Siddharth Vashishth

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Why is USD so dominant? EPGDIB 2018-18

The Rise of the U.S. Dollar

When World War I broke out in 1914, many countries abandoned the gold standard to be
able to pay their military expenses with paper money, which devalued their currencies.
Three years into the war, Britain, which had steadfastly held to the gold standard to
maintain its position as the world’s leading currency, found itself having to borrow money
for the first time.
The United States became the lender of choice for many countries that were willing to buy
dollar-denominated U.S. bonds. In 1919, Britain was finally forced to abandon the gold
standard, which decimated the bank accounts of international merchants who traded in
pounds. By then, the dollar had replaced the pound as the world’s leading reserve.

World War II and the U.S. Dollar

As it did in World War I, the United States entered World War II well after the fighting had
started. Before it entered the war, the United States served as the Allies’ main proprietor of
weapons, supplies, and other goods. Collecting much of its payment in gold, by the end of
the war, the United States owned the vast majority of the world’s gold. This precluded a
return to the gold standard by all of the countries that had depleted their gold reserves.

The Dollar and Bretton Woods

In 1944, delegates from 44 Allied countries met in Bretton Wood, New Hampshire, to come
up with a system to manage foreign exchange that would not put any country at a
disadvantage. It was decided that the world’s currencies couldn’t be linked to gold, but they
could be linked to the U.S. dollar, which was linked to gold. The arrangement, which came
to be known as the Bretton Woods Agreement, established that the central banks would
maintain fixed exchange rates between their currencies and the dollar. In turn, the United
States would redeem U.S. dollars for gold on demand. Countries had some degree over the
currencies in situations where their currency values became too weak or too strong relative
to the dollar. They could buy or sell their currency to regulate the money supply.

Standing on Its Own as the World’s Reserve Currency

As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the
world’s reserve currency, backed by the world’s largest gold reserves. Instead of gold
reserves, other countries accumulated reserves of U.S. dollars. Needing a place to store
their dollars, countries began buying U.S. Treasury securities, which they considered to be a
safe store of money.
The demand for Treasury securities coupled with the deficit spending needed to finance the
Vietnam War and the Great Society domestic programs caused the United States to flood
the market with paper money. With growing concerns over the stability of the dollar, the
countries began to convert dollar reserves into gold. The demand for gold was such
that President Richard Nixon was forced to intervene and delink the dollar from gold, which
led to the floating exchange rates that exist today. Although there have been periods
of stagflation–high inflation and high unemployment–the U.S. dollar has remained the
world’s reserve currency.
Why have most countries have elected to hold the bulk of their reserves in USD? To fulfil
this role, a country has to have:
 large, liquid financial markets capable of taking huge investments (there are
currently at least $6.3tn – that’s trillion dollars -- in reserves held in USD, and
probably closer to $7.2tn);
 a reputation for safety and rule of law, so that other countries are willing to
invest billions and billions of dollars in that country’s government securities; and
 a willingness to run current account deficits indefinitely, since that’s the
counterpart of a financial account surplus.
I think you’ll find that at the moment, there is only the US that fits all three criteria, and I
don’t see any other country volunteering to take its place any time soon.
What other country’s bond market could take even half that amount?
 Only Japan has a big enough bond market, but they have shown zero interest – in
fact significant negative interest – in having their currency play this role. That’s
because they insist on running a current account surplus, so the last thing they
want is inflows on the financial account. They’ve gotten upset before when
foreign central banks started buying their bonds and pushing up the value of the
yen.
 The Chinese government bond market is also large and growing, but of course
China has an estimated $1tn or more in USD reserves – where can it put that
money besides USD? Plus of course the problem again of the current account
surplus.
 And the EUR can’t take over that role, because the bond markets there are too
fragmented - there are only national bond markets, not one large Eurozone bond
market. The biggest EUR bond market is Italy, which nobody particularly wants to
hold nowadays. Plus the ECB has bought a considerable percentage of the
outstanding bonds, meaning it would be difficult to move the funds into EUR
without causing major disruption of markets and dreadful price movements. And
again, there’s the current account problem: Germany’s economy is dependent on
exports, so they might not like the appreciating currency that goes along with a
major reserve role.
On the contrary, most countries fight to prevent their currency from being held as a major
reserve currency, since that causes the currency to appreciate, exports to fall, dampens
growth, and causes unemployment.
You see, in order to accumulate foreign exchange reserves, the rest of the world buys US
financial assets — mostly bonds. This means the US runs a financial account surplus (surplus
in this terminology means net money coming in.) But if a country runs a financial account
surplus, by definition it has to run a current account deficit (unless the government
intervenes like crazy, as in China). That’s because the money coming in has to equal the
money going out. Money coming in to buy US bonds gets recycled when US consumers buy
foreign goods.
Internationalization of Rupee

The argument for internationalizing Rupee include benefits availed by any currency which is
internationalized. These include currency gains for importers and exporters, lower
borrowing costs for domestic borrowers and financial institutions and benefit of seigniorage
for the government. But the bigger argument for the internationalization of Rupee lies in
the progress of the Indian economy. Literature suggests that economic size, the
sophistication of the domestic financial market and stable macroeconomic policies
(especially low inflation) ought to be important determinants of currency
internationalization, and empirical evidence is generally supportive (Chey, 2013). India has
made a lot of progress against some of the parameters which was also evident in the
evolution of international currencies over the last century, including the rise of the U.S.
dollar in the 1920s and 1930s, the Japanese yen, Deutsche mark and the Euro more
recently. This further builds a case for internationalization of INR
Some of the preliminary steps which have already been taken by Reserve Bank of India to
liberalize the foreign exchange markets and develop the bond markets include allowing
cancellation and rebook of foreign contracts, introduction of INR billing, increasing the FII
debt limit, allowing issuance of INR bonds etc. However, some of the other steps which RBI
could take in this direction could be as follows:

Liberalization of Currency Market: These would include allowing cancellation and rebook of
FX contracts for foreign institutional investors (FII), relaxing trading restrictions for domestic
and foreign banks by allowing them to trade in exchange traded contracts forwards and
options for their own books and developing a deeper options market.

Deregulation and Deeping of Bond Markets: CRISIL estimates that India will need approx USD
650 billion for infrastructure till 20201. Use of Corporate Bonds for the LAF, developing
Exchange Driven markets for Interest Rate Swaps etc could help.

Increased trade flows in the currency: While RBI has a guideline in place to support exports
in INR, from a more strategic point of view, it makes sense for India to have local currency
invoicing arrangements mostly with countries with which it enjoys a surplus in bilateral
trade. A local currency swap arrangement with countries from whom India imports will only
encourage more imports.

Having said the above, the roadmap to internationalization of Rupee also has many
challenges. China, runs large current account surpluses but India has generally been a current
account deficit country. In view of the large current account deficit, the exchange rate of the
rupee is susceptible to the influence of large capital movements, especially during crisis
periods. Strong and deep bond and currency markets along with robust regulatory and
settlement systems would need to be in place. Further to denominate the trades in a common
currency other than USD with the adjoining countries in Asia a certain degree of financial
market integration is essential. Asian countries have not yet shown the degree of integration
as displayed by Europe. There is a definitely more scope for greater cooperation.
One of the important drivers for internationalization of a currency is the country’s share in
global merchandise and commercial services trade. India’s percentage share in the global
trade is still on the lower side and it limits the pricing ability of domestic businesses in Indian
Rupee. Moreover, the share of Indian Rupee in the Global foreign exchange market turnover
at present is also very low. Internationalization of Indian currency would also require full
capital account convertibility. As a policy, we have followed a gradual and cautious
approach in opening up the capital account. The capital account is being progressively
liberalized in accordance with the evolving macro-economic conditions and requirements of
the Indian industries, individuals and financial sectors. Government has been taking
measures to promote the internationalization of the Indian Rupee. Recently, a framework
was put in place for issuance of Rupee denominated bonds overseas by Indian corporate.

Internationalisation of Indian Rupee Internationalisation of a currency is a policy matter and

depends upon the broader economic objectives of the issuing country. There are various
policy issues involved, like the extent of capital account liberalisation. There is a need for
caution in approaching liberalisation in practice. Capital account liberalisation in the
presence of macroeconomic imbalances is as likely to hurt as to help. Hence sequencing of
reforms plays almost a decisive role in determining the impact of capital account
liberalisation. India’s approach in this context has been reflected in a full but gradual
opening up of the current account but a more calibrated approach towards the opening up
of the capital account. While foreign investment flows, especially direct investment is
encouraged, debt flows in the form of external commercial borrowings are generally subject
to ceilings and with some end use restrictions. India, at present, does not permit rupee to
be officially used for international transactions except those with Nepal and Bhutan
(Bhutanese Ngultrum is at par with the Indian Rupee and both are accepted in Bhutan. The
Indian rupee is also accepted in towns of Nepalese side of Nepal-India border). Non-
residents cannot hold rupee assets and more importantly, liabilities denominated in Indian
rupee, beyond certain limits. For instance, no individual FII-sub account can hold more than
10 per cent of paid up capital of an Indian company. All FIIs, taken together can invest no
more than US $ 3.2 billion in government securities and treasury bills. In case of corporate
debt, this limit is US$ 1.5 billion. Non-residents cannot hold tradable rupee balances.
Similarly, restrictions have been imposed on the domestic and international banks with
respect to transactions in Indian rupee. The funds in vostro accounts (accounts in Indian
rupee held by foreign banks) held by non-resident banks can be used only for the purpose of
transactions with Indian residents.

What China has done to internationalize Renminbi (RMB)

Since the late-2000s, the People's Republic of China (PRC) has sought to internationalize its
official currency, the Renminbi (RMB). RMB Internationalization accelerated in 2009 when
China established the dim sum bond market and expanded Cross-Border Trade RMB
Settlement Pilot Project, which helps establish pools of offshore RMB liquidity. The RMB
Qualified Foreign Institutional Investor (RQFII) quotas were also extended to other five
countries — the UK (extended 15 October 2013), Singapore (22 October 2013), France (20
June 2014), Korea (18 July 2014), Germany (18 July 2014), and Canada (8 November 2014),
each with the quotas of ¥80bn except Canada and Singapore (¥50bn). Previously, only Hong
Kong was allowed, with a ¥270bn quota.
The launch of Shanghai–Hong Kong Stock Connect (SSE and HKEx) in November 2014
embarked China upon the next stage of internationalization. In January 2015, the Chinese
Premier Li Keqiang announced a planned second Stock Connect linking Shenzhen and Hong
Kong exchanges. The China's RMB internationalization and foreign exchange (FX) reforms
are evolving rapidly and full convertibility is expected over the next couple of years. In 2014,
Hong Kong removed the conversion limit of 20,000 RMB per day for its residents.

2007: Creation of Dim Sum bonds and offshore RMB bond market
The majority of dim sum bonds are denominated in CNH, but some are linked to CNY (but
paid in USD). In July 2007, dim sum bonds worth a total of US$657 million were issued for
the first time by the China Development Bank. These financial assets were issued to foreign
investors in renminbi, rather than the local currency.
In June 2009, China allowed financial institutions in Hong Kong to issue dim sum bonds.
HSBC was the first institution that issued these. In August 2010, McDonald was the first
corporation that issued dim sum bonds. In October, the Asian Development Bank (ADB)
raised a ¥1.2bn 10-year bond, and became the first supranational agency which issued dim
sum bonds and also the first issuer listed in the HKSE. The dim sum bond market grew 2.3
times from 2010 (¥35.8bn) to 2013 (¥116.6bn), with an outstanding amount at the end of
2013 of RMF 310bn.
In August 2012, China and Taiwan signed a memorandum of understanding on new cross-
strait currency settlement, and in March 2013, China Trust Commercial Bank became the
first to issue RMB bonds in the Taiwan market (Formosa bond). In November, CCB (Hong
Kong) issued a Formosa bond after mainland banks became eligible.

2008: Cross-Border Trade RMB Settlement Pilot Project

Phase I: on 24 December 2008, China allowed import and export in RMB between (i) Yunnan
province and countries in GMS including ASEAN countries (ii) Guangdong province and Hong
Kong and Macau.
Phase II: on 1 July 2009, China officially announced regulation on the RMB Settlement Pilot
Project and opened up Shanghai and four cities in Guangdong (Guangzhou, Shenzhen,
Zhuhai and Dongguan) with Hong Kong, Macau and ASEAN countries.
On 1 July 2010, it expanded to Mainland Designated Enterprises (MDE) in 20 pilot areas (4
municipalities [Beijing, Tianjin, Chongqing, Shanghai], 12 provinces [Liaoning, Jiangsu,
Zhejiang, Fujian, Shandong, Hubei, Guangdong, Hainan, Sichuan, Yunnan, Jilin, Heilongjiang]
and 4 autonomous regions [Guangxi, Inner Mongolia, Xinjing Uygur, Tibet]), which allow
cross border payments of current account items with any country in the world.
By 2014, RMB cross-border trade settlements reached RMB 5.9 trn making a 42.6% (year-
over-year) increase, which represents 22% of China's trading volume.

2009: Offshore Renminbi (CNH)

Since 2009, China has signed currency swap agreements with numerous countries and
regions such as Argentina, Belarus, Brazil, Canada, ECB, Hong
Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea, Thailand, the United
Kingdom, Uzbekistan and Tajikistan.
On 17 August 2010, PBoC issued a policy to allow Central Banks, RMB offshore Clearing
Banks and offshore Participating Banks to invest excess RMB in debt securities or in the
onshore Inter-bank Bond Market. In November 2010, China and Russia began trading in
their own currencies, abandoning the United States dollar as the medium of exchange in
bilateral trade.[16] This was soon followed by Japan in December 2011. On 19 December, the
direct trading of yuan against Thai baht was launched in CFETS (Interbank FX trading system)
in Yunnan and on 31 December, PBC released the Announcement of the People’s Bank of
China Concerning the Implementation of Measures for the Pilot Program of Allowing Fund
Management Companies and Securities Companies Approved as Renminbi Qualified Foreign
Institutional Investors (RQFII) to Invest in Domestic Securities Market. The RQFII program
allows RMB investment funds to be set up in Hong Kong and invest in mainland China's
securities markets.
In June 2013, the United Kingdom became the first G-7 country to set up an official currency
swap line with China.
As of July 2014, 25 countries have signed the RMB Bilateral Swap Agreement with PBoC with
total facilities of over ¥2.7 trillion.

2013: Shanghai Free Trade Zone (SFTZ)

The Shanghai Free-Trade Zone (SFTZ) was launched on 29 September 2013 with key
implementation details announced in May 2014. The SFTZ was being used as a test ground
for trade, investment and financial reforms, before the roll out to nationwide. The RMB can
flow freely between Free Trade Accounts (FTA), non-resident onshore accounts and offshore
accounts. Transactions between resident onshore accounts outside SFTZ and FTA with the
same entity are also allowed, provided they do not involve capital account transactions that
are not yet approved by PBoC and SAFE.

2016: Cross Border Financing

Effective from May 3, 2016, PBoC expanded its pilot program for macro prudential
management of cross-border financing from FTZ to nationwide.

2019: QFII and RQFII lifted

In September 2019, SAFE announced that the QFII and RQFII quotas are revoked. RMB's
share as a global payment currency ranked #5 as of August 2019 with market share of 2.22%
preceding by USD (42.52%), EUR (32.06%), GBP (6.21%) and JPY (3.61%).

The People's Bank of China (PBOC) renewed a reciprocal currency swap agreement with its
Ukrainian counterpart earlier this week, allowing the exchange of local currencies between
the two central banks for up to 15 billion yuan ($2.17 billion), or 62 billion hryvnias, for
three years.
Aiming to facilitate bilateral trade and investment with other countries, China has
established or expanded such currency swap agreement with an increasing number of other
economies.
The yuan's global push generally started from pilot yuan settlements in cross-border trade
in 2009, as China, a major trading nation, looked to lower transaction costs and smoothen
foreign trade and investment.
China has taken measures to further reduce unnecessary restrictions and improve the policy
framework on the cross-border use of the currency, including launching crude oil futures in
Shanghai, easing restrictions on QFII and RQFII programs for foreign institutional investor

These developments aside, China's Belt and Road Initiative (BRI), connecting the Asian,
European, and African continents, is an important platform for promoting RMB as a global
currency through modernizing trading routes with infrastructure development along the
Belt and Road.
China has pursued payments for imported crude oil in yuan. Both Russia and Angola, the top
suppliers of crude oil to China, along with Saudi Arabia, have shown interest for oil trade in
yuan. Moreover, the central banks of Turkey and China concluded a Turkish lira-Chinese
renminbi swap deal on Nov 30 2016, using both their local currencies in a bilateral trade and
investment deal worth $132 million.