Harvard economist Martin Feldstein argues that even though the US dollar is losing its status as the world’s principal “reserve currency”, it has a bright future as an “investment currency”. The large foreign exchange holdings held by some central banks, he argues, are not reserves in the traditional sense. In reality they are investment funds, albeit “investment funds that also deter attacks by forex speculators”.
It is prudent for any country with large foreign exchange balances to diversify those funds. It is not surprising then that countries such as China and Korea are diversifying away from dollars, primarily into euros.
That diversification cuts demand for the dollar, putting pressure on its value. Market participants should see this as a natural consequence of the shift of foreign exchange balances from liquid dollar emergency reserves to longer-term multi-currency investment portfolios. But even as countries diversify away from exclusive reliance on dollars, the dollar will continue to be the main form of liquid investment for countries around the world.
As this portfolio rebalancing comes to an end, demand for dollars will stop falling. At the same time, the dollar’s reduced value will shrink the US trade deficit, reducing the annual supply of dollars. This stronger demand for dollars and reduced supply can end the dollar’s decline. What looks like a crisis of confidence in the dollar as a reserve currency is just part of the evolutionary process that will eventually halt the dollar’s decline.
Martin Feldstein, “The dollar’s fall reflects a new role for reserves”, Financial Times, 10 December 2009.
Nothing can go on forever, certainly not the decline of the dollar, but I am not confident that the process of adjustment will be so easy. The implication of Feldstein’s line of reasoning is that central banks will choose to invest only a small amount of their foreign exchange in US treasury bills. What will happen to US interest rates – and the cost of financing the massive US public debt – as Asian central banks dump US treasury bills? Big sums are involved. As Feldstein notes, Thailand holds foreign exchange assets of $100 billion, South Korea $200 billion, Taiwan $300 billion, and China more than $2,000 billion.
Tags: exchange rates, Martin Feldstein
