The US Dollar is the most widely used currency in the world. In addition to central banks, public and private entities around the world hold the US Dollar in their reserves. In fact, it is true that most US Dollar banknotes are in reality held outside the United States.
In India we buy our biggest imports namely, crude and gold in US$, a legacy of the Bretton Woods System. While it is true that the Bretton Woods system had put the US$ in a supreme position, there is a lot of buzz about changing the reserve currency to something other than the US$ mostly because of 2 reasons.
First, given that the current US Debt Ceiling is getting close to US $17 trillion, questions are being raised about the ability of the United States to honour its debt.
Second, and more importantly why should countries continue to hold their US Dollar reserves if the share of the United States in global trade is constantly reducing? The world today is dealing more and more with the European Union and China. The EU nations contribute 12.2 % of total international trade followed by the United States (10.6 %) and China (10.6 %). All estimates suggest that the United States will soon slip below China in this regard (unless that may have already happened) – See here. For a more elaborate statistical data you can visit here. It is indeed interesting that despite these trends, central banks continue to hold US$ reserves more than any other currency. The biggest reason for this is that over the years the world has become habitual to the use of US$ and habits are difficult to change. Human nature is such that it is hard to find people who will break away from a fixed norm, irrespective of its virtues.
The reality is that even if the world does not necessarily trade with the US, whoever else the world trades with accepts the US$. So isn’t it an easy thing to do to just hold the US$ as reserves than any other currency? Fair point, but this will be good only until the world keeps accepting the US$.
Consider this example, what if China which owns approximately 10% of US debt or approx US$ 1.17 trillion, demands this money back. What will the United States do? I think the United States may consider this – print US$ and give it to China. Sure the US Debt Ceiling will have to be raised further, to print more money. I am equally sure that this will be done.
Now let’s assume that for some reason the whole world looses faith in the US$. Central banks start selling their reserve dollars. Where will the buyers come from on such a day? Will the United States buy back its dollars? In short, what will the United States pay back its debt with if the world refuses to accept the US Dollar?
Euros? Or may be Gold, as the United States does have the largest gold reserves in the world (8,133.5 tons, according to the World Gold Council). Just for comparison, Germany is a distant second with 3,395.5 tons and the IMF is in third place at 2,814 tons. So, the United States has a lot of gold, but is it enough to back all the debt which the United States owes to the world? Not even in the least.
I do not think that any such drama will happen. What I am sure will happen though is that central banks and businesses will start holding different currencies such as the Euro or Yuan and reduce their US$ reserves. The process may be gradual but it will happen and slowly the US Dollar will be replaced as the reserve currency by something else.
Many things will remain unanswered until future events unfold. For example, how will currency conversions (i.e. pairing) work in the absence of a single base currency? If we return to the gold standard, will the prices of gold skyrocket?
If all the printed US$ in circulation is used to buy the available gold in the world then you will have to price the gold a great deal higher than its current price. So yes, if we go back to the gold standard, then gold may prove to be a multibagger investment. I think the exact opposite will happen. Read here for my views on gold as an investment option. I have been maintaining these views for a while now.
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