
The end of Bush administration,ever-increasing recession in the US and a downward trend in world financial markets have become the subjects of an ongoing political debate.The US dollar with its sustained weakness in the backdrop of serious US credit crisis is at the risk of losing the status as the world's prime reserve currency.the long term questions arising out of this situation has opened up new vistas leading towards a global monetary system.
Since the abolition of convertibility of gold in 1971 under president Riched Nixon the supremacy of the US currency was maintained based on the trust of international economic agents places in the growth prospects of the US economy and the strength of the US Federal Reserve to hold the price stability.
The situation has changed now.Certain exercises manifestly carried out by the FED to maintain an artificial boom has today come to a model doomed to extinction.For capitalism to survive there has to be a large consumer group.US adopted a policy of becoming the "consumer of last resort"designed to maintain the status of the US dollar.
The Asian Financial crisis of 1997-98 made the victim countries to sell off a significant percentage of their foreign exchange reserves and were finally forced to abandon their fixed exchange rate to the dollar,and to adopt strongly export-led growth models targeted towards accumulation of foreign-exchange reserves in a context of fixed and undervalued national currencies.The global monetary arrangement implicitly provided for the US to buy consumer goods manufactured in East Asia ostensibly supporting the development of production there,prompting the countries in turn to "recycle" the export surpluses in US government Bonds,ultimately financing US consumption.
The system works like this;-Central naks of other countries purchase US government bonds,the foreign demand for US bonds helps to keep the US interest rates at low levels resulting in the increase of business profits and equity including property values leading to a confidence build up and a tendency to consumer in the US.With the rising oil prices since 2002 the oil producing countries became parties to this global deal by investing their foreign exchange earning in the US securities market.It is interesting to note how China and other emerging markets have built up huge current account surpluses and invested their foreign exchange earning in the US securities market.China alone has accounted for a sevenfold growth between 2002 and 2006,to a level of US $250 billion.During the same period US current account deficit swelled from US$459 billion to US$811 billion(6.2% of US GDP for 2006).
The effect of this on the dollar value worsened due to fiscal expansion measures pursued by the Bush administration,pushing the public budget into deep red causing the US$ to spiral downwards losing over 50% of it's value against the euro.This trend has since accelerated leading to several critical situation in 2007.The Federal Reserve is faces with a dilemma pressed with a need to work for both price stability and full employment and has opted to stimulate the economy and project jobs.The FED is also faced with the problem of the downward trend in domestic business activity and a decline in the external value of the US currency.All these factors indicate that the confidence foreign investors and central banks have hand for many years in the ability of US to link economic growth with price stability is fast eroding.
This is reflected in the moves recently pursued by world's central banks. Eg:a number of countries in recent years have diverted substantial amounts of their foreign exchange trade surpluses into sovereign wealth funds(SWFs).There are some inherent advantageous in this method of reserves in that they earn higher returns(on account of their riskier investment strategies)and they are note subject to the same multilateral reporting requirements in effects for official currency reserves.Another deviation is that many countries are resorting to maintain a high percentage of there reserves in currencies.this is because states are required to report regularly to the IMF on the level of their total reserves,but not on the latter's currency composition which many countries treat as a state secret.
On account of these two large unknowns(investments in SWFs and currency composition of reserves)and on the basis of a declining US$ exchange rate,the world is likely to experience a reshuffle of official funds.The percentage of currency reserves held in US$,however,is still over 69 percent of the reserves with known composition.Hence the world has a collective interest in supporting the US$.But individually most countries are diversifying their own reserves as a measure of safety before the dollar falls any further.This may run to a risk of a sudden downward spiral.The East Asian countries which have opted to export driven growth models,need US as a consumer in this framework,therefore have a special interest in supporting the dollars external purchasing power.The oil producing countries have a much lesser interest in supporting the US role as a consumer of last resort.
These facts indicate that the US$ is in for a sudden fall.Such a situation will alarm for a shift in the current global monetary system.The possible tendencies under this scenario are as follows:
- The possibility of the Fed talking steps in conjunction with US federal budget to redress the US current account deficit,bringing a return of the confidence of the international investors.In such a situation Asian central banks would likely come to the conclusion that the US will be able and will continue to pay the role of the consumer of the last resort and consequently seek to extend the relationship.
- Euro to emerge as the new world currency.Today the world has an alternative currency,one with comparable liquidity in bond and foreign exchange markets,the euro. Earlier US$ survived with out losing its position as a reserve medium due to the non availability of a feasible alternative.In 2007 the European economy out performed the US economy and now there is scope for the European monetary Union for further enlargement. A comparison of the sizes of the two economies between US and the eurozone,we find that in the coming years the balance is likely to tip in favor of the latter.For the first time in post war history.There is another currency area large enough currency area large enough to stand a realistic chance of supplanting the US dollar as the world's key reserve currency.
- The order option available to the world is monetary regionalisation.Like the European union concept there is a possibility of countries of other regions to join forces to create free-trade area and currency zones,engaging in regional external economic policy.This phenomenon is already visible in Asia,Latin America and also in Gulf States.
Many countries have until now sought,on their own mostly,currency stability in relation to the US$,depending on the US' position as an important worldwide trading partner.If a recession weakness the US position for imports,other countries will be compelled to re-consider their continuation to gear their currency stability policy to the US.In this context Europe is in a very advantageous position to leverage its emerging new role to push for a multilateral institutionalization of the global monetary order.