mean, though, that its time is up?

In the long run, the most likely contender to the USD as the dominant international reserve currency, in our opinion, is likely to be an Asian currency centered on the Chinese RMB. But this risk may be several decades away, we suspect.

In Morgan Stanley's view, the US dollar will remain

the most efficient unit of account for many internationally traded commodities... It makes little sense for individual oil exporters to unilaterally change their pricing menu to any other currency... Many oil exporters have most of their external debt denominated in USD, mainly because oil prices are in USD. There will, thus, be a great deal of ‘stickiness’ in currency denomination in commodities.

The dollar's role is also maintained as a medium of exchange. Jen notes that more than half of the bilateral pegs in the world continue to reference to the USD, and when any such pegs are disbanded, it is rather to establish a local independence than to replace the USD with the EUR or any other peg.

However, Jen does admit that the dollar has a major problem as a store of value:

The main argument for investors not to sell the dollar now is that it already appears extremely under-valued, measured by many valuation models, including our own. Having said this, however, it is important to note that these policy and macro problems can be fixed, and a flexible economy such as that of the US should be able to re-orient itself... It is now up to the US to restructure itself to compete in a more competitive world.

Jen explores some other ideas that may affect the USD as a reserve currency:

1. SWFs may further erode the USD’s hegemony.
2. The weaker form of ‘Bretton Woods II’ is still dollar-supportive, though its strong form may be USD-negative.
3. Asset diversification. Jen reports that it is well known that US real money accounts have been major currency diversifiers since 2003, and that several Asian countries have also begun to reduce their financial ‘home bias’.

In conclusion, whatever the arguments, it would be extremely difficult to replace the USD as the dominant international reserve currency:

Not only will another country or a currency area need to significantly surpass the US, both economically and financially, we believe that the US will need to make some serious policy mistakes for it to relinquish the dollar’s lead. The EUR is clearly the first challenge the dollar has faced since surpassing the GBP after WWII. However, our guess is that only China, or an Asian economy/monetary union, has a good chance at becoming significantly bigger than the US.

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Gary Smith

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