Feldstein: The Dollar is the World's Primary "Investment Currency"
Martin Feldstein says the role of the dollar in foreign exchange reserve balances has changed:
The dollar’s fall reflects a new role for reserves, by Martin Feldstein, Commentary, Financial Times: I am often asked whether the ongoing decline of the dollar implies that it can no longer serve as a reserve currency. My short answer is that most countries no longer hold dollars and other currencies as traditional reserves. The role of foreign exchange balances has changed from being short-term funds used to bridge export-import gaps to being long-term investment funds. In this new world, the dollar has shifted from being almost the sole “reserve currency” of many countries to being the primary “investment currency”, a role that it will continue to play far into the future.
A bit of history is helpful... In 1997 the Thai government tried to maintain the Thai bhat at an overvalued level. When it exhausted its reserves doing that, it was forced to devalue, generating substantial profits for those who had borrowed bhat and sold it for dollars.
Speculators then attacked other Asian currencies. Even a currency not fundamentally overvalued could be profitably attacked if speculative borrowing and short-selling could force the government to exhaust its reserves and have to devalue.
These experiences taught governments two lessons. First, it is dangerous to try to maintain an overvalued currency. Second, even if its exchange rate is not overvalued, a country could face a successful attack by forex speculators if it does not have a very large amount of foreign exchange.
Countries responded by deliberately keeping their currencies undervalued to run trade surpluses and using these surpluses to accumulate foreign exchange. We now see Korea with foreign exchange assets of $200bn (€136bn, £123bn), Taiwan $300bn, Thailand $100bn and China more than $2,000bn.
These funds are no longer held to manage temporary swings in imports and exports or investment flows. They are best seen as investment funds that also deter attacks by forex speculators. Similarly, the oil-producing countries ... recognize the investment nature of their foreign exchange accumulation. Instead of just holding these balances in short-term US Treasury bills, they have created sovereign wealth funds with sophisticated investment strategies.
It is prudent for any country with large foreign exchange balances to diversify those funds. ... That diversification cuts demand for the dollar, putting pressure on its value. ... But even as countries diversify away from exclusive reliance on dollars, the dollar will continue to be the main form of liquid investment for countries around the world.
As this portfolio rebalancing comes to an end, demand for dollars will stop falling ... What looks like a crisis of confidence in the dollar as a reserve currency is just part of the evolutionary process that will eventually halt the dollar’s decline.
