Investors have a predilection for dollars, and they are repeatedly sued to undertake their investments or commercial transactions with this currency, leading to the global economy being sustained under the so-called dollar standard. But where does this attachment to dollars come from?
The birth of the dollar standard is political, because it comes from the consequences of the Second World War. At that time, global currencies were backed by gold and each government guaranteed that their money was worth a certain amount of gold. Then came the Bretton Woods agreement of 1944, which created the World Bank and the International Monetary Fund (IMF), and also established the US dollar as the new gold.
From there, the Bretton Woods fixed exchange rate scheme collapsed in the 1970s, when President Nixon unlinked the dollar from the gold standard during a period of domestic inflation, and many industrialized economies chose to float their currencies on the open market.
From that moment, the dollar began its depreciation. Nonetheless, the market has continued to choose it as the favorite currency by four basic points: the strength of the American economy, the widespread belief in the American financial model, confidence in American political and financial institutions, and the leadership role of the United States in international affairs.
In the currency market, the dollar rules. About 90% of currency trading is done with the US dollar, that is, within one of the pairs the US currency intervenes. The dollar is only one of 185 world currencies according to the International Organization for Standardization List, but most of these currencies are only used within their own countries.
According to the IMF, eight main reserve currencies are recognized: the Australian dollar, the British pound sterling, the Canadian dollar, the Chinese renminbi, the euro, the Japanese yen and the Swiss. franc and US dollar. The US dollar is by far the most common reserve currency, and represents more than 60% of world foreign exchange reserves.
Day by day, about 40% of world debt is issued in dollars. As a result, foreign banks need a large amount of dollars to conduct business. This became evident during the 2008 financial crisis. Non-US banks had valued $ 27 trillion in foreign currency-denominated international liabilities, and of that amount, $ 18 trillion were in US dollars. 5 As a result, the Federal Reserve had to increase its dollar swap line. That was the only way to prevent the world’s banks from running out of dollars.
Consequences of the high demand for dollars
That the world is demanding dollars on a recurring basis has its benefits but also its drawbacks for the United States. A global appetite for dollars provides cheap financing for US investment abroad, but at the same time can cause a trade deficit sustained by the high value of the currency relative to the rest.
The cheap financing capacity of the United States has been referred to as “exorbitant privilege“, a phrase coined by former French Finance Minister Valery Giscard d’Estaing in the 1960s. Simplifying, The United States would have the power to print $ 100, while the world needs to produce those $ 100 worth of goods and services.
The United States could have recurring government deficits or high levels of debt and would be unimportant given that its debt is widely demanded by global investors to give a return on those dollars acquired.
If the dollar remains the central axis in the monetary exchange, the US debt will be triple A. Paradoxically in countries that could have similar levels of debt, having their own local currency, as was the case in Greece at the time, your debt is no longer sued although they were backed by the euro.
Another advantage to keep in mind is that when the dollar assumes a central role in the global payments system it also the power of financial penalties is increased by the United States. Thus the United States can make it difficult to conduct business for those it blacklisted.
We have talked about the positive aspects of the dollar being the most coveted currency by investors, however, certain costs must also be taken into account. negative aspects for the United States.
If your currency is broadly like the dollar, the valuation increases against the set of global currencies. This force on the part of the dollar has an impact by making imports cheaper but also making exports more expensive, which can reach harm national industries who sell their products abroad. Especially in times of economic meltdown, investors look to the safety of the dollar, which squeezes exporters at an already difficult time.
The United States is also hurt by currency manipulation, when another country keeps the value of its currency low to maintain a large trade surplus, as is the case with China. A country that has a trade surplus may face pressure for its currency to appreciate, making its goods more expensive and curbing exports. Instead, you can keep the value of your currency artificially low by building up dollar reserves, hurting US exporters in the process.
In tense monetary environments, you want to save in dollars
The role of the dollar is interesting when we are in economic territories that suffer a high tension in prices as is the case of Venezuela or Argentina, both with inflation rates that may be unaffordable from the perspective of developed countries accustomed to inflationary rates below 2%.
In Venezuela, for example, they already exceed seven years of economic contraction and the largest hyperinflationary scenario in the world.
The number of dollar transactions has only skyrocketed in recent years and Venezuelans see the dollar as a safe haven alternative to the constant devaluation of the Venezuelan bolivar. 66% of transactions are already made in US dollars.
The Maduro government has had to accept the defeat of its own currency and has had to loosen controls they were strangling private companies that have brought in more than $ 2 billion in remittances.
Argentina has a serious problem with inflation. The projection for this year is that the resulting rate would be around 47.3%. Inflation is a disease for Argentina and the vaccine in demand has been the dollar.
In the last decade, Argentine dollar holdings grew 106% but deposits in banks only 35%. This means that Argentines do not trust the local financial system or the government itself, but rather they prefer the mattress, safe deposit boxes or deposits in foreign banks.
If local monetary authorities do not curb unleashed inflation, dollarizing the economy is a perfectly valid way to stop high rates of inflation. We have the clearest example in Ecuador that dollarized its economy in January 2000 and price stability was achieved in 2004. Since then, inflation has averaged 3.1% per year, lower than the 28% average between 1970 and 1999, and similar to that of Chile (3.3%), Colombia (4.4%) and Peru (2.9 percent) in the same period.
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