Is the dollar about to get taken down a peg?

By Ira Iosebashvili

Source: Wall Street Journal (Sept. 24, 2017)

The U.S. currency has been the most important in the world for decades. Central banks hold the bulk of their reserves in dollars. The currency is involved in 9 out of every 10 transactions in the $5.1 trillion-a-day foreign-exchange market. Oil, sugar and almost all other commodities are priced in dollars.

Now some economists and analysts think Washington's political dysfunction and growing push for isolation may loosen the dollar's central role in the global economy.

Let's be clear: The experts don't think the world will simply drop the dollar. But, they say, the state of U.S. politics could spook investors and central banks enough to pare their dollar-denominated holdings and seek shelter elsewhere. Those fears are reflected in part by the dollar's big declines in 2017, to its lowest level in nearly 2 years.

"We are closer to a loss of confidence in the dollar," says Ben Cohen, a professor of international political economy at the University of California, Santa Barbara. If the dollar's status were to change, he says, "the most likely explanation would be a failure of domestic policy."

Even an incremental decline in the dollar's global status could have ripple effects across the U.S. and abroad. Demand for dollar-denominated Treasurys has helped keep U.S. interest rates low. A diminished dollar would likely pressure rates upward, making it more expensive to borrow money and weighing down economic growth. Americans traveling abroad would find their dollars buy less, even as foreigners enjoying a stronger currency snap up more U.S. assets such as real estate. Companies and nations that had avoided transaction costs by conducting business in dollars would be faced with increased expenses on everything from cross-border investment to tourism, as they increasingly buy and sell currencies.

The dollar has enjoyed its privileged position since World War II, when central banks agreed to link exchange rates to the U.S. currency instead of gold, leading to them hold dollars in reserve instead of the metal. The first serious rival to the dollar's dominance came in 1999, with the birth of the euro. Europeans heralded the single currency as a new rival to the dollar when it was introduced, but its status was dimmed by a 2010 financial crisis that stoked fears that Greece, and perhaps other countries, would leave the euro.

The most immediate current concern about the dollar surrounds the remote but catastrophic possibility of a U.S. government default if lawmakers can't agree on raising the debt ceiling. Earlier this month, Congress approved a three-month extension of the government's borrowing limit. But that sets the stage for another showdown at year's end, and a number of House Republicans have indicated a preference for tying the debt-ceiling extension to spending cuts or other causes.

Some economists also worry that the prospect of new protectionist measures could stymie U.S. trade and lessen the dollar's influence overseas. Likewise, concerns are growing that the U.S. retreat from global leadership, starting with the Trump administration's more-skeptical view of global trade agreements and pullback from the Paris climate accord, could augur poorly for the dollar.

Other scenarios that could shake investor confidence would include President Donald Trump squabbling with longstanding U.S. allies or ratcheting up tensions with enemies such as North Korea, Mr. Cohen says.

There's little consensus on what an exodus from the dollar would look like, and how it would play out in markets. The last currency to give up top-dog status was the British pound, which accounted for some 60% of global trade at the beginning of the 20th century and lost its spot after Britain's economy was ravaged by two world wars.

Few see such a path for the dollar. A wholesale flight out of the dollar is equally unlikely, most analysts believe.

"You would think, 'How can a country with that kind of political backdrop have a global reserve currency?,' " says Martin Barnes, senior vice president and economic adviser at Montreal-based BCA Research. "The thing is, there's no alternative."

A more-realistic scenario would see investors gradually pare back dollar positions and increase holdings in other currencies. One sign that investors are losing faith in the dollar would be an accelerating decline in the its exchange rate, particularly against such other safe-haven currencies as the euro, yen or Swiss franc, Mr. Cohen says.

In the long term, one significant challenger to the dollar could be the yuan: The IMF added the currency to its elite basket of reserve currencies in 2016, an acknowledgment of China's growing economic might. However, experts say China's financial markets will have to become deeper and more stable to make the currency more appealing to central banks and other big investors. Such a transition could take years, or even decades, economists say.

And Washington's gridlock would have to become much worse before investors begin wondering if the U.S. is able to honor its debts, says TorstenSlok, chief international economist at Deutsche Bank. Investors ask "in which country in the world they are most likely to get their money back on government bonds," says Mr. Slok, "and still come to the conclusion that the U.S. is that country."

List three reasons that the USD has been the dominant global currency for decades.

List three reasons why the USD might start to play a less central role in the global economy.

List three currencies that might replace the central role of the USD in the global economy.

Why is a wholesale flight out of the dollar unlikely in the immediate future?

What types of risks would companies and consumers face if the value of the USD were to depreciate?

Calculation Section (5.76 points)

1.Show all steps and calculation

2.Use the calculation editor where needed to show your work.

3.(For this section, round numbers to .0000)

The Turkish Lira spot exchange rate is currently at 0.2795$/Lira.

The 1 year forward exchange rate on Lira is 0.2445$/Lira.

(Source:ftp://ftp.cmegroup.com/pub/settle/stlcur(Links to an external site.)Links to an external site.).

The 1 year interest rate in Turkey is 11.5% (http://www.tradingeconomics.com/Turkey/interest-rate)

The 1 year interest rate in the U.S. is 1.5%.

According to the Interest Rate Parity condition, what is the 1 year forward exchange rate? Is there an arbitrage opportunity? Why?

If yes, what are the arbitrage profits per 1 million Turkish Lira? Show the arbitrage strategy and calculation steps.

What is the expected spot rate in 1 year? Explain which two international parity conditions you could use to reach this result.