Articles,  Dollarization of International Finance

Dollarization of International Finance

By  Praveen Sharma

Introduction

Dollarization is when, alongside or in lieu of its domestic currency, a nation starts to accept the US dollar as a medium of exchange or legal tender. It is the term for when the U.S. dollar is used in addition to or instead of the domestic currency of another country. In developed nations with a weak central monetary authority or an uncertain economic climate, dollarization typically occurs. It can happen as an official monetary policy or as a process of the de facto market. The primary reason for dollarization is to reap the benefits of greater currency value stability over the domestic currency of a nation. The dollarizing country effectively outsources their monetary policy to the U.S. Federal Reserve. To the degree that US monetary policy is set in the interest of the U.S. economy and not the interests of dollarized countries, this may be a negative factor. Dollarization could prove to be useful if it helps to take advantage of a monetary policy economy of scale that enables the dollarizing country to save on capital that would have to be committed to supplying and maintaining its own supply of currency. The US dollar is used as the basic unit of currency in foreign markets for goods such as gold and petroleum, in addition to being the primary currency of the United States. Many non-U.S. multinational companies who deal in globalized markets, such as Airbus, list their prices in dollars. The U.S. dollar is, together with the euro, a significant international reserve currency. The euro obtained this status from the German mark and has improved its standing substantially since its launch, often at the expense of the dollar. Given the recent losses of the dollar to the euro, it is still by far the major foreign reserve currency, with more than double the accumulation of the euro. The US dollar rules over the foreign exchange market and around 90% of the forex trading is done in US dollar. With the financial crisis, the dollar has become much more widely used. The banks of Germany, France, and Great Britain kept more dollar-denominated liabilities in 2018 than in their own currencies. In addition, dollars have been made scarce by bank legislation imposed to avoid another recession, and the Federal Reserve has raised the rate of fed funds. By making dollars more costly to borrow, that decreases the money supply. The resilience of the dollar is why governments are able to keep the dollar in their reserves for foreign exchange, Through their financial transactions, governments obtain currencies. They are also received by domestic companies and travelers who redeem them in local currencies.

Bretton Woods Agreement& It’s Collapse

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus, the name “Bretton Woods Agreement. Gold was the basis for the U.S. dollar under the Bretton Woods Model, and other currencies were pegged to the value of the U.S. dollar. In the early 1970s, when President Richard M. Nixon declared that the U.S. would no longer trade gold for US currency, the Bretton Woods Scheme essentially came to an end.In July 1944, approximately 730 delegates from 44 countries met in Bretton Woods with the key objectives of developing an effective foreign exchange mechanism, preventing competitive currency devaluations and fostering international economic development.These priorities were central to the Bretton Woods Agreement and Framework. Two significant organizations, the International Monetary Fund (IMF) and the World Bank, were both established under the Bretton Woods Agreement. While the Bretton Woods system was dissolved in the 1970s, the IMF and the World Bank have remained strong pillars of foreign currency exchange.The Bretton Woods System’s main architects were the prominent British economist John Maynard Keynes and the U.S. American Chief International Economist. Harry Dexter White of the Treasury Department. The hope of Keynes was to build a strong global central bank called the Clearing Union and to issue a new foreign reserve currency called the banking system.Instead of the development of a new currency, White ‘s proposal envisaged a more modest lending fund and a greater position for the US dollar. The adopted strategy eventually took suggestions from both, leaning more towards White ‘s plan.

In 1971, President Richard M. Nixon, worried that the U.S. gold supply was no longer sufficient to support the amount of dollars in circulation, devalued the U.S. dollar relative to gold. He announced a temporary suspension of the dollar’s conversion into gold after a run on gold reserves. The Bretton Woods structure collapsed in 1973. Countries were therefore free, with the exception of pegging their value to the price of gold, to select any exchange agreement for their currency. For example, they might attach their value to the currency of another country or a basket of currencies, or simply let it float freely and allow market forces to decide its value relative to the currencies of other countries.The Bretton Woods Agreement remains a significant event in world financial history. The two Bretton Woods Institutions it created in the International Monetary Fund and the World Bank played an important part in helping to rebuild Europe in the aftermath of World War II.

Dollar as king of global finance

Global trade was strongly based on the gold standard before World War I. Nations related their currency directly to gold and gold was used to carry out all trade between the countries. As a result, countries with trade surpluses saw their stocks of gold pile up. Countries with trade deficits have exhausted their gold reserves, on the other hand. The 20th was soon shaken by the first world war which terrible affected resources and economies around the globe. The gold standard fell flat on its face, creating the need for a currency structure that was more pliable. This paved the way for the rise of the British Pound Sterling and the US Dollar as world reserve currencies. As smaller countries moved to inconvertible paper money, the gold stock of relatively powerful countries rose. The gold standard had become operational again by the late 1920s, but in a different form: the gold-exchange standard. In this scheme, instead of being pegged directly to gold, the currency was pegged to another foreign gold-linked currency. History replicated itself until, in the aftermath of the Great Depression in the 1930s, this structure collapsed too. Even the U.K. suspended the gold standard in 1931. The only big countries that were left with significant gold reserves were France and the US. The mutual want for a stable worldwide currency reserve led to the July 1944 Bretton Woods Agreement. At the United Nations Monetary and Financial Conference, held in Bretton Woods, New Hampshire, delegates from 44 countries negotiated. As much of the world’s gold reserves were owned by the US and the gold-backed dollar was relatively stable, delegates decided to accept the US dollar as their official reserve currency.

The gold for dollar system worked during 1950-70. But it came under strain as the US started printing and spending a large value of dollars on post-war reconstruction efforts. When countries holding these dollars went for exchange with gold, the US gold reserves started vanishing.  Gold supply was finite, but the dollar printing knew no limits. The story came to an end in August 1971 when the US reneged from its commitment to convert the US dollar to

gold.De-linking gold with dollar made the US the linchpin of global finance. Through selling, other nations need to receive foreign exchange; the US Fed only has to press the print button. The Fed has almost become the global central bank. In order to be in line with the Fed, central banks around the world have to calibrate their policies. Without thinking about domestic inflation or balance-of-payments, it could print dollars because over two-thirds of all the dollars in circulation are kept outside the US. The USA could carry out massive expenditures on military activities and foreign aid to achieve its political objectives.The only big country challenging the dollar’s status was the Soviet Union, and that was the biggest explanation for the Cold War. Reluctantly, Europe and Japan joined the diplomatic and military umbrella of the US, recognizing the dollar as the de facto world currency.

Demand for new Global Currency

In March of 2009, U.S. Treasury Secretary, Timothy Geithner, let it slip that he was “quite open” to the idea of an eventual move toward a global currency run by the International Monetary Fund (IMF).One of the most frequently cited backers of a single currency is the legendary economist, John Maynard Keynes. For a world currency, there will be a little bit for everyone. Since there would no longer be currency danger in foreign trade, all nations would definitely benefit. Traders, anticipating currency fluctuations, will no longer have to hedge their bets. Both international finance-related transaction costs will also be reduced. Exchanging currencies often needs a transfer, which banks charge as a cost, and changing one currency to another will result in a loss of value. All of this will be removed by having one global currency. It will support individuals travelling abroad as well as corporations conducting operations in other countries. It there will ever be a global currency then, as a way of making their products cheaper on the global market, China could no longer use currency trade. China has been manipulating its currency for a long time, undervaluing it and thereby making the price of its products more competitive around the world. This has become a drawback to other nations’ economies. China wouldn’t be able to do this with one global

currency, nor would it have a justification to do so.The adoption of a stable currency, which would form the basis for potential economic growth, would also help developed countries considerably. Zimbabwe, for instance, has suffered from one of the worst hyperinflation crises in history. Global currencies, such as the U.S. dollar, had to replace the Zimbabwean dollar in April 2009.

However, the most obvious downfall to the introduction of a global currency would be the loss of independent monetary policy to regulate national economies. For example, in the 2008 economic crisis in the United States, the Federal Reserve was able to lower interest rates to unprecedented levels and increase the money supply in order to stimulate economic growth. These actions served to lessen the severity of the recession in the United States.This kind of active management of a national economy would not be feasible under a global currency. On a country-by – country basis, monetary policy cannot be implemented. Instead, any monetary policy adjustment will have to be made at a global level. Given the increasingly global nature of trade, each nation’s economies around the world still vary considerably and need different management. This would subject all countries to one monetary policy which could likely lead to policy decisions that would benefit some countries at the expense of others.This will probably result in negative impacts on developed nations rather than developing nations. For example, when its economy had all but collapsed, Germany had to bail out Greece, investing billions of euros to keep Greece from entering bankruptcy.

The IMF recommended on April 13, 2010 that the world adopt a global currency called the “Bancor” and that a global central bank be established to administer that currency. China in 2009 also called for a global currency to replace the dominant dollar, showing a growing assertiveness on revamping the world economy. China has long been uneasy about relying on the dollar for the bulk of its trade and to store foreign reserves. Premier Wen Jiabao publicly appealed to Washington this month to avoid any response to the crisis that might

Conclusion

It can be concluded that in a dollar-controlled economy acountry’s economy is ransom to Fed’s actions. If Fed increases the interest rate, dollars flow back to the US, and if it lowers rates, dollars move to the world to take advantage of growth stories or interest rate arbitrage of individual countries.Trillions of dollars loaned to corporates at near zero interest rate transfer wealth from the people to corporates, a key reason for the concentration of wealth in the top one per cent of the population.US actions are being emulated by China and other countries which have also printed and offloaded large volume of money in the past 10 years. Awash with cheap loans, Chinese firms export subsidized goods with no relation between cost and price. This has distorted the world trading pattern.The world reserve currency status became the source of U.S. global power because it could borrow as much as it wanted in the international capital market without worrying about payment defaults.For example, the U.S. government treasuries were (and still are) the world’s most sought-after financial assets because the face value and interests were to be repaid in U.S. dollars, deemed the “safest” currency on Earth.If China decided to sell over one trillion U.S. dollar treasuries, for example, all that America had to do was to print that amounts of greenbacks to repay the Asian country. While there would be side effects such as depreciation of the U.S. dollar and rise in interest rates (both of which could wreak havoc on the global financial system and the economy), including those of the U.S., the U.S. would be “debt free.” China, on the other hand, would be receiving depreciated greenbacks, effectively reducing America’s debt burden. Therefore, the researcher suggests that the world should strongly consider the option of having a uniform global currency. Establishing an international currency to replace the greenback will not be easy, but it should and must be done. Only then would international economic and financial systems be stable or free from U.S. meddling and bullying.

 

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