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Will
the Dollar Remain Dominant?
By
Jane Hughes
The dollar has followed a rocky road in recent months, tumbling
to nearly $1.18 against the resurgent euro and to an anemic 119
yen, as foreign investment in both bricks-and-mortar and portfolio
investment in the States has ebbed. If the foreign exchange rate
is essentially the bottom line of the country, then investor sentiment
toward the once-mighty U.S. dollar – and the economy that
underpins it – is definitely cooling.
But while day-to-day currency movements remain well-nigh unfathomable,
there has been surprisingly little structural change in the FX
markets, even over the past decade. The dollar may be slipping
in value, but it continues to dominate the markets in other, perhaps
even more important, ways. The arrival of the euro in 1999 was
supposed to herald a new era in which dollar dominance of the
FX arena gradually gave way to a more equitable distribution of
power among a tri-zone currency world (dollar, euro, and yen).
This has not happened. According to the most recent report by
the Bank for International Settlements (BIS) on FX market activity,
published in 2001, within the tri-zone world the dollar still
reigns supreme. A whopping 90% of all currency trades still include
the dollar on one side of the deal; by contrast, the euro figures
in just 38% of all FX transactions.
The potential for internationalization of the euro – its
use in transactions not involving the 12 component countries,
and therefore its ability to challenge the dollar’s dominance
of global FX markets – remains murky. As a general rule,
this potential may be assessed in three ways: the euro’s
use as a medium of exchange for Europe’s trade with non-European
countries; its role as a store of value for stocks and bonds on
world capital markets; and its use in official FX reserves held
by the world’s central banks.
By these yardsticks, the picture is mixed.
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Role in world trade: The U.S. accounts for only 14% of world
trade, but the dollar is used to invoice close to 50% of the
world’s exports. Clearly, there is room for the euro to
play a much bigger role in world trade. Countries with close
political, economic and financial links to the eurozone, like
those in central and eastern Europe as well as some former colonies
in Africa, may move toward the euro as an anchor currency. This
would result in the emergence of a broader, informal “eurozone”
encompassing countries well beyond its official limits.
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Role on international capital markets: The introduction of the
euro, clearly, is playing a big role in broadening the depth,
liquidity, and appeal of European capital markets. In 1999,
euro-dominated bonds accounted for 45% of all bonds issued on
international markets, slightly outstripping the 42% of bonds
issued in dollars. This could presage the evolution of the euro
into a safe-haven currency over time, as investors assess the
strength and stability of the euro as well as the credibility
of the European Central Bank.
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Role
in official reserves: The dollar accounts for 57% of global
FX reserves, and central banks have been loath to trade in
their dollars for euros thus far. Political issues may eventually
hasten this movement, but the huge bulk of FX reserves held
in Asian central banks (China alone is holding around $200
billion) are conservatively managed. Given the initial weakness
of the euro, and lingering doubts about the long-term viability
of European monetary integration, it seems unlikely that the
euro will challenge the dollar as a reserve currency for the
foreseeable future.
So FX markets are still largely dominated by dollars. What
else has not changed on FX markets? The birth of the euro led
some observers (mostly French and German) to predict that London
would experience a gradual decline in its importance as an international
financial center, to be replaced by Frankfurt and Paris. This,
too, has not happened. London continues to handle close to 1/3
of FX trading activities, far more than any of its competitors,
and the institutional skills and infrastructure in the City
of London command a hefty competitive advantage in the FX business.
Trading in “exotic” currencies, too, was supposed
to take off. Faced with liberalization and deregulation in emerging
currency markets around the world – and faced simultaneously
with the need to replace lost opportunities in intra-European
currency trading – many traders looked to exotic currencies
as the next frontier. A decline in trading activity and increased
efficiency in markets for the mature currencies of western Europe
and North America (the euro, after all, is entirely about removing
market inefficiencies) threatened FX trading profitability.
Fortunately, at the same time governments in Asia, central and
eastern Europe, Latin America, and even Africa were enthusiastically
opening their markets to foreign capital. The result seemed
inevitable.
Or was it? In fact, the data on exotics market activity has
failed thus far to support the overheated rhetoric. According
to the BIS, trading in emerging market currencies comprised
just 4.5% of total FX market turnover in 2001, compared to 3.1
percent in 1998. So while trading in exotics is certainly edging
up, and is expected to play a greater role in FX trading as
the mainstream currencies get even older and stodgier, the markets
are still heavily dominated by trading in dollars, euros, yen,
and British pounds. (Indeed, trading in the three main currency
pairs – dollar/euro, dollar/yen, and dollar/pound –
accounts for close to 2/3 of total market activity.)
A few possible trends to watch for, then:
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First, the possibility of a serious decline in market
liquidity is worrisome. FX market participants have complained
in the past couple of years that liquidity has become erratic.
The rise of electronic brokers, consolidation within the
banking industry, and the higher level of risk aversion
among global hedge funds all contribute to this trend, and
make it increasingly difficult to predict when these pockets
of illiquidity will occur.
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Second, the FX markets may prove more herd-like than
ever, as trading business is more and more concentrated
among a few large players and the big macro hedge funds
play a cautious role. This may, in turn, presage more sudden
and dramatic currency swings.∑ Next, the markets may
prove more inexplicable than ever, stemming from the growing
influence of equities, and merger and acquisition activity,
in currency trading. Traditional reliance on fundamental
macroeconomic factors to predict FX movements is increasingly
discredited in this environment, but it is far from clear
what can replace this methodology.
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Finally, trading volumes will probably rebound after
the period of consolidation at the end of the 1990s. Once
the fallout from the emerging markets crises of 1997-87
is fully absorbed and the euro finds its rightful place
in the markets, the inexorable march of globalization and
resulting rise in cross-border capital flows will be reflected
in higher turnover on FX markets. But buyer beware: The
larger and more unwieldy the market becomes, the less responsive
it will be to government intervention – and the easier
it will become for traders to destabilize currencies of
smaller and vulnerable emerging market countries.
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