The New Fed Chief Must Defend the Dollar ... From President Trump

 | Nov 02, 2017 | 11:17 AM EDT
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President Donald Trump probably hopes the new Federal Reserve chairman will take a dovish stance because he prefers a weak dollar. But the new Fed chief must be careful not to erode the U.S. currency's main competitive edge -- specifically, the "exorbitant privilege" of being the world's reserve currency, as economist Barry Eichengreen called it in his famous book.

Somewhat paradoxically, the new Fed chair may find himself in the position of defending the U.S. currency from symbolic attacks emanating from precisely the man who nominated him to the position in the first place.

The Trump administration is focused intently on ensuring that the main trading partners of the U.S. do not manipulate their currencies to put U.S. exporters at a disadvantage. In its latest report to Congress in October, the U.S. Treasury, while not identifying any major trading partner that actually manipulates its currency, warned that the current state of affairs in world trade cannot continue.

"Treasury remains deeply concerned by the significant imbalances in the global economy. Bilateral trade imbalances with many of our major trading partners have grown to very large levels," the report said.

"This global configuration of external positions is untenable. The United States should not and will not bear the burden of an international trading system that unfairly disadvantages our exports and unfairly advantages the exports of our trading partners... It is critical that our major trading partners durably avoid foreign exchange and macroeconomic policies that facilitate unfair competitive advantage."

This may be music to the ears of President Trump, but such a tough stance, if maintained, risks wearing away the dollar's world reserve status. This status relies on other countries' need to hold dollar reserves and have trade surpluses with the U.S. The more reserves they hold, the safer the dollar is.

Right now, the dollar reigns supreme. It makes up around 64% of the world's total foreign exchange reserves, followed by the euro with 20%, the Japanese yen with 5% and the British pound with 4%, according to data from the International Monetary Fund (IMF). The Chinese yuan makes up around 1% -- not bad for a currency that its country's central bank heavily restricts for use as a portfolio investment.

European credit rating agency Scope Ratings notes that the share of the U.S. dollar among other indicators also remains the highest. For example, 63% of international debt securities are denominated in dollars, while 22% are denominated in euros; likewise, 59% of international loans are in dollars, with 21% in euros.

When it comes to over-the-counter foreign-currency derivative contracts, 44% are denominated in dollars, with 14% denominated in euros. Things are a bit more balanced when it comes to international payments; 42% are in dollars and 31% in euros.

All the preceding means that the Fed can print almost as much money as it wants without risking a flight from U.S. debt because Treasury notes and bonds are bought by every central bank elsewhere as part of their foreign currency reserves. The world's central banks are very unlikely to start dumping U.S. Treasuries suddenly, whereas they might do that (and did) with euro-denominated debt when they lost confidence in the currency.

Still, "very unlikely" does not mean it is impossible for the dollar to end up replaced by another currency, or by a basket of currencies. Such a shift could happen in two ways, according to analysts at Scope Ratings: either abruptly, via a major geopolitical shock like the one that saw the dollar replace the British pound at the end of World War II, or gradually over a long period of time, spurred on by U.S. policy changes or market-driven structural changes.

For now, President Trump's obsession with the "unfair" currency advantage that other countries supposedly have over the U.S. seems to suggest the second way would be the most likely, if it happens at all. It very much depends on how the new Fed chair navigates the minefield that has become the dollar's exchange rate policy.

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