Currency’s future

By Eswar Prasad

Is the US dollar in decline? Since the global financial crisis, speculation has been rampant about its looming, if not imminent, displacement as the world’s leading currency. The logic is compelling: the US faces high public debt, risks created by the Fed’s aggressive use of unconventional monetary policies and political dysfunction — factors that might set off an economic decline, eroding the dollar’s importance.

Yet, a case can be made that the financial crisis has actually strengthened the dollar’s position as the predominant store of value. True, its role as a medium of exchange may shrink over time… But financial assets denominated in dollars, especially US government securities, are still the preferred destination for investors interested in safeguarding their investments…

By raising the demand for safe assets even as the supply of them shrank in the rest of the world, the financial crisis left US as the main provider.

So, emerging economies have astronger incentive to accumulate foreign exchange reserves as insulation against the consequences of volatile capital flows. Financial regulatory reforms have added to the demand, because banks need a larger supply of liquid assets.

The prospects for US currency look even better when a stark question is posed: if not the dollar, then what? The government bonds of many other major economies, such as the eurozone, Japan and the UK, look shakier in the aftermath of the financial crisis.

From “The Dollar Trap”