Supremacy of the US Dollar

Supremacy of the US Dollar ABSTRACT This assignment briefly discusses the supremacy of US Dollar. It includes suggestions and recommendations to its near future position, internationally. The proponents of the assignment are divided into the history of the US Dollar and its role as the dominating currency in the world. Ever since other currencies began to take part actively in the foreign exchange markets, they began to challenge the role of US Dollar. Arguments were put forward that the US Dollar would have to compete with the various emerging currencies to maintain its position as the most influential money dominator. The paper intends to discuss the currency contenders, which are the Euro, Japanese Yen Chinese Renminbi and the Russian Rouble and why are they the nearest competitors to challenge the US Dollar. Chapter 1 HISTORY The United States emerged from World War II not only as military victor but as an economic victor as well. It was by far the strongest economic power in the world. Under the Dollar standard, the Dollar standard, agreed to make the Dollar â€Å" as good as gold† redeemable on demand by any central bank at the rate of $35 an ounce in 1933. This meant that the dollar became the accepted medium of exchange for international transactions. This seemingly routine event was to have far reaching implications for the international financial system, certainly beyond what anyone would have imagined. According to James Grant the US dollar is the greatest monetary achievement in the history of the world. In year 1792 the first US dollar issued by the United States Mint which same in size and composition to the Spanish dollar. The US dollar was created and defined by the Coinage Act of 1972. The Coinage Act 1792 set the value of at 10 dollars, and the dollar at 1/10th eagle. It also called for 90% silver alloy coins in denominations of 1,  ½,  ¼, and 1/10. The timeline of US dollar currency will be discussed which as follows: I. Colonial Bills 1690 The Massachusetts Bay Colony, one of the Thirteen Original Colonies, issued the first paper money to cover costs of military expeditions. The practice of issuing paper bills spread to the other Colonies. II. Franklins Unique Counterfeit Deterrent 1739 Benjamin Franklins printing firm in Philadelphia printed colonial bills with nature printsunique raised impressions of patterns cast from actual leaves. This process added an innovative and effective counterfeit deterrent to bills, not completely understood until centuries later. III. British Ban 1764 Following years of restrictions on colonial paper currency, Britain finally ordered a complete ban on the issuance of paper money by the Colonies. IV. Continental Currency 1775 The Continental Congress issued paper currency to finance the Revolutionary War. Continental currency was denominated in Spanish milled dollars. Without solid backing and easily counterfeited, the bills quickly lost their value, giving rise to the phrase not worth a Continental. V. The Bank of North America 1781 Congress chartered the Bank of North America in Philadelphia as the first national bank, creating it to support the financial operations of the fledgling government. VI. The Dollar 1785 Congress adopted the dollar as the money unit of the United States. VII. First Central Bank 1791 Congress chartered the Bank of the United States for a 20-year period to serve as the U.S. Treasurys fiscal agent. The bank was the first to perform central bank functions for the government and operated until 1811, when Congress declined to renew the banks charter. Recognizing that a central banking system was still necessary to meet the nations financial needs, Congress chartered a second Bank of the United States in 1816 for another 20-year period. VIII. Monetary System 1792 The Coinage Act of 1792 created the U.S. Mint and established a federal monetary system, set denominations for coins, and specified the value of each coin in gold, silver, or copper. IX. Greenbacks 1861 The first general circulation of paper money by the federal government occurred in 1861.Pressed to finance the Civil War, Congress authorized the U.S. Treasury to issue non-interest-bearing Demand Bills. These bills acquired the nickname greenback because of their color. Today all U.S currency issued since 1861 remains valid and redeemable at full face value. X. First $10 Bills 1861 The first $10 bills were Demand Bills, issued in 1861 by the Treasury Department. A portrait of President Abraham Lincoln appeared on the face of the bills. XI. The Design 1862 By 1862, the design of U.S. currency incorporated fine-line engraving, intricate geometric lathe work patterns, a Treasury seal, and engraved signatures to aid in counterfeit deterrence. Since that time, the U.S. Treasury has continued to add features to thwart counterfeiting. XII. National Banking System 1863 Congress established a national banking system and authorized the U.S. Treasury to oversee the issuance of National Banknotes. This system established Federal guidelines for chartering and regulating national banks and authorized those banks to issue national currency secured by the purchase of United States bonds. XIII. Secret Service 1865 The United States Secret Service was established as a bureau of the Treasury for the purpose of controlling the counterfeiters whose activities were destroying the publics confidence in the nations currency. XIV. Bureau of Engraving and Printing 1877 The Department of the Treasurys Bureau of Engraving and Printing began printing all United States currency. XV. Paper Currency with Background Color 1905 The last United States paper money printed with background color was the $20 Gold Certificate, Series 1905, which had a golden tint and a red seal and serial number. XVI. Federal Reserve Act 1913 The Federal Reserve Act of 1913 created the Federal Reserve as the nations central bank and provided for a national banking system that was more responsive to the fluctuating financial needs of the country. The Federal Reserve Board issued new currency called Federal Reserve Notes. XVII. The first $10 Federal Reserve Notes 1914 The first $10 Federal Reserve notes were issued. These bills were larger than todays bills and featured a portrait of President Andrew Jackson on the face. XVIII. Standardized Design 1929 The first sweeping change to affect the appearance of all paper money occurred in 1929. In an effort to lower manufacturing costs, all currency was reduced in size by about 30 percent. In addition, standardized designs were instituted for each denomination across all classes of currency, decreasing the number of different designs in circulation. This standardization made it easier for the public to distinguish between genuine and counterfeit bills. XIX. In God We Trust 1957 The use of the National Motto In God We Trust on all currency has been required by law since 1955. It first appeared on paper money with the issuance of the $1 Silver Certificates, Series 1957, and began appearing on Federal Reserve Notes with the 1963 Series. Chapter 2 Characteristic of US Dollar Currency Introduction The U.S. dollar is the currency most used in international transactions. It is also used as the standard unit of currency in international markets for commodities such as gold and petroleum. There are also some Non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in dollars cause of the international acceptance and the value of the dollar. At the present time, the U.S dollar remains the worlds foremost reserve currency. In addition to holdings by central banks and other institutions there are many private holdings which are believed to be mostly in $100 denominations. The majority of U.S. notes are actually held outside the United States. All holdings of US dollar bank deposits held by non-residents of the US are known as Eurodollars (not to be confused with the euro) regardless of the location of the bank holding the deposit (which may be inside or outside the US). Economist opinion said that demand for dollars allows the United States to maintain pers istent trade deficits without causing the value of the currency to depreciate and the flow of trade to readjust. Strong arguments do exist for why the dollar remains strong and still remain for world currency. There are (at least) three sources of demand for dollars that exert an exogenous force on normal balance of trade dynamics: * A demand for dollar liquidity for transaction needs; * A foreign desire for asset security found in the dollars role as a reserve currency; and * Developing country attempts to accelerate economic growth through an export dominated economy. To date all three factors have increased the incentive for foreigners to collect dollars (by selling goods and services in exchange for dollars) and decreased the incentive to dishoard dollars (by buying goods and services with the dollars). If these dynamics were to reverse, they would exert pressure to devalue the dollar above and beyond pressures exerted by the balance of trade dynamics. Before discuss further about the characteristics of US Dollar that makes it the worlds foremost reserve currency, a better understanding regarding the basic function of money is crucial. The main basic functions of money are: a) Medium of exchange When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the double coincidence of wants problem. b) Unit of account A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a measure or standard of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. c) Store of value To act as a store of value, money must be able to be reliably saved, stored, and retrieved. The value of the money must also remain stable over time. In that sense, inflation by reducing the value of money diminishes the ability of the money to function as a store of value. d) Standard of deferred payment Standard of deferred payment is distinguished as an accepted way to settle a debt a unit in which debts are denominated, and the status of money as legal tender, in those jurisdictions which have this concept, states that it may function for the discharge of debts. When debts are denominated in money, the real value of debts may change due to inflation and deflation, and for sovereign and international debts via debasement and devaluation. Based on the explanation above, there are some main characteristic of the currency shall have to be the main player. In this paper, we will discuss from the various aspects. a) Currency and asset substitution Currency and asset substitution are typically induced by past inflations, devaluations, currency confiscations and the growth of underground economies. The effective money supply is much larger than the domestic money supply and is, moreover, less easily controlled by the monetary authority because of the publics propensity to substitute foreign for domestic currency. To peg the exchange rate to the US dollar, authorities have to intervene and purchase foreign exchange, hence the accumulation of holdings of US foreign exchange reserves, US currency has many desirable properties. It has a reputation as a stable currency, and is therefore a reliable store of value. It is available in many countries, is widely accepted as a medium of exchange, and protects foreign users against the threat of domestic bank failures, devaluation and inflation. Cash usage preserves anonymity because it leaves no paper trail of the transaction for which it serves as the means of payment and is therefore the preferred medium of exchange in underground transactions. Indeed the very characteristics that make the US dollar a popular medium of exchange also makes it difficult to determine the exact amount and location of US notes circulating abroad. Nevertheless, there is a direct source of information that can be used to determine the approximate amounts of US cash in circulation in different countries. Currency substitution also has fiscal consequences that are particularly salient for transition countries. Foreign cash transactions reduce the costs of tax evasion and facilitate participation in the unreported or â€Å"underground† economy. This weakens the governments ability to command real resources from the private sector and deepens fiscal deficits. The shifting of economic activity toward the underground economy distorts macroeconomic information systems (Feige, 1990, 1997), thereby adding to the difficulty of formulating macroeconomic policy. b) International Reserve Currency Furthermore, another characteristic of US dollar as world currency is because of the international reserve currency. Over the past three decades, academic and financial analysis that argued the US would suffer dollar devaluation due to national consumption exceeding national production has been largely wrong. That such an intuitive argument has been so consistently wrong is the source of much frustration and consternation. What has become clear is that when discussing exchange rates and determinants of exchange rates, there is a necessary delineation between the dollar and the rest of the world currencies. Because the dollar is the world reserve currency, special dynamics exist for it in addition to the normal trade and monetary dynamics one would expect. The euro inherited this status from the German mark, and since its introduction, has increased its standing considerably, mostly at the expense of the dollar. Despite the dollars recent losses to the Euro, it is still by far the major international reserve currency; with an accumulation more than double that of the euro. In August 2007, two scholars affiliated with the government of the Peoples Republic of China threatened to sell its substantial reserves in American dollars in response to American legislative discussion of trade sanctions designed to revalue the Chinese yuan. The Chinese government denied that selling dollar-denominated assets would be an official policy in the foreseeable future. c) Usage of the US Dollar Other characteristic of US Dollar as a main currency is when there are a few nations besides the United States use the US Dollar as their official currency. For example, Ecuador, El Salvador and East Timor all adopted the currency independently; former members of the US-administered Trust Territory of the Pacific Islands (namely Palau, the Federated States of Micronesia and the Marshall Islands) decided that, despite their independence, they wanted to keep the U.S. dollar as their official currency. Additionally, local currencies of several states such as Bermuda, the Bahamas, Panama and a few other states can be freely exchanged at a 1:1 ratio for the U.S. dollar. d) Secure the Safety Trade As the so-called â€Å"safety trade† turn into dollars that occurred in the second half of 2008, made ironic event in two ways. The dollar represents security to foreign entities is partly due to historical good behaviour and partly due to wishful thinking on the part of foreign entities. Certainly through 1960, the US had a virtually unblemished record in paying its debts and honouring its obligations. This historical precedent combined with geopolitical considerations and force of habit has created the foreign perception that exists to this day that the US dollar is â€Å"as good as gold.† Thus, historically when a country suffered from a balance of payment crisis, the most common alternative to the home currency was the dollar. The list of countries whose private citizens hoard dollars as an alternative to the home currency is long. The reason for this hoarding is fairly easy to understand. If a country pegs its currency to the dollar and the peg is kept too high, citizens of the country will consume more than they produce and the country will run a current account deficit. Mirroring this current account deficit, a country will run a financial account surplus which decreases its supply of dollars. As the supply of dollars approaches a critical point, citizens will speculate that the peg cannot be maintained and will â€Å"make a run† on the currency, trading all of their domestic currency for dollars in anticipation of the devaluation. This is referred to as a balance of payments crisis, and results in a devaluation of the national currency. Examples of recent balance of payment crises include the Argentine economic crisis (2001-2002) and the Asian financial crisis (1997). Citizens in countries who have suffered balance of payment crises will often hold a portion or even a majority of their wealth in dollars in anticipation of currency devaluation. As an additional demand, it is commonly considered good practice for a developing country to carry reserves in excess of what is necessary for transactions as a preventative measure against balance of payments crises. Thus, there is actually an incentive to peg a currency too low, as a method for accumulating a protective supply of dollars to prevent balance of payment crises. e) Exchange Rate Dynamics While all other countries have two primary mechanisms that determine their exchange rate, the US dollar has five. The two mechanisms present for all currencies are: the relative supply of the currency (determined by the central bank); and the terms and attractiveness to foreigners of domestically produced goods and services. All else equal, the greater the supply of currency the higher the exchange rate (depreciated), and the more attractive the terms of domestically produced goods the lower the exchange rate (appreciated). Both of these mechanisms are reflected in the current account: if a country devalues its currency through an increase in money supply, it will have higher interest payments on foreign denominated assets. In this circumstance, a net debtor will generally see a deterioration in the current account, and a net creditor will see an improvement. If a country increases the attractiveness of terms on its production to foreigners, it will improve the current account. f) US Role As Most Develop Country In The World Financial and currency news are not just the only stories of news but interests to all. As for example, Foreign exchange (Forex) traders also have a lot of interest in political news that may have an impact on different countries currencies. Political events, such as the U.S. presidential election cycle has substantial consequences on the valuation of currency. The essence of money is purchasing power and power is at the heart of politics. Power goes to those who create money, those who receive it, those who spend it, and most of all, those who control it. Money, in other words, is anything but neutral. Money can be controlled or governed in very different ways; these systems of governance are described as monetary regimes. Chapter 3 BENCHMARKING THE US DOLLAR In order to understand the current international monetary system and its problems, one must realize that, for practical purposes, all international financial transactions are inextricably linked to the US Dollar. As the dollar goes, so goes the international financial system. Recently, as been mentioned earlier, the US Dollar remains the worlds foremost reserve currency. The US Dollar has been referred as the standard unit of currency in international markets for commodities such as gold and oil. Some non-U.S. companies dealing in globalized markets, such as Airbus, list their prices in US dollars. US Dollar has a value based on supply and demand of the market. As demand of US Dollar increase and more people willing to pay more to buy the US Dollar, then US Dollar will increase the value. We can also know the performance/value of US Dollar by using the benchmark in US Dollar. Benchmarking of the US Dollar means that we measure or evaluate the performance/value of US Dollar with another similar item in an impartial scientific manner. The US Dollar Index (US Dollar X) is type of index used as a benchmark in US Dollar. US Dollar Index is an index (or measure) of the value of the United States Dollar relative to a basket of foreign currencies. It is a weighted geometric mean of the dollars value compared only with Euro (EUR), 57.6% weight Japanese yen (JPY), 13.6% weight Pound sterling (GBP), 11.9% weight Canadian dollar (CAD), 9.1% weight Swedish krona (SEK), 4.2% weight and Swiss franc (CHF), 3.6% weight. (Source: Wikipedia) Like declining real estate or stock prices, the diminishing dollar is neither uniformly beneficial nor harmful. In an article written by Karen (2008), the author provided an example of Accor North America, Inc., a division of Paris-based Accor, a global hotel operator. She added that when the company needs extra funds, perhaps to make an acquisition, the declining dollar comes in handy. Taking advantage of the dollar devaluation means that its cheaper to borrow from our parent than a bank, says Stephen Manthey, senior vice president and treasurer with the Carrollton, Texas-based firm. This is because the parent companys Euros now are more valuable than they were a year or two ago (Karen, 2008). Animesh Ghoshal, a Professor of Economics at DePaul University, Chicago, once mentioned that exporters typically do well when their currency drops, as their products become more competitive outside their home markets. Conversely, importers take a hit, as the costs of their goods or materials rise. Karen (2008) also quoted a statement from Dean Baker, a co-director of the Center for Economic and Policy Reseach, an independent research group in Washington, D.C. Dean mentioned that people think of a strong dollar like a strong body, but, theres no particular virtue in having a strong dollar. In November 2007, prices for imports from the European Union rose for the seventh consecutive month, increasing 0.2 percent, while prices for goods coming from Canada jumped 4.7 percent. For the year ending in November, the prices of imports from Canada were up 12.9 percent, while imports from the EU were up 3.3 percent. The rises can be attributed to higher fuel prices and the declining dollar, rep orts the Bureau of Labor Statistics. From 4 below, we can see that the US Dollars relative strength compared to Euro had been declining over the 2007. The declining US Dollar may bring more harm than benefits to the US importers. Chapter 4 Factors Affecting US Dollar Currency a) Trade Deficit A trade deficit occurs when a country imports more than the exports. This leads to a net outflow of a countrys currency. Countries on the other side of the transaction will typically sell the importing countrys currency on the open market. As supply of the countrys currency increases in the global market the currency depreciates. As a net importer, the US has seen its trade deficit grow rapidly over the last decade. In last year (2008), the United States had a record of trade deficit of $816 billion dollars. This trade deficit weakens the US dollar relative to other currencies since foreign goods are denominated in foreign currency. Thus raising of demand for foreign goods increases the demand for foreign currency and decreases the demand for US dollars. This causes the US dollar to depreciate. b) Budget Deficit Chart below show that US Public debt has grown substantially over time. When a countrys government spends more than it earns from taxes or other sources of revenues, it is forced to borrow from its citizens and/or from foreign entities. As a countrys debt load increases, the value of its currency may decrease as result of fears within the international community over its ability to repay the debt. In addition, by borrowing money from foreign countries, the US increases the demand for foreign currency in exchange for US Bonds. The US is the worlds largest debtor with approximately $12 trillion dollars in debt in total debt. Over half of this debt is owned by foreign countries and lenders. (Source: Wikipedia) c) China, Japan, and India may stop holding large US Dollar Reserves Japan ($349B) and China ($643B) are two of the largest purchasers of US debt. China in particular has exhibited a voracious appetite for US debt. Its rapidly growing economy is heavily dependent on exports, and the US is one of its largest trading partners. In any given year, the US imports much more from China than it exports to China. As a result there is a net flow of dollars to China. Normally, one might expect China to sell these dollars on the global market, causing the dollar to weaken. Instead China reinvests its dollars in US debt. In doing so, China strengthens the US dollar and limits the appreciation of its own currency. Chinese exports remain cheap to American consumers. However, due to large deficits many countries, China and India in particular, have begun to reconsider diversifying their reserves to protect themselves from a devaluation of the US Dollar. In November 2009, the Indian Central Bank announced that it would purchase $6.7B worth of Gold to diversify its reserves. China, which is the single largest purchaser of US Securities, has similarly increased its reserves of gold by 76% since 2003 and has hinted at further purchases. The decision of these large countries to shift increasingly towards Gold as a reserve currency greatly decreases the demand for US Dollars and weakens the US Dollar. d) Monetary Policy Inflation Demand for a countrys currency is highly dependent on the relative value of holding it, ie. the real, relative return of U.S. government bonds. Fear over higher inflation erodes the real value of bonds, which in turn decreases demand for US dollars. Similarly, tighter monetary policy raises the real interest rate on U.S. Gov. bonds, at which demand for US dollars increases until the relative, risk adjusted return on those bonds is equivalent to the return on bonds for another country. e) The Federal Reserve Rate The Federal Open Market Committee, comprising of the Chairman, Vice Chairman, and three other members, along with the chiefs of the regional branches of the Federal Reserve System, come together regularly to determine the Federal Funds Rate, which is the rate at which financial institutions with deposits at the Federal Reserve lend to each other. The release of the decision is usually accompanied by much media fanfare, analysis and commentary, and with good reason. Lending at the federal funds rate is the normal channel for banks with financing needs, and it represents the wholesale market for large financial institutions. The Federal Reserve Rate also determines the Dollar Libor rate which is the basis of many different types of financial transactions from complex derivative contracts, to credit card and mortgage interest rates. Libor is the cost of short-term unsecured interbank lending (where theres no collateral exchanged between counterparties). As such, it is one of the building blocks of the modern financial system. Although most transaction in the unsecured market are limited to a single month at most, the benchmarks themselves are regularly quoted and taken as a basis for contracts and agreements. f) Equity Market The equity market can impact the currency market in many different ways. For example, if a strong stock market rally happens in the U.S., with the Dow Jone and the Nasdaq registering impressive gains, we are likely to see a large influx of foreign money into the U.S., as international investors rush in to join the party. This influx of money would be very positive for the US DOLLAR, because in order to participate in the equity market rally, foreign investors would have to sell their own domestic currency and purchase U.S. dollars. The opposite also holds true: if the stock market in the U.S. is doing poorly, foreign investors will most likely rush to sell their U.S. Equity holdings and then reconvert the U.S. dollars into their domestic currency which would have a substantially negative impact on the greenback. Chapter 5 The impact of US Dollar a) Dollar Hegemony (Domination of the Dollar) The Bretton Woods negotiations at the end of the Second World War paved the way for establishing the dominance of the dollar as international money. This role was sustained by the confidence that the United States with its vast reserves of gold would honor the commitment to provide gold to foreign central banks in exchange for dollars at a fixed rate of $35 per ounce. By the end of the sixties, the growing trade deficit and the burdens of its military interventions in Vietnam created a huge dollar overhang abroad. In the face of increased demands for gold in exchange for dollars the United States unilaterally abandoned gold convertibility. This, however, did not lead to the dismantling of dollar hegemony. Instead, the refashioning of the international monetary system into a â€Å"floating dollar standard† in the post-Bretton Woods period was associated with the aggressive pursuit of liberalized financial markets in order to encourage private international capital flows denomin ated in dollars. In the 1970s the Eurodollar markets served as the principal means of recycling oil surpluses from the oil exporters to developing economies, particularly in Latin America. This process became a tool of resurgent U.S. political dominance. The 1970s military dictatorships in Chile, Indonesia, and Argentina, and the â€Å"Chicago School† free market regimes that followed, were bolstered by repression and supported by the readily available loans from U.S. banks flush with oil funds. Once this cheap bonanza of credit came to an end with the debt crisis in 1982, a new wave of neoliberal reforms and financial liberalization was imposed through the IMF-World Bank rescue packages. The crisis was deployed to further entrench the dominance of the dollar and U.S. imperialist agenda. In country after country the IMF and World Bank imposed â€Å"structural adjustment† policies during the crisis phase that destroyed all attempts at independent economic development while engulfing thei r financial systems in the ambit of dollar hegemony. This set in motion another surge of dollar denominated private capital flows to emerging markets and a fresh round of crisis in the 1990s when capital flowed back to the United States From 1973, up until about 2003 (the run-up to the present crisis) the periods when flows to emerging markets surged were also periods with a net efflux from the United States. As the surge comes to an end in the wake of capital flight and crisis, as in the Latin American debt crisis in 1982-83 and the Asian crisis in 1997-98, private capital flows are sucked back into the United States (see chart 2). The privileged role of the dollar provided the United States with an international line of credit that helped fuel a consumption binge. Cheap imports allowed consumption to be sustained despite stagnant or declining real wages. The export-led economies of Asia (first Japan, later East Asia and China) in turn depended on mass consumption in the United States to drive their economies. But the dependence on cheap imports precipitated growing trade de