Closing Case Emerging MarketsEthical Dilemma The Less Mighty Dollar

For eight decades, the dollar has reigned supreme in the global economy. It was the worlds official reserve currency between 1944 and 1973, and has been the unofficial reserve currency since 1973. Although the US share of the global economy has fallenrelative to its rivalsand its politics have turned inward, the dollar remains indispensable. At present, the United States contributes 23% of global GDP (measured at official exchange rates), 9% of goods trade, and 35% of market capitalization. However, according to official data from the IMF, 61% of the worlds foreign exchange reserves are in dollarsfollowed by 21% in euros, 6% in yen, 5% in pounds, and 2% in yuan. In terms of overall economic size, China has caught up, contributing approximately 18% of global GDP and 12% goods trade. The United States is the biggest export market for 32 countries, down from 44 in 1994. The comparative numbers for China grow from two to 43. Yet no American firm bothers to list in Shanghai, while a small number of elite Chinese firms such as Alibaba enjoy a badge of honor for their ability to successfully chase the dollar by listing in New York. Whenever an economic crisis erupts, the dollar is typically the safe haven to which investors rush. Swiss bankers, Mexican drug lords, and Cambodian taxi drivers all prefer to hold and transact using the almighty dollar. Clearly, the global demand of the dollar does not depend on US export competitiveness or creditworthiness alone. Widely viewed as a major source of soft power, the dollar helps American firms trade and invest abroad with less currency risk.

What is the proper role of the dollar? This is a trillion-dollar question. The recent economic turmoil has intensified this global debate. In terms of international trade competitiveness, a strong dollar makes it harder for US firms to export and to compete on price when combating imports at home (see Table 7.5). Conversely, a weak dollar may facilitate more US exports and stem import growth. Further, the dollar is the dominant currency in international trade not involving the United States. This means that if the dollar is strong, exporters from the rest of the worldmore than half of them invoice in dollarswould have a hard time competing on price. Therefore, a strong dollar reduces worldwide exports and thus worldwide trade. Conversely, a weak dollar not only boosts US exports, but also stimulates worldwide exports and trade.

Table 7.5

A Strong Dollar versus a Weak Dollar

Panel A. A Strong (Appreciating) Dollar
Advantages	Disadvantages
US consumers benefit from low prices on imports. Lower prices on foreign goods help keep US price level and inflation level low. US tourists enjoy lower prices abroad. US firms find it easier to acquire foreign targets.	US exporters have a hard time to compete on price abroad. US firms in import-competing industries have a hard time competing with low-cost imports. Foreign tourists find it more expensive when visiting the United States. Exporters from the rest of the world have a hard time competing on price abroad, suppressing worldwide trade.

Panel B. A Weak (Depreciating) Dollar
Advantages	Disadvantages
US exporters find it easier to compete on price abroad. US firms face less competitive pressure to keep prices low. Foreign tourists enjoy lower prices in the United States. Foreign firms find it easier to acquire US targets. The United States can print more dollars (quantitative easing) to export its problems to the rest of the world. Exporters from the rest of the world find it easier to compete on price abroad, boosting worldwide trade.	US consumers face higher prices on imports. Higher prices on imports contribute to higher price level and inflation level in the United States. US tourists find it more expensive when traveling abroad. Governments, firms, and individuals outside the US holding dollar-denominated assets suffer from value loss of their assets.

Although critics in an influential Economist (2015) report argued that the dominance of the dollar in the face of fading US economic supremacy is unsustainable, its would-be contenders are in a worse shape. The very existence of the euro, the same Economist report opined, cannot be taken for granted. Thanks to Brexit, the pound has taken a severe pounding. The yen is a forgotten currency to which nobody outside Japan has paid much attention for two decades. The newest darling, the yuan, is on the lips of many bankers from Hong Kong to London. But it is an underachiever. Despite progress, the yuan is not fully internationalized. Only about 15% of Chinas trade with the world uses the yuan. The freely traded part of Chinas stock markets is only the size of Switzerlands. In other words, although China is a giant in trade and FDI, it is a mid-sized power in finance, currencies, and financial markets, according to the same Economist report.

Overall, the rise of the yuan will be slower than commonly predicted. At best, according to experts in Foreign Affairs, the yuan will assume a place among secondary reserve currencies, such as the euro, the pound, the yen, and the Swiss franc. But it is a far cry from displacing the dollar. There are generally long lags between a countrys emergence as a leading economic power and the widespread use of its currency by foreigners. As early as in 1872, the US economy became larger than Britains. But it took 70 years (including two world wars) for the dollar to displace the pound as the reigning international currency. A practical question is why anyone not doing business with China would want to hold yuan. The vast majority of yuan-denominated stocks, bonds, and assets are in China. But if Chinas capital markets are not open to foreigners holding yuan, their incentive to hold yuan would not be strong.

So, what are the two lessons from history? First, a country that does not grow its economy cannot continue to provide adequate liquidity to the global economy indefinitely. At some point, the tension between the real economic clout and the financial muscle will cause the faultline to collapse. As Chinas economy seems destined to become the largest in the world, according to the Economist, it would be strange if its currency forever lagged far behind.

Second, while the process will take a very long time, some US actions may accelerate the dollars demise. Exorbitant privilege of the dollara term coined by former French president Valry Giscard dEstaingcarries significant responsibility. Recent US actions to weaponize the dollar to impose sanctions on countries and individuals that have attracted Uncle Sams wrath may motivate friends and foes to reduce their reliance on the dollar. Ultimately, all US-dollar transactions, including those not involving any US party, go through New York. When the United States withdrew from the Iran nuclear deal in 2018, European exporters, whose governments kept the deal and continued to support doing business with Iran, could not sell Iran planes, cars, and wines in dollars. European exporters have a hard time invoicing the Iranian buyers in euros too, because as long as the European banks involved have any US-dollar transactions, their wings can be clipped for violating US sanctions. An upset French finance minister argued, I want Europe to be a sovereign continent, not a vassal. Going back to an extremely primitive way of trading, the Europeans and Iranians are taking great pains to set up a barter (goods-to-goods exchange) to avoid involving banks.

At the same time, China and Russia are busy reducing their dollar dependence. Russia currently pays 15% of Chinese imports in yuan. In a CNN interview, Carrie Lam, chief executive of Hong Kong who was sanctioned by the US government for implementing a Chinese national-security law, admitted, I'm using cash everyday for all the things. I have piles of cash at home because I dont have a bank account. She made HK$5.2 million (US$672,200) a yeara huge pile of cash. Banks in Hong Kong, including those owned by the Chinese government such as Bank of China, were afraid of facing US sanctions themselves should they work with Lamsuch was the long arm of the US dollar dominance. The upset Chinese media wrote that this was a reminder that China's national sovereignty and security is at stake with US dominance in global financial transactions. The upshot? China has intensified its effort to internationalize the yuan.

Case Discussion Questions

1. How does the worlds reliance on the dollar help US firms trade and invest around the world?

2. From the standpoint of your country, do the pros of the exorbitant privilege of the dollar outweigh its cons?

3. ON ETHICS: The more we condition the use of the dollar and our financial system on adherence to US foreign policy, the more the risk of migration to other currencies and other financial systems in the medium term grows, according to Jacob Lew, treasury secretary during the Obama administration. If you were the current US treasury secretary or CEO of Citigroup, how would you advise the US president on this sensitive issue?