An Exorbitant Privilege? Implications of Reserve Currencies for Competitiveness
October 2015 | by Steve Johnson
Sharp exchange rate volatility is a sign of stress in the world currency system and has reignited debate about whether the dollar will continue to be the world's primary reserve currency and what system could emerge in its place. But nobody has asked a more fundamental question—what are the benefits and costs of issuing a global reserve currency? Answering this question may shed new light on how the global currency system might evolve and whether businesses and economies should expect a continuation of an "unmanaged" reserve currency system that increases exchange rate volatility and threatens their competitiveness.
Some observers assume that the United States continues to enjoy an "exorbitant privilege" because of the dollar’s reserve currency status, as former French Finance Minister Valéry Giscard d’Estaing charged in the 1960s. But we find that the United States may not enjoy much of a privilege at all. In 2007–2008—a "normal" year for the world economy, the net financial benefit to the United States was between about $40 billion and $70 billion—or 0.3 to 0.5 percent of US GDP. In a "crisis" year—such as the year to June 2009—we estimate that the net financial benefit fell to between—$5 billion and $25 billion because the dollar appreciated by an additional 10 percent due its status as a "safe haven."
Our research finds that reserve currency status has two benefits. The first benefit is seigniorage revenue—the effective interest-free loan generated by issuing additional currency to nonresidents that hold US notes and coins—that generates an estimated $10 billion. The second benefit is that the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies. We estimate that these purchases have reduced the US borrowing rate by 50 to 60 basis points in recent years, generating a financial benefit of $90 billion. The major cost is that the dollar exchange rate is an estimated 5 to 10 percent higher than it would otherwise be because the reserve currency is a magnet to the world's official reserves and liquid assets. This harms the competitiveness of US exporting companies and companies that compete with imports, imposing a net cost of an estimated $30 billion to $60 billion.
This raises an interesting question. Mindful of the only modest benefits of reserve currency status, will the United States continue to prioritize its domestic growth and jobs agenda over its implicit responsibility to maintain global financial stability, causing greater volatility that threatens the competitiveness of economies and corporations? Our analysis suggest that the US may not be inclined to tighten its fiscal and monetary policy to safeguard its dominant reserve currency position, even if it perceives that status to be at genuine risk.
And yet we find that there is no realistic prospect of a near-term successor to the dollar. Although the euro is already a secondary reserve currency, we find that the eurozone has little incentive to push for the euro to become a more prominent reserve currency over the next decade. The small benefit to the eurozone of slightly cheaper borrowing and the cost of an elevated exchange rate today broadly cancel each other. But if the euro came to equal the standing of the dollar as a reserve currency by 2020—an accelerated path from today’s trajectory—there would be a net cost of 0.1 percent of eurozone GDP. The renminbi may be a contender in the longer term—but today currency is not even fully convertible.
This analysis suggests that it is likely that we will continue to see an unmanaged reserve currency system in which both the United States and the eurozone prioritize their respective domestic economic agendas over supporting the global system. Given the pressures on the exchange rate system, and the scale of capital flows, this could pose significant risks to the stability of global currency markets and represent a threat to the competitiveness of economies and corporations.
A December 2009 our global survey of executives found that both the level of exchange rates and exchange rate volatility have a large, and growing, negative effect on profits and investment decision making. Some 21 percent of respondents report that exchange rate uncertainty has reduced their planned investment over the next two years. And 29 percent of respondents report that exchange rates have an "extremely" or "very" significant effect on company profits.
Companies may argue that grand schemes about global financial architecture are the preserve of politicians and none of their business. But exchange rates that are substantially out of line with economic fundamentals coupled with currency volatility will generate real economic costs. Whether the world resolves the reserve currency issue or not is therefore very much the business of businesses.