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Why is the US Dollar a reserve currency?
Or what connects a fallen Indonesian dictator to foreign exchange reserves
This is part one in a multiple part series on the USD’s role as a reserve currency.
The TL;DR (Too Long Didn't Read)
The US Dollar is used very frequently in international trade even among countries that do not use it domestically. This happens because it has very strong network effects
So, central banks sell their currency and buy the USD to devalue it. This makes their exports cheaper internationally. A byproduct of that is they have several US Dollars which end up in US Government Treasuries.
Several countries don't have bond markets strong enough to finance their government and corporate borrowing needs. They borrow in US Dollars in the US because of large and liquid American capital markets.
In the case of excessive currency depreciation, the amount of domestic currency needed to pay your foreign debts increases. In some cases, this may lead to government default or a banking crisis. Central banks buy USD so that they can sell it in times of crisis and prevent large scale defaults on their debt.
An easy way to get attention is to predict the end of the world. If you say that the world is going to end because of some bad event that is going to happen, people will listen to you! They might listen to you because they think you are right, they might do it because they like to doomscroll, or they might do it because it’s fun to see what you’re saying and have a laugh at your expense later.
And so in financial commentary, people end up predicting that the US Dollar is going to become worthless tomorrow. They suggest that foreign central banks will end up moving their reserves away from the US Dollar and will move to the asset of their choice (usually bitcoin or gold). But as long as these calls have been made, the dollar has done fine. And the longer the dollar does fine, just by the nature of luck, more bad things happen to it. And the more bad things that happen to it, the more that people predict that the dollar will end. Today’s example is the freezing of Russian foreign exchange reserves and sovereign wealth fund assets by the US, EU and other countries. The WSJ op-ed predicts that the US Dollar’s exorbitant privilege might be taken away by Russia and China and as does China-friendly SCMP.
From point A to B
When two companies from different countries want to trade, they have to pick a currency. One possibility is that they’ll pick the producer’s currency. After all, the producer can only use their domestic currency at home. If you’re a Nigerian firm selling to a Brazilian company, it makes no sense for the payment to be in Brazilian real, but a lot more for the payment to be in Nigerian Naira. The Nigerian firm can now spend the Naira at home, instead of having to convert Real to Naira and then spend it.
But there are very good reasons for this to not happen. First it is that it is very hard to get Nigerian Naira outside of Nigeria especially in large quantities. You can’t walk into a bank and ask for 20 billion naira without moving the price quite a bit. (You will probably have to go to a black market and not a bank given strict Nigerian capital controls).
Second, even if you do get how many ever Naira you wanted, the price of the Naira is unlikely to stay constant over the course of your contract. The value of the Naira (and for that matter the real) is very volatile, and all the uncertainty makes the pricing much harder.
What’s the solution here? For a lot of international trade the answer has been to use the US Dollar for this. Why? It is that the USD has in recent history been the most widely traded currency, which makes it the first resort of anyone looking for a currency to price their goods in. Since the end of World War 2, the US has been the dominant economic power and so in international transactions, the USD has been the most commonly used. This made it convenient for third parties to use the USD for trade, which kept the loop going. As explained in Why Did So Many Countries Join the Gold Standard, network effects play an extremely important role in determining domestic currency usage. For international usage you would expect that effect to be much stronger! If a lot of people already use the US Dollar, it only makes sense to start pricing your goods in the USD. Add to that the fact that it is easy to obtain and has no capital controls, and it becomes clear why the USD is dominant in international trade.
Now comes the question, how much exactly is the USD used in international trade? That is a difficult question to answer for the reason that this data is not usually public, and when it is, it is very limited across time and country. Our best estimates come from this paper by IMF economists where they estimate that 40% of global trade is invoiced in US dollars, despite the US being involved in just 10% of trade. There are two caveats here. The first is that their dataset does not include China which is the largest trading partner for several countries. The second is that the data is distorted by the existence of the EU because another 40% is denominated in EUR, a majority of which is internal EU trade.
But what about trade between countries that are not the US or members of the EU? We can see some of it in Gita Gopinath’s excellent paper The International Price System, where it shows that for several developed countries almost all their trade is priced in US Dollars. From this we can get some insight on Chinese trade as well. Australia's largest trade partner is China and over 75% of Australian trade uses the US Dollar. Same for South Korea where over 90% of trade is denominated in the US Dollar and China is also their largest trading partner. Of course for trade between China and the US almost all of it is priced in US Dollars.
So the first reason for Dollar dominance is that the US Dollar has a great loop going on: people use the US Dollar which leads to it being more common, which leads to more people using it and the loop repeats.
The other use of the US Dollar is that countries and companies borrow money in the US Dollar. They do it because there aren’t debt markets large enough in their own country where they can borrow from. For governments the problem is that the pool of domestic savings is rarely large enough to meet their financing needs. So, they borrow in foreign currencies and sell their debt in foreign markets so that they can attract larger amounts of capital. Through this process, they accumulate large amounts of debt denominated in US Dollars.
But for corporations, the reasons are slightly different. In most developing countries, credit systems are bank dependent. Most companies borrow from banks instead of bond markets, but this doesn’t scale very well. Banks usually can’t support large borrowers because they just don’t have enough money to lend to them while not having extremely high amounts of risk to one company. So those companies end up borrowing from the bond market. In many countries, the domestic bond market is not very active, even for large borrowers. They aren’t able to borrow much at rates comparable to borrowing in New York or London. So, it makes financial sense for them to take some currency risk and borrow in a foreign currency.
A good example of this is Reliance Industries, a large Indian conglomerate. This January, Reliance raised around US$ 4 billion in dollar denominated bonds, which would have been extremely large for the Indian corporate bond market. The average debt raised in the last few quarters )per issuer has been in the range of $30 to $40 million which is very small compared to Reliance's $4 billion debt issue. It makes sense for companies to raise money in US Dollars if they don't have a bond market at home.
The next question is: why pick the US Dollar? Why not any other currency? The answer is that American capital markets are among the largest in the world. The American corporate debt markets have over $7.4 trillion outstanding (not counting financial companies like banks), compared to about $603 billion in the UK and $1.4 trillion for the largest 5 Eurozone countries combined ($278 billion for Germany, $801 billion for France, $189 billion for Italy and $159 billion for Spain). For large companies who want their debt to be priced well, inertia and more importantly the presence of large American investment banks and deep capital markets in the US make it convenient to sell debt in the US in American currency.
And so we get this graph where the US Dollar’s only competitor is the Euro which has slowly gained share over time.
Share of foreign currency debt issuance (source here)
Dollar liabilities need Dollar assets
And all of this ends up in the hot topic of the day: foreign exchange reserves. The first reason why foreign governments have reserves in the US Dollar is a byproduct of depreciating their currency and buying US Dollars.
For a country like Japan or China which has a large percentage of its exports and imports in dollars, changes in the exchange rate of their currency relative to the dollar would affect their domestic economy. Japanese companies import oil and machinery from abroad. An increase in the value of the dollar relative to the yen would hurt them by making it more expensive. On the other hand Japan exports microchips and cars to other countries. An increase in the value of the yen would make them less competitive.
Note that it doesn't matter where they export these currencies to. They would still be invoicing their goods in the USD. This makes the exchange rate relative to the USD very important for Japanese policymakers. To depreciate their currency and promote their exports, foreign governments have sold their currency and bought massive amounts of US Dollars.
Where do these dollars end up? It is pointless holding just US dollars as they earn no interest relative to government and safe corporate bonds. So they take the small interest rate risk of investing in bonds and own American government debt and large corporate bonds. This is where a lot of Chinese holding of US debt came in the last two decades. This process led to the undervaluation of the Yuan which benefitted Chinese exporters at the expense of American exporters.
The second reason why governments have Dollar reserves is because of foreign currency debt. As mentioned above, several foreign firms have debt denominated in the USD. But having debt in the US Dollar when your revenues are in a different currency creates a problem for companies: if the value of the other currency falls, they will still have to pay the same level of US Dollar debt (which is now a higher amount in the local currency). And if this is a financial corporation like a bank, the bank defaulting on its loans can lead to a financial crisis when depositors believe that the bank is insolvent and they remove their money from the bank causing a bank run and actual insolvency.
This is not a hypothetical! A great example of this is the Asian Financial Crisis of the late 90s where several economies in South East Asia had their currencies pegged to the dollar and high levels of foreign external debt. Several companies and banks in Indonesia and Thailand borrowed large amounts of money in the US Dollar believing that the exchange rate peg would stick. But declining capital flows led to the value of the currencies fall and the government didn't have enough US Dollar reserves to support the currency.
In the end, the rupiah and the baht fell quite a bit! This led to bankruptcies and bank runs in Indonesia and they had to ask the IMF for assistance.
In many countries this was perceived as humiliating and they did not want to subject their economies to the experience of asking a foreign investor for money at terms that were unacceptable to the home country. The below photo of the IMF Deputy Director Stanley Fischer looking down at Suharto as he signed the loan agreement was seen as a symbol of how the Indonesians felt about it. Suharto’s regime fell as a result of the crisis.
The Asian Financial Crisis was the point at which several developing countries saw the importance of high levels of foreign exchange reserves and decided to learn from the mistakes of others. So the high levels of reserves held are a sort of insurance against external debt crises.
The most commonly reported example of US Dollar reserves is petrodollars recycling. Large oil producers sell oil to the US, get dollars and invest their profits in the United States. A great example of this is the Saudi Arabian sovereign wealth fund invested in Softbank which invested in (among other countries) the United States. One of Softbank's largest investments was Uber. Softbank's Uber investment was what gave Uber the money to have a price war against Lyft. If there is one takeaway you have here it should be that 'Saudi oil profits were recycled into cheap taxi prices for Americans'.
But surplus investment, while being famous, isn't a very big part of foreign currency reserves. Most of it is recycled into riskier assets like stocks, startups, real estate and high yield bonds. For example only a quarter of Norway's oil fund is invested in bonds and a fraction of that is in government bonds. Its the same for Temasek (less so of GIC -Singapore’s other wealth fund), Mabudala, Qatar's SWF and probably every other sovereign wealth fund.
In the end you've to remember a few things: the reason why central banks have USD reserves is because it is used a lot! Any currency that wants to replace the US Dollar will have to be used quite a bit for central banks to shift their reserves
Part 2 of this is coming very soon: Why it is very hard to replace the Dollar. Sign up here for more!