By Barry Eichengreen
If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the dollar. It was not that long ago that confident observers were all predicting that the dollar was about to lose its “exorbitant privilege” as the leading international currency. First there was financial crisis, born and bred in the United States. Then there was QE2, which seemed designed to drive down the dollar on foreign exchange markets. All this made the dollar’s loss of preeminence seem inevitable.
The tables have turned. Now it is Europe that has deep economic and financial problems. Now it is the European Central Bank that seems certain to have to ramp up its bond-buying program. Now it is the euro area where political gridlock prevents policy makers from resolving the problem.
In the U.S. meanwhile, we have the extension of the Bush tax cuts together with payroll tax reductions, which amount to a further extension of the expiring fiscal stimulus. This tax “compromise,” as it is known, has led economists to up their forecasts of U.S. growth in 2011 from 3 to 4%. In Europe, meanwhile, where fiscal austerity is all the rage, these kind of upward revisions are exceedingly unlikely.
All this means that the dollar will be stronger than expected, the euro weaker. China may have made political noises about purchasing Irish and Spanish bonds, but which currency – the euro or the dollar – do you think prudent central banks will find it more attractive to hold?
There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.
Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.
China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. This has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. It has not prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.
So the dollar is here to stay, more likely than not, if only for want of an alternative.
The one thing that co
