U.S. Federal Reserve Board Chairman Ben BernankeKAREN BLEIER
Even Ben Bernanke acknowledges that the United States doesn't have an unalienable right to be the custodian of the world's reserve currency.
The U.S. Federal Reserve chief reassured members of Congress Thursday that the dollar's status isn't in immediate danger, but he warned that the situation could change if the country doesn't carefully manage its economic affairs, including reining in its $1.6-trillion (U.S.) deficit.
"If we don't get our macroeconomic house in order, that will put the dollar in danger, and … the most critical element there is long-term fiscal stability," Mr. Bernanke told the House of Representatives banking committee.
Holding the world's reserve currency means that the Fed essentially conducts monetary policy for everyone else. This puts tremendous power in the hands of the Fed, whose only official mandate is to keep U.S. growth and prices in balance. The catch is that the right economic policies for the United States may not be appropriate for other parts of the world.
There has been much debate of late on the use of the greenback as a reserve currency given the financial crisis and the weakness in the dollar and America's fiscal deterioration.
China, the world's largest holder of reserves with roughly $2-trillion worth, as well as Russia have made noises this year about shifting away from the dollar. Earlier this year, Chinese Premier Wen Jiabao suggested replacing the dollar with a basket of currencies overseen by the International Monetary Fund (IMF).
Mr. Bernanke was drawn into a debate stoked this week by World Bank president Robert Zoellick, who warned that there "will increasingly be other options to the dollar." Mr. Zoellick, a former top Bush administration official, said the rapid ascent of China and India is reshaping the global economic order "before our eyes," and so the United States shouldn't take its currency's status for granted.
The comments come amid fresh evidence that the dollar's perch is slipping.
Figures released this week by the IMF show that the greenback's share of global reserves fell to its lowest level since 1995 in the second quarter - to 62.8 per cent. That's down from 65 per cent in the first quarter.
But experts said the figures don't necessarily mean the world's central bankers are consciously dumping dollars. The value of the dollar has weakened substantially this year against most other currencies - including the yen, euro and the loonie - and that automatically boosts the value of reserves held in other currencies.
"A large portion of the recent shift in the dollar's share of global reserves can be explained by the weakening U.S. dollar, rather than by changes in the behaviour of reserve managers," explained Capital Economic analyst James Lord.
A reserve currency refers to the monetary unit that central banks and major financial institutions hold to pay off their foreign debts.
Meanwhile, a top IMF official suggested yesterday that Asian countries may need to let their currencies float higher against the dollar to sustain the global recovery. IMF chief economist Olivier Blanchard urged China and other Asian countries to adopt more flexible exchange rates - something they have been loath to do in the past because their exporters benefit from currencies that are weak compared with the U.S. dollar and the euro.
Referring to the "rebalancing" that's needed in the world economy, Mr. Blanchard said it is "hard to see how this could happen with current exchange rates." He took his point a step further, adding that it is "hard to see how this could happen without appreciation of Asian exchange rates."
So far, there's little evidence Chinese authorities have backed up their threats to move away from the U.S. dollar with actions. Indeed, China increased its holding of U.S. Treasuries between the first and second quarter of this year.
Longer term, Mr. Lord said central banks and other financial institutions are likely to diversify away from the dollar. But it's not yet having much of an impact on the status of the dollar.
Menzie Chinn, an economics professor at the University of Wisconsin, said the United States would have to adopt "calamitously bad policies" to see it cede its reserve status to the euro, yen, yuan or the IMF's special drawing rights (or SDRs).
As Mr. Bernanke suggested, rapid currency depreciation or high inflation would do the trick, Prof. Chinn said.
But in the current environment, he said there's "no greater reason to believe that the conditions are in place for a drastic reversal of fortune."
As Messrs. Bernanke and Zoellick warned, expansionary fiscal policy can undermine what the Fed is trying to do, sideswiping the dollar in the process.
A rising U.S. budget deficit, for example, would force the government to pay higher yields on Treasuries, which in turn would undermine the Fed's efforts to keep mortgage rates low and spur economic activity at home. On the other hand, if Treasury rates didn't rise, the dollar would likely fall, driving commodity prices higher, economists said.
Also yesterday, Mr. Bernanke appeared to soften his stance on whether the Fed should have broad powers to monitor systemic risks to the U.S. financial system. He told the House committee that the Fed should share that role with a proposed council of financial regulators. The Fed chairman said this position is not new. But some lawmakers suggested that less power in the hands of the Fed could help smooth passage of a financial reform package.