A hot question among economic pundits of late is, “What will replace the US dollar (USD) as the world’s reserve currency?” Perhaps a better question is, “Does there need to be an actual replacement?”
Currently, the USD plays several major roles:
- It is universally accepted as payment of goods and services,
- It is highly liquid and can be instantly converted into other currencies,
- It can easily be invested in broad and deep capital markets, and
- The sovereign risk is that of a stable government.
There would appear to be no current alternative that completely contains every one of these attributes.
But recently, there has been a plethora of bi-lateral and multi-lateral trade agreements, particularly among the BRICS nations (Brazil, Russia, India, China, South Africa), which provide the ability to settle trade transactions in local currency or other acceptable payment mechanisms, thus satisfying the USD role number one cited above. Simply put, if a country can settle much of its trade liabilities without requiring the USD, then it no longer needs to hold USD in reserve.
In this new environment, there would be no need to actually replace the current reserve currency since one of the major roles it performs would be significantly diminished. So why bother?
As the role of the USD diminishes as a settlement mechanism for international trade, one would expect that much of the USD held here in the USA would simply be sold for local currency – and the implications could be significant. Such actions should move US interest rates higher, as existing US Treasuries currently held by foreign nations as reserves are sold off and future Treasury auctions would face far fewer international buyers. Such events would make funding the current (and future) US debt load far more difficult. Moreover, the reduction of foreign demand for the currency would likely reduce its exchange rate, adversely impacting the inflation rate, although it should be noted that the lower value would aid the US export sector.
Virtually everyone has concluded that, at least for now, there is no currency unit that represents a viable replacement for the US dollar as a global reserve currency. That said, the recent bi-lateral and multilateral agreements which effectively by-pass the US dollar has drastically reduced the need for much of the world to hold US currency as a reserve in the first place. Consequently, there is a sharply diminished need to hold dollars, or any other currency for that matter, in reserve at all.