An Indian view on dollar domination

Business Standard, 10 July 2023

The United States was at the upper edge of per capita GDP among nations of the world by 1820. By 1920 it was the biggest GDP of the world. Prior to Nazi rule in Germany, there were no capital controls anywhere, so the size of the US financial system attracted investing and fund-raising activities from across the world. This created a predominant role for the US dollar in global affairs. There is a lot of hand-wringing about the domination of the dollar and attempts to `dethrone' the dollar, but any big decline in the role of the USD is unlikely. This shapes how we think about the place for the rupee and the place for India in the global economy.

Why is the USD so important?

A currency is sometimes viewed as "international" in the context of international trade (currencies used in invoicing for trade transactions) or the official reserves portfolio (currencies held on the balance sheet of central banks). The bulk of what happens on the currency market, however, is international finance. Most of the activity on the currency market consists of capital account transactions.

The US dollar is the most important vehicle of this international finance. It is useful to envision this at the level of one private decision maker and then at the level of a macroeconomy. A private person has money to invest: what would she do? New York and London are the greatest collections of institutional capacity to find global investment opportunities. Or, a private person wishes to raise capital. New York and London are the greatest pools for fund-raising. The bulk of this fund-raising or investing is denominated in the USD.

A network effect is at work: Suppliers of capital operate in USD because the users of capital operate in USD, and vice versa. This is undergirded by the USD bond-currency-derivatives nexus which has the best liquidity in the world. This is also undergirded by institutional quality in the US: A non-resident holding assets in New York does not worry about inflation, taxation, capital controls, or demonetisation.

These are the factors that created USD domination, after the first world war. This arrangement is convenient for persons who keep score in USD, as their currency risk is reduced. For everyone else, international activities take place in USD but there is currency risk when expressing back into home currency. A sophisticated array of deep currency derivatives markets are required to make the best of this world.

Savings-investment imbalances in one country at a time

In a macroeconomic perspective, the gain from capital account openness is the ability to have savings diverge from investment. In some years, there is optimism about India, domestic investment is on fire, and investment exceeds savings. At such times, we run a current account deficit, i.e. we import capital from the global financial system. Conversely, when there is pessimism in India, and investment lags savings, we export capital into the global financial system.

The term `global financial system' here refers to the advanced democracies, all of which have open capital accounts. The institutions and policy arrangements of these countries are giving India the privilege of this balancing service - to absorb or supply capital based on the state of optimism in India. The bulk of this activity takes place through USD denominated financial contracts, and the US economy plays a major role in supplying this balancing function.

Revisionist views on the USD

State actors at the receiving end of Western sanctions (such as Iran, Russia or North Korea) and state actors envisioning such conflicts in the future (such as China) resent the possibilities for economic statecraft that flow from the economic domination of the advanced democracies. These concerns have become heightened in `the third globalisation', where participation in globalisation has been made conditional on amity with the core. Revisionist powers have sought pathways to do business without routing through the West. These possibilities are, however, limited, as is shown by a quick tour of the three challengers:

Challenger 1: The Japanese Yen
In the 1990s there was one big state-led campaign to dethrone the USD, by the Japanese state. Japan had a lot of strengths in this: They were the second largest economy in the world, they had good institutions, and they commanded confidence from the world on the possibilities of inflation, taxation and capital controls. They tried a big `industrial policy' push to establish the Japanese Yen as a major international currency. This attempt failed, and the Yen remains a small player when compared with the importance of the USD.
Challenger 2: The Euro
Then came the rise of the Euro. The Euro is now an important currency, and in some respects the EU rivals the US as an economic powerhouse. The Euro has made gains as an international currency and it is likely that it will become more important in the future with more countries adopting the Euro. However, the Euro remains a small player when compared with the importance of the USD.
Challenger 3: The Chinese Renminbi
The Chinese government has launched a big program of using state power to try to push the RMB as an important currency on a global scale. However, China has an even weaker hand of cards when compared with Japan in the 1990s. China has an Indian-style administrative system of capital controls. The Chinese central bank primarily pegs the RMB to the USD, so it is not even a true independent exchange rate of its own right. China's institutional quality on questions of inflation or taxation does not inspire confidence. Unlike Tokyo, it does not have an attractive financial system where non-resident investors or fund-raisers might like to partake. Hence, this ambition of the Chinese state is likely to go unfulfilled.

An Indian perspective

For India, there are two distinct aspects at work:

  1. India can and should become a powerhouse of internationalised financial services production. The pathway to this lies in the Percy Mistry `Mumbai as an international financial centre' (2007) report, and in Justice Srikrishna's `Financial Sector Legislative Reforms Commission' (2011-2014). This work program does not require the rise of the INR as an international currency: it primarily involves interoperating with the existing global economic system. In this sense, India's interests lie with the status quo.
  2. What about the role of the INR in the world economy? Policy-makers should aspire to restore the pre-independence environment where the INR was trusted and used all over South Asia, in South-East Asia, in the Middle East and in East Africa. This requires a 50 year run with good institutions on display on questions of inflation, taxation, capital controls and demonetisation. On inflation, an institutional commitment to 4% inflation was made in February 2015, now we need to achieve a 50 year block where inflation has a 4% average and low volatility.

Back up to Ajay Shah's 2023 media page
Back up to Ajay Shah's home page