Monthly Archives: October 2015

The Continuing Dominance of the Dollar: A Review of Cohen’s “Currency Power”

Every year I choose a book that deals with an important aspect of globalization, and award it the Globalization Book of the Year, also known as the “Globie.” Unfortunately, there is no cash prize to go along with it, so recognition is the sole award. Previous winners can be found here and here.

The winner of this year’s award is Currency Power: Understanding Monetary Rivalry by Benjamin J. Cohen of the University of California: Santa Barbara. The book deals with an issue that is widely-discussed but poorly-understood: the status of the dollar as what Cohen calls the “top currency.” The book’s appearance is quite timely, in view of the many warnings that China’s currency, the renminbi (RMB), is about to replace the dollar (see, for example, here).

Cohen proposes a pyramid taxonomy of currencies. On the top is the “top currency,” and in the modern era only the pound and dollar have achieved that status. The next level is occupied by “patrician currencies,” which are used for cross-border purposes but have not been universally adopted. This category includes the euro and yen, and most likely in the near future the RMB. Further down the pyramid are “elite currencies” with some international role such as the British pound and the Swiss franc, and then “plebeian currencies” that are used only for domestic purposes in their issuing countries. Below these are “permeated currencies” which face competition in their own country of issuance from foreign monies that are seen as more stable, “quasi-currencies” that have a legal status in their own country but little actual usage, and finally at the base of the pyramid are “pseudo-currencies” that exist in name only.

Cohen points out that not too long ago the euro was seen a competitor for the dollar as a “top currency.” The euro’s share of the publicly known currency composition of central banks’ foreign exchange reserves has fluctuated around 25% in the last decade, and its share of the international banking market is higher. But Cohen believes that the relative position of the euro may have peaked due to its inability to devise a way to deal with fiscal imbalances among members of the Eurozone.

Cohen compares the Eurozone’s institutional framework with that of the U.S., which adopted a common currency early in its history. The U.S. system includes fiscal transfers (“automatic stabilizers”) between the federal government and the states but no bailout of a state government in fiscal distress, accompanied by balanced budget restrictions in most states. The European Union’s (EU) Stability and Growth Pact put a limit on the budget deficits of its members and their debt, and was followed by the European Fiscal Compact that mandates balanced budget regulations in national laws. But resistance to the EU’s oversight of national budgets has been widespread. Moreover, the European Stability Mechanism, the EU’s instrument to assist members in financial crisis, is still a work in progress, as the lack of resolution of the Greek debt crisis demonstrates. While the size of the Eurozone ensures the wide usage of the euro and a role as a “patrician currency,” the inability of its member governments to decide on how to handle fiscal governance ensures that it will never rival the dollar.

China does not face the problem of unruly national governments, although the finances of local governments are shaky. The RMB has become more widely used in international commerce, not a surprising development in view of the rise of China as a global trading nation. The IMF is considering the inclusion of the RMB with dollars, euros, pounds and yen in the basket of currencies that comprise the IMF’s own unit of value, the Special Drawing Right. The Chinese government sees the upgrade in the status of the RMB as a confirmation of that country’s ascent in economic status.

But Cohen cautions against interpreting the increasing use of the RMB in trade as a precursor to the widespread adoption of the RMB as a global currency. He points out that there are private functions as well as official roles of an international currency, including its use for foreign exchange trading and financial investments. The RMB is not widely used for financial transactions, in part due to barriers to the foreign acquisition of Chinese securities, while the size of Chinese financial markets, while growing, is limited. Eswar Prasad and Lei Ye of Cornell reported in 2012 that “China still comes up short when it comes to the key dimensions of financial market development, and financial system weaknesses are likely to impede its steps to heighten the currency’s international role.”

Moreover, the government’s response this summer to the volatility in its stock markets was seen as heavy-handed. Cohen questions whether the Chinese government is willing to relinquish its control of the financial sector, despite its desire to promote the international use of the RMB. Capital flight would be a threat to stability and a sign of the government’s loss of legitimacy.

Cohen concludes his insightful analysis with a prediction that “Well into the foreseeable future, the greenback will remain supreme.” The U.S. currency continues to have widespread usage for many purposes. But any sort of triumphalism would be short-sighted. A recent working paper by Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated the amount of dollar-denominated credit outside the U.S. at about $9 trillion. A rise in the cost of borrowing in dollars will be passed on to the foreign borrowers, which will further slow down their economies. The decision in September of the Federal Open Market Committee to delay raising interest rates reflected its concern about the global economy, which complicates its ability to use monetary policy for domestic goals. The U.S. can not ignore the feedback between the international roles of the dollar and its own economic welfare. Great responsibility comes with great power.

The External Debt of the Emerging Market Economies

The outflow of money from emerging markets this year will most likely surpass inflows for the first time since 2008, and net capital outflows may total $541 billion according to the Institute of International Finance. The flows have been accompanied by currency depreciations, stock market collapses, and in the case of Brazil, a downgrade in its credit rating to junk bond status. The IMF has responded to this turbulence by lowering its forecast for growth in the emerging markets and developing economies this year from 4.2% to 4%.

The emerging market nations that export commodities have been particularly hard hit, as China cuts back on its imports of raw materials and commodity prices plunge. Other factors that could signal further weakness are declining foreign exchange reserves, current account deficits and political uncertainty. Countries besides Brazil that have been identified as most vulnerable to further downturns include Russia, Venezuela, Turkey and Indonesia. When the long-awaited increase in U.S. interest rates finally does take place, the rise in the cost of borrowing in dollars will exacerbate the position of these countries.

There is another factor that will affect how an external shock will affect economic performance: the composition of a country’s external balance sheet. This records the holdings of foreign assets held by domestic residents and domestic liabilities held by foreigners. A country’s net international investment position (NIIP) as a creditor or debtor depends on the difference between its assets and liabilities. Both assets and liabilities can take the form of equity, which includes foreign direct investment (FDI) and portfolio equity, or debt in the form of bonds and bank loans. In addition, countries may hold assets in the form of foreign exchange reserves at their central banks.

Assets are denominated in foreign currencies, particularly the dollar, while equity liabilities are denominated in the home currency. Debt liabilities may be denominated in the domestic or a foreign currency. Foreign lenders who are concerned about the government’s macroeconomic policies—a phenomenon known as “original sin”—may insist that bonds be issued in dollars.

After the financial crises that afflicted many emerging markets during the late 1990s and early 2000s, many of these nations altered the composition of their external balance sheets. Countries that had obtained external funds primarily through debt turned to equity for sources of finance. As a result, their equity liabilities grew steadily, both in terms of absolute magnitude and relative to their debt liabilities. Their assets, on the other hand, largely consisted of foreign exchange reserves, held in the form of U.S. Treasury bonds, and other debt holdings. This profile is known as “long debt, short equity,” and differed from the “long equity, short debt” composition of most advanced economies that held equity and issued debt.

The payout on equity is contingent on the profitability of the firms that issue it, while debt payments are contractual. As a result, over time equity carries a higher return than debt—the “equity premium.” Consequently, the “long equity, short debt” profile in normal times is profitable for those countries that are net holders of equity.

But the situation changes during a crisis. The decline in the value of equity liabilities raises the NIIP of the countries that issued them. In addition, a depreciation of the domestic currency increases the value of the foreign assets while lowering those liabilities denominated in the domestic currency. Bonds issued in a foreign currency, however, will rise in value—a phenomenon observed during the Asian crisis of 1997-98. In addition, short-term liabilities may not be rolled over by foreign lenders, while FDI is much more stable.

Phillip Lane of Trinity College (working paper here) has claimed that the composition of the emerging market economies’ external balance sheets served as a buffer against the global financial crisis (GFC) of 2007-09, while the structure of the advanced economies’ external assets and liabilities heightened their vulnerability. In a recent paper I investigated this claim and found that countries with FDI liabilities had higher growth rates, fewer bank crises and were less likely to borrow from the IMF during the GFC. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit. The “long debt, short equity” strategy of emerging markets did mitigate the effects of the global financial crisis, and acted as a countercyclical crisis buffer.

But the balance sheet profiles of the emerging market economies has changed in the wake of the crisis. The corporate debt of nonfinancial firms in many emerging market economies, particularly bonds denominated in dollars, grew rapidly during this period. The IMF in its latest Global Financial Stability Report has drawn attention to this shift, which it reports has been driven by global drivers, such as the decline in U.S. interest rates.

A newly-issue report by the Committee on International Economic Policy, Corporate Debt in Emerging Economies: A Threat to Financial Stability?, views this increase in debt as a threat to financial stability. The report, written by Viral Acharya of New York University, Stephen Cecchetti of Brandeis University, José De Gregorio of the University of Chile, Sebnem Kalemli-Ozcan of the University of Maryland, Philip Lane of Trinity and Ugo Panizza of the Graduate Institute in Geneva, reviews the changes in the balance sheets of the emerging markets. They find that “…there has been a deterioration in the net foreign debt positions of many emerging economies in recent years.” While the amounts of corporate debt are limited, the authors point out, “…even a category that appears relatively small can be a source of systemic financial stability.” Moreover, bonds denominated in a foreign currency have accounted for a large component of the growth in corporate debt, and there has been “…an overall decline in the net foreign currency position of many emerging economies.” As a result, “…this has made emerging economies vulnerable to a shift in international funding conditions and macroeconomic slowdown.”

Moreover, the amount of emerging market debt may be underestimated. Carmen Reinhart of Harvard’s Kennedy School points out that debt may go undetected until the outbreak of a crisis. She points to the Mexican crisis of 1995-95, the Asian debt crisis of 1997-98 and the current Greek crisis as examples of the detection of “hidden debt” that became visible as the crisis emerged. She fears that lending by Chinese development banks for infrastructure projects in other emerging and developing economies may not be included in the data for their external debt, and could add to their vulnerability.

The authors of the report on corporate debt in emerging economies point out that policymakers have a variety of policy tools to deal with the risks of external borrowing. These include capital and liquidity regulations, directly lending to small and medium-sized enterprises when banks are constrained by exposure limits, and central clearing of derivative contracts. But all this will come after the deterioration to the external balance sheets has taken place. Governments should monitor the external borrowing of domestic firms and public agencies during “boom” periods to track their vulnerability to shocks to global liquidity. Meanwhile, the IMF is preparing for the next crisis.