US share of World GDP declining, but share of US Dollar keeps rising

Carmen Reinhart has a piece explaining this dilemma:

Since the end of World War II, the United States’ share in world GDP has fallen from nearly 30% to about 18%. Other advanced economies have also experienced sustained declines in their respective slices of the global pie. But you wouldn’t know it from looking at the international monetary system.

Over the same period, China’s share of world GDP almost quadrupled, to around 16% (just behind the US), and emerging markets now account for about 60% of global output, up from about 40% in the immediate post-war years. Given that advanced-economies’ growth prospects remain subdued, these trends are likely to continue – even with the evident slowing in China and other emerging markets.

And yet global finance has not mirrored this shift in balance from the advanced to the emerging. The post-war Bretton Woods arrangements institutionalized the role of the US dollar as the main reserve currency, and until the 1970s, about two-thirds of global GDP was anchored to the greenback. The remainder was largely split between the British pound and the Soviet ruble.

In a recent study that I undertook with Ethan Ilzetzki and Kenneth Rogoff, we document that the US dollar has retained its dominant position as the world’s reserve currency – and by a significant margin. Over 60% of all countries (accounting for more than 70% of world GDP) use the US dollar as their anchor currency. Other metrics, which include the proportion of trade invoiced in dollars and the share of US assets (notably Treasuries) in central banks’ foreign exchange reserves, suggest a similar degree of “dollar dominance.”

The euro is a distant second. From the early 1980s until the introduction of the euro in 1999, the Deutsche Mark’s (DM) influence expanded first in Western Europe and later in Eastern Europe. But the rise of the euro, which consolidated the DM and French franc (Africa) zones, appears to have stalled. By some measures (given the shrinking share of Europe in world output), its global importance has declined.

No other major established international currencies currently compete for global leadership.

This is nothing but the modern Triffin dilemma. The US can continue its existing ways but there are other possibilities as well:

Now as then, the US could meet the rest of the world’s appetite for dollars by issuing more dollar debt. This would require the US to run sustained current-account deficits, mirrored in fiscal deficits. Of course, while the link to gold is passé, any domestic fiscal objective to curb US debt growth would be at odds with the international role as sole provider of the reserve currency.

One way or another, China will figure prominently in the resolution of this modern “Triffin dilemma.” One possibility is that the inevitable reduction of US current-account deficits (whenever that comes) may result from sustained dollar depreciation (as in the 1970s), implying a capital loss for China and other major holders of US Treasuries. Alternatively, China could eventually become a new supplier of reserve assets. In this scenario, the supply of the reserve asset would align with the world’s fast-growing regions.

This connection could be direct, if the renminbi acquires reserve-currency status; or indirect, if the International Monetary Fund’s unit of account, special drawing rights, becomes a favored asset of reserve managers, as the renminbi is now in the SDR currency basket. Reserve status for the SDR is a long-held IMF ambition, though the idea has never gotten much traction.

But there is a third possibility: global demand for US reserve assets may subside. While China’s ongoing capital flight is fueling an immediate and substantial decline in demand for US Treasuries, a more sustainable scenario would entail China’s transition to a managed floating exchange-rate regime with a deeper domestic financial market – and less emphasis on maintaining a credible war chest of foreign reserves.

One doubts whether the transition would be as easy.

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