Dollar: A Dominant and a Surprising Currency

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This is my first article on the Hackernoon platform. I generally write at my blog/newsletter Tap to Unlock.

The article is about Dollar’s Dominance in Trade and Finance and shares a few instances when the dollar moved counter to a lot of people’s expectations and surprised everybody. So let's dive in

Finance

In 2007 the U.S. recorded a current account deficit of over $700 billion, roughly equivalent to 5 percent of annual U.S. gross domestic product (GDP). The current account deficit represents the amount a country borrows to finance its consumption and investment.

Running current account deficits is not always disadvantageous. If a country uses external debt to finance investments that have higher returns than the interest rate on the debt, the country can remain solvent while running a current account deficit. Developed countries while often run deficits and emerging economies often run surpluses.

And then the 2008 financial crisis happened. The meltdown of the housing market earlier in the year and crash of Lehman Brothers in September send strong signals that the dollar was going to collapse. As when a country is hit by the financial or currency crisis, both domestic and foreign investors start looking for exits, they pull their capital out and dump the domestic currency. Though initially, this was true investors did pull their capital out and moved it countries like Switzerland evident from the appreciation of Swiss franc, then something happened from September to December 2008, U.S. had net capital inflows (inflows minus outflows) of $500 trillion.

The dollar, which should have plunged in value, instead of rose sharply against virtually every other currency.

Another example to surprise you

The United States Debt Ceiling Crisis

The US debt ceiling is the aggregate figure that applies to gross debt (debt owed to the public (i.e., anyone who buys U.S. bonds) plus debt owed to federal government schemes such as Social Security and Medicare). It limits how much money the federal government can borrow.

If the United States breached its debt ceiling and were unable to resort to other "extraordinary measures", the Treasury would have to either default on payments to bondholders or immediately curtail the payment of funds owed.

This was a huge debate in July 2011, political brinksmanship led to a standoff between President Obama’s administration and the Republican-controlled U.S. House of Representatives. Finally, on July 31, 2011, the two parties reached an agreement to raise the debt ceiling.

On August 5, the rating agency Standard & Poor’s (S&P) cut the rating on U.S. government debt from AAA to AA+. According to S&P, the safest financial instrument in the world was no longer as safe as it had been thought to be. With the downgraded rating, the yields on US debt should increase as now that the US debt had been deemed riskier.

But yields on ten-year Treasury notes fell by 1% from July to September of that year. Net capital inflows into the U.S. jumped to nearly $180 billion in August and September. The dollar spiked up in value once more.

Conclusion: “Dollar will never fail to suprise you”

Trade

Opening the economy by reducing trade barriers like tariffs and quotas, depreciating the domestic currency, and adopting the floating exchange rate policy has been a go-to solution for small open and emerging economies to find growth.

In our international macroeconomics class we have been taught the mechanics of foreign trade between countries and how does this play out. And this is what we are taught, if a merchant in Singapore wants to buy cars from a merchant in Japan, he will exchange his currency the “Singapore dollar” with Japanese “yen” to pay and import the cars from Japan.

Similarly, if a Japanese merchant wants to buy goods from a merchant in Singapore, he will exchange his currency which is “yen“ with the “Singapore dollar” to pay for the goods to the merchant in Singapore. Hence in the above example, the bilateral exchange rate of the Singapore Dollar and the Japanese Yen is important.

This is called the Mundell - Fleming model or paradigm (MFP). Robert Mundell also won Nobel Prize in 1999 for this paradigm. It takes into account 2 assumptions:

• Prices of goods are sticky in the short run irrespective of fluctuations in the exchange rate.
• Goods are priced in the exporter’s currency.

Under this model a depreciation in the exporter’s currency will raise the price of imports and will lower the prices of exports, thus improving competitiveness and trade balance.

The paper “Dominant Currency Paradigm (DCP)” by Camila Casas, Federico J. Díez, Gita Gopinath, and Pierre-Olivier Gourinchas questions the general validity of this framework.

Today, the vast majority of international goods trade is invoiced in a dominant currency, which is most often the US dollar. In the paper, Gita Gopinath reported statistics on trade invoicing for a sample of 43 countries in the paper she presented at the Jackson Hole Symposium 2015.

These 43 countries represent 55% of world imports and 57% of world exports. In contrast to the MFP, she documents that the dollar’s share, as an invoicing currency, is 3.1 times its share in world exports. That is, many non-US exporters invoice their exports in dollars.

This in turn means that most world imports are also invoiced in dollars. Indeed the dollars share as an invoicing currency is estimated to be around 4.7 times its share in world imports.

While the euro's share as an invoicing currency in world exports is 1.2 times the share of euro country exports. In other words, while some non-euro countries invoice exports in euros this is of a much smaller magnitude than the use of dollars. Take a look at the picture below

In other words, most countries do not use their currency for exports. The real exception here is the U.S. with 93% of its imports and 97% of its exports invoiced in its currency. Argentina for example 97% of all its exports are invoiced in US dollars while the US is not even a dominant trading partner (only 2% of its exports go to the US).

Some insights from her extensive research with other co-authors.

• According to MFP, a 10% depreciation of the dollar raises import prices in the U.S. by close to 10%. According to DCP, a 10% depreciation of the dollar raises import prices in the U.S. by close to 0%. The difference arises because in the case of DCP prices are sticky in dollars.
• According to MFP, the number of exports should rise following depreciations. According to DCP, export expansions for non-U.S. economies, and especially developing countries should be weak.
• This does not imply that exporters in non-dominant currency countries do not benefit from a weaker exchange rate. They do, but it mainly works through increases in mark-ups and profits even while the quantity exported does not change significantly.

Why’s that

Because of integrated global value chains most exporters use imported inputs for producing their product, if these inputs are priced in dollars it implies that a significant fraction of an exporter’s costs are denominated in dollars which then incentivizes them to price in dollars.

Secondly, in a world where an exporting firm’s competitors are pricing in dollars, it is optimal for an exporter to also price in dollars to prevent excess variation in its price relative to its competitor's prices and therefore to preserve market share.

The strength of the U.S. dollar is therefore shown to be a key predictor of rest-of-world aggregate trade volume and consumer/producer price inflation. The DCP framework applies to any environment with dominant currencies and does not require the dominant currency to be the dollar.

Conclusion

The main contenders for unseating the dollar are the euro and the Chinese yuan. Despite the euro being in existence for a long time, it has had only a small impact on dollar dominance. More recently the Chinese government has made a big push for internationalizing the yuan by invoicing more of its trade, especially with countries in Africa in yuan in exchange for loans that are also denominated in yuan.

However, given the entrenched use of the dollar in both international trade and finance, and the strength of the U.S. monetary system, displacing the dollar will be a difficult and long-term endeavor.

Tweetable Remarks

The meltdown of the housing market and crash of Lehman Brothers in September send strong signals that the dollar was going to collapse. The dollar, which should have plunged in value, instead of rose sharply against virtually every other currency. (Tweet This)

The US has 93% of its imports and 97% of its exports invoiced in its currency, whereas Argentina for example 97% of all its exports are invoiced in US dollars while the US is not even a dominant trading partner only 2% of exports of Argentina go to the US (Tweet This)