Friday, June 18, 2010

The Dominance of the US dollar - 1

In this first of a 2-part series, we shall study the reasons for the dominance of the US dollar as the global reserve currency, and its impact on economy and trade. In the next part, we shall see its impact on the USA being an economic superpower, and why the US dollar cannot be replaced as the world's global currency.

Note : We use the term "Central Bank" and "Reserve Bank" interchangebly. Both mean the apex bank in a country that prints currency notes, and regulates the currency. In India, we have the RBI, and its counterpart in the US is the Federal Reserve.

Presently, the currency used in transacting almost all global trade is the US dollar. Thus, trade between, say, Russia and India as well as between Japan and Venezuela is conducted in the US dollar. This prompts the Reserve Banks of all countries to keep a physical reserve of dollar notes, ranging from a few tens of billions of dollars, to over $2 trillion that China has. This is done so that the exporters and importers of the country are able to convert their monetary transactions in the US dollar. Of course, a reserve of other important currencies is kept too, such as the Euro and Yen. But the size of the dollar reserves usually far exceeds these currencies.

First, we shall understand the basics of how the exchange rates of currencies are decided, by undertaking a hypothetical example. Let us assume 2 countries namely, A and B. Country A is technologically advanced, and exports fighter jets, tanks, machine guns etc. Country B is ruled by a theocratic party, is poor and technologically backward, but which has a good produce of bananas. Bananas are not grown at A. So, both nations trade technology and bananas with each other.

Assume that at normal trading sessions, a fixed quantity of bananas is traded for a fixed number of weapons hardware. However in a particular festive season in A, since the market demand for bananas at A becomes much more than the market demand for technologies at B, A has to part with a higher proportion of its goods in return (than usual) for the same quantity of bananas from B. Vice-versa, during times of war with its neighbouring despotic states, the demand for hi-tech weaponry at B increases. So, it has to part with more ship-loads of bananas to get the same quantum of hi-tech weaponry.

In economic parlance, countries such as B are called banana-republics, whose economies depend solely on the export of an abundant natural resource to fuel their economy. Examples are Saudi Arabia (oil), Kuwait (oil), Ivory Coast (coffee and cocoa), and Cameroon (timber).

Now, the above simplistic example shows that a fluctuation in demand for the exports of a country, brings it to a better negotiating position :- it can import a greater value of goods, for the same quantum of exports. Now replace the simplistic (barter) trading system in the hypothetical example above, with currency, and we can see clearly how do currency fluctuations take place.

When the exports of a country find high demand abroad, it brings in a lot of US dollars to the Central bank (or Reserve bank) of that country. Thus, the value of that country's currency rises with respect to the dollar (and so, its exports become more expensive). Conversely, when the exports of a nation find less acceptance abroad, that country's Central Bank finds lesser and lesser dollars in its "vaults". This leads to its currency falling with respect to the dollar (and so, its goods sell cheaper abroad). {Actually in the short term this may have a sort of "yo-yo" effect, i.e. when a currency of a country falls, its exports become cheaper, which in turn results in a demand for its exports --- and this strengthens its currency, only to make its exports costlier once again. But the point is, that the long-term rate of any country really hovers around a range. Example : the Rupee hovers around 45-50 per US dollar).

Now, as per various US government websites, India currently enjoys a trade surplus with respect to the US. In other words, India is a net exporter to the US, which means that the US needs more of India's goods & services, than does India from the US. The trade surplus with respect to the US was over $600 million last year. But despite that, the Indian rupee remains at 45 to the US dollar. But as per our discussion above, this should not happen and theoretically, the rupee must be stronger than the dollar ! So, how may we explain this anomaly ? The reader is requested to keep this question in mind, as it shall be answered in the next post.

We must note that since there are over 200 nations globally, there cannot be an exchange rate of each currency with all other 199 odd currencies. It has been precisely the impracticality of the barter system that has long led to a currency system being adopted. Currencies have been used since the ancient Greek, Mesopotamian and Egyptian civilizations, because as the economy grew and lives became more complex than those of nomads, they all realized that the barter system would no longer be practical.

A currency note is nothing but an IOU (I Owe You), or in other words, a receipt of debt. You promise to pay the bearer a sum of (or value of) X rupees, when he theoretically presents the receipt back to you. Though this is not in practice at the individual level, it IS in practice at the international scale. As an example :- when you pay your milkman Rs. 100, he won't come back to you later to demand hard goods and services worth Rs. 100, saying, "This is only a receipt of debt issued by the RBI that says "Rs. 100". I want your knife set worth this much to redeem this receipt".

Now here it is very important to mention that currencies did NOT come into play as soon as the barter system ended. Traders and merchants decided that all goods and services must be exchanged not against barter, but against one universal commodity, whose value is ascertained by the forces of all round demand and supply. This commodity was gold (sometimes other precious metals also), which was universally accepted even across civilizations --- like when the Greeks traded with the Egyptians or the Indians. Gradually, a more "subtler" form of currency came into being, and which is the ones in use today, like ordinary coins and paper notes.

Throughout the 19th century and up to World War -2, gold bullion was used as a standard medium of exchange that facilitated international trade amongst countries, which had different currencies and purchasing powers. This was known as the gold standard, and which allowed the currencies of all participating nations to be pegged to a standard weight of gold. So, if country A wanted to trade with country B, it would trade in gold bullion and its Central Bank would have to release gold from its vaults to country B. Every nation's currency was fixed to command different weights of gold. So, a British pound could buy more gold, than, say, the Saudi dinar.

Now the important thing is this :- if a foreign trader somehow got hold of a nation's currency, he could redeem it ONLY for gold --- when he just went and presented it to that nation's Central Bank. This is the exact antithesis of the example we gave of the milkman : he can't come back to you with the very Rs. 100 note you gave him to demand your collection of cricket T-shirts. This has much wider implications, because ultimately no matter where a currency may be anywhere in the world, it had to ultimately find its way back to its country of origin in return for hard goods & services. We very conveniently forget this BASIC fact, after being used to seeing the US dollar as the international currency for so long.

On a side note, we may observe the barter system does indeed form the basis of all transactions --- currencies simply facilitate it.

Now after World War -2, Britain, France, Japan, Russia and other nations reported a near-bankruptcy in their reserves of gold bullion. The US was the sole surviver of the war, with a thriving industrial base and a lower impact on its finances including its gold reserves. Japan, UK and Germany were eager to start trading again and like many other countries, needed a quicker medium of exchange instead of going through the time-consuming route of building gold reserves. So they took loans from the US --- in US dollars only, and not gold. They would use these dollars to buy goods, technology and services from American companies like Pfizer, DuPont and IBM, to help rebuild their countries, which were devastated by the war. Of course, the borrowers also had to ultimately repay their debt to the US Federal Reserve, in gold. The dollars were temporary mediums of exchange only.

But the "catch" for US was this :- the borrowing countries could use those very dollars to trade with other nations too most notably, oil-exporting Saudi Arabia and Iran.

This was especially attractive to the newly formed "Oil-republics" in the middle-east like Saudi Arabia, Kuwait, Iran and Iraq. They were technologically quite backward. But they had one commodity called crude oil, which was needed globally to run vehicles, power, roads, chemicals, etc. It practically fueled the human civilization. Besides, they knew that after World War-2, the US was the "last man standing". In other words, if they presented dollars to American exporters like General Electric (to build power plants), to GM (to export cars) and to Boeing (to sell aeroplanes and fighter jets), they would readily oblige.

Also, once they got whatever goods they wanted from the US, the excess dollars could always be redeemed for gold, if they simply presented them to the American Central Bank (the US Federal Reserve). Add to this, that all countries (like India and China) needed oil from these middle-eastern nations. So, they too started accumulating dollars to pay Saudi Arabia and other oil republics. They did this simply by exchanging their gold reserves for dollars. So, if the Indian RBI wanted dollar notes to finance its oil imports from Saudi Arabia, it would exchange its gold reserves with the US Federal Reserve for fresh dollars.

Here, the view of a dollar note being an IOU issued by the US Federal Reserve is clear. So now, the US dollar became the global de-facto reserve currency. But the most important thing to note here is that it was backed by gold, which meant that outside US soil, a dollar note wasn't only a piece of paper.

This concludes the first part of this series. We saw how after World War-2, the US dollar came about to be the global reserve currency. In the next part, we shall answer the question we posed earlier :- why is the India rupee still quote 45 to the US dollar, even though India has a trade surplus with the US ? A hint has already been given.

We shall also see how has this arrangement helped the US be a global economic superpower, and why the US dollar CANNOT be replaced by the Chinese yuan as the global reserve currency.

Any comments and suggestions are welcome.


  1. Ur way of writing is interesting. U have explained the complicated and complex things very simply. :)

  2. Hi Chandrika. Thanks for your comments.

  3. Since I live in the U.S. I can but say that I hope you're right about the dollar.

  4. If you don't have opinions, there's no point writing a blog post. That's better than copy-pasting from various sites. what you have said is nothing new. The same points have been made a thousand times by every financial paper/armchair economist.

  5. Snowbrush : Thanks for your comments. Do read part-II of the same topic, that shall attempt to explain why the US dollar can't be replaced by any other currency as the global reserve. The US is however, on a "precarious" position now.

    To the Anonymous commentator, I'd say that this post is a brief compilation of the history of how the US dollar came to be the global reserve currency. You can read about the following topics from wikipedia that I've condensed and posted here :-

    1) The Gold Standard.
    2) The Bretton Woods Agreement.
    3) The Nixon Shock.

    This post is a precursor or background to the next post, where we'll attempt to answer why the dollar shall continue its supremacy, and its importance for USA's superpower status.

    Thank you.


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