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The end of monetary sovereignty
As markets integrate and globalize, national currencies should become fewer and stronger.

- DIANA FARRELL AND SUSAN LUND (The McKinsey Quarterly, 2000 Number 4, pp. 56-67).

 

Traditional economic symbols of national sovereignty are going the way of the dinosaur. Around the world, national airlines, telephone companies, banks, and other government-owned institutions, once bulwarks and extensions of the nation itself, are being privatized and placed under market control. In the aftermath of the financial crises of the 1990s, many of them sparked by drastic currency depreciations, it is time for policy makers to narrow sovereignty's scope still further by treating currencies as what they are - simple mediums of exchange.

While policy makers tinker with exchange rate regimes, companies and investors around the world are quietly choosing to operate in a single standard currency: the US dollar. Like it or not, the same economic considerations that impelled 11 European nations to replace their national currencies with the euro are turning the dollar into the de facto global currency. Why? Because the United States has adapted to the new economic era of global markets by developing a financial market infrastructure that meets the needs of investors, issuers, and intermediaries.

As the dollar comes to predominate, emerging markets that maintain illiquid national currencies incur a significantly higher cost of capital and stunt the development of their financial markets. And while much ink has been spilled about the benefits of an independent monetary policy, the record of many central banks in emerging markets has been one of hyperinflation, overvaluation, and capital flight.

We are not, however, arguing for the hegemony of the dollar. Instead, we look forward to competition among currencies. Countries should either adopt the most attractive leading currency or compete to create one, a process that would strengthen all contenders and ensure the emergence of the best global medium of exchange. Even in the best of circumstances, it will take a decade or more for one or a few truly global currencies to appear, so instead of flinching from the fierce political opposition that is bound to arise, legislators, regulators, and central bankers should begin moving in that direction today.

GLOBAL MARKETS ARE ADOPTING A SINGLE CURRENCY

Around the world, product and capital markets are becoming increasingly integrated. Governments are opening their borders to foreign goods and capital while technology is revolutionizing communication, permitting companies to operate globally. To facilitate transactions and reduce costs, market participants are adopting a common medium of exchange, the US dollar.

For most of the time since the end of World War II, the US dollar has been the world's dominant currency. At the start of the 1970s, when it was still the benchmark currency of the Bretton Woods system, the US dollar accounted for almost 80 percent of central-bank reserves around the world. After the collapse of that system a little later in the decade, other currencies, no longer pegged to the dollar, could compete for international standing. Yet they failed to achieve it. On the eve of the euro's creation, in 1997, the dollar accounted for only 60 percent of central-bank reserves, but there was no corresponding increase in holdings of the deutsche mark or yen, which remained at 12 and 5 percent, respectively.

Despite the rapid growth of equity and bond markets, almost half of equities and bonds around the world are denominated in dollars (Exhibit 1). Savers have accumulated nearly $30 trillion in dollar-denominated bonds, equities, and currency deposits◊the world's largest such pool. By contrast, 9 percent of equities and 16 percent of bonds are denominated in yen, while euro-area currencies account for 15 percent of equities and 24 percent of bonds. The adoption of the euro has caused companies within the European monetary zone to issue far more equities and bonds than they used to, but the currency has yet to attract many foreign issuers.

The dollar's predominance can't be explained by the size of the US economy, which, though the world's largest, accounts for less than 30 percent of the global gross domestic product. Instead, it reflects the world's marked preference for dollar-based financial instruments. Take international bank lending. US banks extend only 10 percent of foreign-bank loans, yet 45 percent of the value of foreign-bank loans is denominated in dollars. In most emerging markets, the proportion is even higher. In Thailand, for example, almost all foreign loans on the eve of the 1997 crisis were denominated in dollars, even though fewer than 10 percent of them came from US banks.
Moreover, the dollar's status in global financial transactions is underscored by its role in foreign-exchange trading: it is involved in nine out of ten foreign-exchange transactions and accounts for most of the trading against every other currency.

Two-thirds of all deutsche mark trades, for instance, are with the US dollar. In the case of less liquid currencies, the proportion rises; almost 90 percent of trading in the Singapore dollar is with the US dollar. The concentration of all trading in a single currency pools liquidity and reduces transaction costs. If every currency were to trade with every other currency, trading volumes in any two of them would be very small indeed.

And the dollar is becoming even more important as increasing amounts of financial activity take place in international rather than purely domestic markets. Twenty years ago, capital was funneled from savers to borrowers by means of bank loans, and capital markets were mainly national affairs. Today, capital markets are supplanting banks as the primary intermediaries, although the pace of change varies from country to country. In the United States, which is furthest along in this transition, bonds and equities represent nearly three-quarters of the total stock of financial assets, up from 60 percent in 1990. At the same time, capital markets around the world have been opened to foreign participation, and companies increasingly seek international financing. These changes have raised the demand for dollars. The nominal value of dollar-denominated bonds issued outside the United States grew from $402.1 billion in 1986 to $2.4 trillion in 1999◊an annual growth rate of 14.9 percent.

In global product markets, too, the dollar is king. Prices of most commodities are quoted in dollars, and dollars are used to pay for almost half of all imports and exports, even though the United States is involved in no more than 29 percent of global trade transactions (Exhibit 3). Global companies thus find it in their interest to dollarize their operations. The Mexican conglomerate Grupo IMSA is a good example. Since the advent of the North American Free Trade Agreement (NAFTA), in 1994, the proportion of Grupo IMSA“s products sold in dollars has grown to 90 percent. A company can eliminate currency risk from its balance sheet by paying dollars for inputs as well. As a result, Grupo IMSA pays its top executives and a growing proportion of its raw-material suppliers in dollars. To facilitate this trend, many Mexican executives now favor making the dollar a second legal currency.

In addition, the dollar is the foreign currency most widely held by private citizens, denominating almost 80 percent of foreign-currency deposits around the world. Dollar deposits account for more than one-third of total deposits in countries as diverse as Argentina, Cambodia, Peru, and Turkey. Because banks tend to lend in the same currency as their deposits, dollar-denominated loans also abound in these countries.

Throughout the world, US dollars and the local currency are often used interchangeably for routine transactions in real estate, for supplier and professional contracts, and for measurements of inventory. As a result, in countries such as Bolivia, Nicaragua, Peru, and Uruguay, almost as much value is circulating in dollars as in local currency. Russia has an estimated $44 billion in US currency, or almost 2.5 times the value of rubles in circulation. Indeed, roughly 60 percent of all US dollars in circulation are now held outside the United States, according to the US Federal Reserve Board. As almost three-quarters of new dollar notes end up abroad, this proportion can only grow.

Why the dollar?

Undoubtedly, the political stability and military might of the United States contribute to the strength of the dollar, but the main reason for its leading role is the world-class financial infrastructure that supports it. The Federal Reserve Board has held inflation in check since the early 1980s, providing a stable monetary base, while the US Securities and Exchange Commission rigorously governs US financial markets, promoting fair operation and the protection of investors. US accounting standards provide the world's highest level of transparency; the US legal system gives creditors and shareholders extensive rights; and the country harbors the world's strongest financial skills as well as most innovation in financial products.

Because a currency becomes more desirable the more people use it, the dollar has become almost beyond challenge. For the same reason, financiers choose the dollar for their innovations, such as the securitization of assets - further widening the distance between it and all other currencies.

What about the euro? What about the yen?

While the euro could eventually rival the dollar, it now lacks the dollar's credibility and infrastructure. The euro is a new and only partially tested currency. The European Central Bank has too short a track record, and its decision making is hampered by political and economic contention.

Although European financial markets are developing rapidly, they are still far behind those in the United States. US companies and government agencies have issued bonds and equities amounting to 278 percent of GDP, against 139 percent for Germany and France and a European average of 183 percent, despite similar per capita income levels (Exhibit 4).

Europe's less investor-friendly market infrastructure explains almost all of the gap. Capital market regulation there is not as vigilant, and legal protection for creditors and minority shareholders is weak. Furthermore, different sets of national regulations still govern financial markets in the euro area, thus preventing their true integration into a single market, while accounting and reporting requirements make it harder to assess the true condition of euro-area companies. All of these factors prevent the euro from challenging the dollar, at least for the time being.

The yen, for its part, suffers from all of the euro“s liabilities and more. High levels of share cross-holdings and a tradition of centralized economic planning - among other factors culminating in Japan's present woes - mean that few non-Japanese companies or investors participate in the Tokyo market. The yen isn't widely used to denominate transactions even in Asia.

ILLIQUID NATIONAL CURRENCIES ARE COSTLY

Global competition makes maintaining an illiquid national currency more and more costly. For one thing, it raises borrowers' cost of capital. A Thai government ten-year bond denominated in baht, for example, traded for 1,218 basis points over US Treasuries in January 1999. At the same time, a Eurodollar bond issued by the Thai government traded for just 288 basis points over US Treasuries. While part of the difference reflects Thai inflation (8.1 percent in 1998), fully 120 basis points of it can be attributed to the risk that the baht will decline in value. This is a huge penalty for Thai companies to pay in a competitive world. Companies in other emerging markets face a similarly bloated cost of capital.

Argentina, by contrast, has sharply reduced its cost of capital by adopting a currency board that irrevocably fixes the value of its currency to the US dollar. Interest rates on domestic loans fell to 19 percent, from 113 percent, within a year of the board's adoption in 1991, while investment soared by more than 35 percent during the years from 1993 to 1998. Today, Argentina could lower its cost of capital still further if it adopted the US dollar officially - a move the country has seriously considered. Eliminating the 10 percent interest rate differential between peso and dollar loans would add an estimated two percentage points to the country's rate of growth.

The second main problem with an illiquid national currency is that it hinders the development of domestic financial markets. It is no accident that Panama, which uses the US dollar, is the only Latin American country with 30-year fixed-rate mortgages. In other emerging markets, borrowers seeking long-term funding are forced to borrow abroad in a foreign currency that might have appreciated by the time it must be repaid or to obtain loans with short maturities and risk having to replace them at prohibitive cost. The hazards associated with raising long-term capital have pushed the largest and most sophisticated companies in emerging markets to list shares in New York and to raise debt in the Eurodollar market. Smaller, purely local companies cannot do that, further burdening the domestic financial system.

A lack of long-term borrowing options in most of the world's currencies is a serious threat to financial stability. Consider again the case of Thailand. Before the 1997 crisis, its companies, banks, and government borrowed almost $75 billion abroad, chiefly in US dollars. Most of this debt was in short-term maturities and unhedged. When the baht lost 40 percent of its value in 1997, the cost of foreign-debt payments rocketed, and many borrowers went bankrupt. Foreign lenders to Thai banks pulled their loans, creating a liquidity crunch. Companies that had used short-term baht loans to finance long-term investments could not roll them over as expected, and many were pushed into insolvency.

The trade-off

What does a country give up when it abandons its currency? Aside from a traditional symbol of sovereignty, the main cost is the loss of an independent monetary policy and of a flexible exchange rate. Brazil and other Latin American countries devalued their currencies in the wake of the Asian and Russian crises in 1998, but Argentina couldn't do so, leaving it with higher interest rates and more expensive exports than those of its neighbors as well as a nasty recession. The relatively high cost of doing business there caused a host of multinationals - from Royal Philips Electronics to Goodyear Tire & Rubber - to shift their production from Argentina to Brazil, taking jobs with them. To make matters worse, the rise in US interest rates has translated into higher rates in Argentina, damping consumer demand.

Despite the pain, Argentina has decided to stand by its currency board because the country values the reduced cost of capital, the price stability, the investor confidence, and the stronger domestic financial system that currency stability has brought. All of these measures have also contributed to economic growth.

A grand illusion

In truth, "monetary-policy independence" is more illusory than real for most emerging-market countries. In a world of growing trade and capital flows, most governments have ceded control of their interest rates and exchange rates to the millions of participants in financial markets. This is particularly true of developing countries that depend on foreign capital. For them, foreign investors, not domestic interests, increasingly dictate interest rate policy as well as exchange rates. After the Russian crisis began in 1998, for example, nervous investors stopped investing in emerging markets. One currency affected, the Mexican peso, depreciated by more than 10 percent. The Mexican government was forced to raise interest rates substantially to reassure investors and thus stabilize the exchange rate.

While flexible exchange rates can absorb an economic shock, it is significant that most emerging markets have nonetheless decided to peg their currencies to a stronger one, usually the dollar. They have done so to promote foreign investment, to lower interest rates, and to encourage savings to stay within the country. These governments have concluded, rightly, that in today's world, exchange rate adjustments are as likely to cause or exacerbate a shock as to absorb it. Sharp changes in the exchange rate hurt exporters and importers alike, as well as anybody who has borrowed abroad. If these constituents are economically important, exchange rate volatility can leave the economy as a whole in tatters. Letting the exchange rate float in an emerging market has been likened to steering a rowboat in choppy seas: rowers may be free to go where they please, but this doesn't help much.

Indeed, the experience of Latin American countries with floating exchange rates has been disappointing. Ricardo Hausmann, chief economist of the Inter-American Development Bank, has summarized their experience. Countries with floating rates, he found, pay higher average real interest rates: 9 percent, against 5 percent for countries with fixed rates. Interest rates in countries with floating exchange rates are also more sensitive to movements of foreign interest rates, making those countries less independent monetarily, not more. When the cost of foreign borrowing increases by 1 percent, for example, interest rates rise by 1.4 percent in Argentina but by 5.9 percent in Mexico. Finally, floating rates tend to encourage workers, who want to be protected from currency fluctuations, to press for wages indexed to the inflation rate. This makes currency devaluations inflationary for the economy as a whole and drives up labor costs.

The other economic benefits of a national currency are neither irreplaceable nor compelling. Take seignorage, the profit that a central bank earns from printing money or, put another way, the difference between the cost of putting money into circulation and the cost of the goods it will buy. In the case of the dollar, the difference is about 97 cents. Since currency pays no interest, the Federal Reserve in effect makes interest-free loans to the federal government. But it isn't inconceivable that a central bank would share seignorage with the countries that formally adopted its currency. As for the central banks' role as "lender of last resort" none of the central banks involved in the crises of the 1990s managed to prevent them. Besides, there are other ways of providing for the lender-of-last-resort function: Argentina, for example, has a $6.7 billion emergency fund.

In light of these facts, it is not surprising that many academics, policy makers, and market participants now agree that dollarization - or euroization - would make sense for many countries. The burden of proof should now shift to those arguing that a national currency confers actual benefits on emerging markets.

THE END OF NATIONAL CURRENCIES

Participants in the globalizing world economy have been steadily adopting one currency, the US dollar, to reduce transaction costs and facilitate exchange. Although it isn't clear whether a single global currency is necessary or optimal, the economic case for moving to a world of fewer, stronger currencies is clear. With more than 175 currencies circulating today, however, completing this transition would take many years.

But even if policy makers do nothing, market participants will drive the informal adoption of the most adaptive currency, probably the US dollar. How would this come about? Consider again Grupo IMSA, the Mexican conglomerate that has begun to pay out its dollar revenues. Suppose that it arranged to pay all of its local suppliers in dollars and that these suppliers then arranged to pay their suppliers with dollars. Whether the government acted or not, a large portion of the economy could end up doing business in dollars instead of pesos.

Unfortunately, the drawbacks of maintaining an illiquid national currency - a higher cost of capital and a less stable and developed domestic financial system - would continue. For this reason, emerging-market countries should take control of their currencies and link those currencies irrevocably to a leading one by adopting either a currency board or the major currency outright, unilaterally or by treaty. The mechanics for doing so are surprisingly simple. Indeed, the cost of replacing one currency with another could be paid with reserves or with loans obtained from international markets. Argentina, for example, would need about $15 billion to replace the peso with the dollar.

At the same time, to provide a viable competitor to the dollar, policy makers in Europe, Japan, and other industrial areas should enhance the desirability of their own currencies. First of all, that means pursuing stable monetary policies. Policy makers should also establish credible and powerful supervisory bodies that ensure the protection of investors and the transparently fair operation of markets. In addition, they should lift restrictions inhibiting innovation and the deepening of markets, embrace standard financial reporting and accounting practices, and recognize that manipulating a currency to achieve the monetary-policy goals of their own country or union is at odds with establishing that currency as a pure medium of exchange.

Yet not every country will want its currency to become an international medium of exchange. Global status carries risks as well as benefits. The benefits include greater liquidity, a lower cost of capital, the elimination of currency risk, higher returns for domestic savers, and seignorage fees for the national government. The potential costs include loss of trade competitiveness because of demand for the currency, greater exposure to international upheavals, and conflicting objectives of the central bank. US Federal Reserve Chairman Alan Greenspan must conduct monetary policy on the basis of US national interests, but his actions have a powerful impact on global markets. As the world's sole remaining central banker, he would have to perform an even more delicate balancing act. Offsetting these risks and benefits for the good of market participants would thus become part of the policy makers' agenda.

The economic case for moving toward a global currency is clear. As markets integrate, the advantages of using a common currency will only increase. Whatever the anxieties over the loss of sovereignty and nationhood, policy makers should encourage public debate on the merits of moving toward fewer and stronger global currencies.

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