- June 17, 2014
- Posted by: IAIP
- Categories: BLOG, Book Reviews
Title: The Dollar Trap: How the US Dollar Tightened Its Grip on Global Finance
Author: Eswar S. Prasad
ISBN: -13 9780670087624; ISBN-10 0670087629
Kindle Price: Rs. 349.50, Hardcover Price: Rs. 503
Reviewed By: Jainendra Shandilya, CFA, CAIA
The Dollar trap is an analytical research work on the state of the global financial system, hitherto dominated by the mighty US Dollar. The author expresses his concern about the asymmetric risk posed to the global financial system, which is obsessed with increasing its reserve of the greenback. He finds a complete trap wherein no other currency, or form of currency, is in a position to dethrone the US Dollar, from its status as the number one reserve currency.
How dollar became currency of choice? How is it that no other country or group of nations are able to dismantle the throne on which the dollar is sitting since long? Many such questions have been answered, keeping in view the level of understanding of not so sophisticated readers lacking background in Macroeconomics. -Prasad illustrates that capital flows from emerging market to developed ones, contrary to the common and rational belief of the other way round. He cites, to elaborate on this paradox, a paper by 1995 Nobel Laureate Robert E. Lucas, Jr., University of Chicago.
The book articulates the mechanism involved in the process followed in making a currency as the reserve currency. How the inflation tax can be exported to outside world, when a country’s currency becomes reserve currency; how seignior age helps a country make monetary gains are the important highlights of the book. In essence, he cites three important preconditions for making a currency as reserve currency – floating exchange rate, internationalization and capital account convertibility. As on date there are four major reserve currencies in the world- the US Dollar, the Euro, Pound Sterling and Japanese Yen. The discussion in the book stretches from the relevance of all these currencies in today’s world, whether they are capable of getting the same status as that of the US Dollar. Almost all the possible rival currency to dollar, be it gold, SDR, Euro, Yen, Rupee, Brazilian Real, Russian Rouble, African Rand, Renminbi, bitcoin, local currency finds mention in the book. The Special Drawing Rights (SDR) is a book entry currency created by the IMF and the IMF takes great pain to ensure its managements as the SDRs can be converted into any of the four reserve currencies based on a formula decided by the IMF. The SDR is different from other forms of loans from the IMF in the sense that there are no pre-conditions attached – the creditor receives interest on its loan and the debtor pays it in the foreign currency. Despite its advantage of having been issued and managed by IMF, the SDR won’t be able to be the next currency of the choice for the trading nations. The reason, not very difficult to guess, is the almost inelastic supply of the SDRs.
Next comes the most talked about currency -the Renminbi, probably because of the economic size of the China and the media hype surrounding it. Whether Renminbi can become reserve currency, and alternatively, whether it can replace the greenback. The answer is no, in the short run. China lacks the financial openness of a reserve currency nations. The size and liquidity of the Chinese debt market is not comparable to other major reserve currency nations, hence making it unattractive for foreigner investors. And China, therefore, will have to develop its financial market and make it as liquid, deep and broad as the major ones. Floating exchange rate, internationalization, open capital account, macro-economic policies, financial market development, economic size are essential for a reserve currency status that a country seeks. On the financial market development front, much is needed to be done by China in order for it to be accepted as a reserve currency in the near future. Why is China sitting up with so much – around $2trillion, of dollar reserve? Why can’t China come out of the dollar trap? The Chinese hate the Americans for their ability to transfer the pain of rising inflation – much of which is borne by outsiders, still they repose so much of faith in the greenback. Many emerging markets, India and China included, lack regulatory framework essential for the growth of corporate debt market – a much needed prerequisite for long term investors.
Why is the dollar so important a currency? The credit goes to the best financial systems, legal institutions, and the liquidity and safety of the dollar that institutions across the world look for in times of financial distress, albeit in the USA itself. The paradox of a financial crisis originating from the USA and leading to increased demand for the US Dollar, contrary to rational expectations, is explained in detail in this book. The US has high quality domestic debt securities valued at around $33trillion, which is much more than $7trillion held by five BRICS economies. The authors finds that China lacks the great institutions that are responsible for the global hegemony of the dollar as regards the financial transaction are concerned. The political stability in the US, the independent judiciary, free press and freely convertible currency are the hallmark of a great nation that can ensure civilian rights, even if the victim is a foreigner. China is still not ready for reserve currency status, how can it dethrone the US Dollar? In other words, China is very far from what is required to be accepted as the next global currency of the choice. China holds equivalent to $- 3.5-trillion of foreign exchange reserves out of which around $2trillion is in US Dollar. Any attempt by the Chinese to sell the same would lead to more loss to China than to US, probably due to the impact cost. Has the US considered the outcome if China resorts to aggressive selling of its Dollar reserve? The Chinese should not, and probably won’t, sell their holdings in the near future. Political compulsions, arising out of realpolitik of the US, may force the Chinese to resort to this option – a very low probability event but highly devastating.
What makes the greenback so special? Is it really anti-fragile to withstand any onslaught of economic wars ravaged by a few hostile nations? The popularity of the US Dollar is due to its ability to bounce back from any setback caused to it. For example, during the global financial crisis that erupted in US, and that should have devastated the US Dollar as a hard currency, large number of investors withdrew their investments from other emerging countries and deposited in the US Treasury. This led to strengthening of the Dollar, rather than any weakness that would have been caused if it was a fragile economic system. This is the strength of the US Dollar built over years of faith reposed by investors across the world. Can the US default on its obligation of over $-12trillion of debt instruments – most of which are held by foreigners including Chinese and Japanese? The answer is no. The US can’t selectively default on its debt, due to lack on information on the debt holders. And second, some $4.5trillion of the debt are held by the local citizens whose retirement income depends on it.
The world is not perfect, in its present situation, hence dollar remains the choice currency for both the deficit and the surplus nations. The author prescribes, in detail, remedy for dealing with situations arising out of future global financial crises. There ought to be a pool of funds to be constituted from insurance premium received from member countries. This premium, opines he, should non linearly increase with the increase in the risk of fiscal health of a nation. Since so many methods to ensure financial stability by the IMF have failed in past, this would probably succeed. The Bank for International Settlement (BIS) would be the natural fund manager to this kind of fund, as there are no conflict involved.
What are the symptoms of nations lurking on the threshold of foreign exchange crisis? What do the nations do to avoid getting noticed by foreign investors about their financial straits? Why is the IMF the last choice for nations facing foreign exchange crisis? There are many explanations and many citations provided in the book.
The book keeps its reader’s interest intact by chronicling various issues in natural order, and that makes it an interesting reading material.
– J S