Globalization has made the world a smaller place. A financial crisis in an advanced market economy like that of the United States or the European Union or even a stock market collapse in China, can send shock waves throughout the world. One way to assess the impact of these economic forces is to look at capital flows across countries, as well as currency exchange rates, says Eswar S. Prasad, Dyson School of Applied Economics and Management, who studies international finance. “We live in a closely connected world where trade and financial flows among the emerging market economies, and also between advanced and emerging market economies, are rising. I take a global perspective in a lot of my research, especially the consequences of globalization and how to improve the cost-benefit trade off.”
Lately, Prasad’s research has focused on currencies. “Although exchange rates might seem an abstract concept, currency values matter a great deal to all of us in our day-to-day lives,” he says. “What happens to the dollar, for example, affects the economic wellbeing of United States citizens, through its impact on inflation, employment, interest rates, and much more. But in addition, what happens to the dollar also has ramifications for the rest of the world.”
The Dollar in the World Economy
The interconnectedness of global markets and the importance of the dollar were highlighted during the 2008 global financial crisis, when the weakening of the United States housing market led to a crisis in United States financial markets. This, in turn, precipitated troubles in international financial markets and led to deep recessions in countries across the world. Prasad’s interest in exploring the dollar’s role in global finance during the 2008 crisis and afterward led to his book, The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance (Princeton University Press, 2014). “I assumed that in the aftermath of the crisis, the dollar’s role in global finance would have been weakened,” Prasad says. “After all, the U.S. was where the crisis started. And after the crisis hit, the U.S. Federal Reserve increased the supply of dollars, even as the U.S. federal government ran up a huge amount of debt. When a country does these things, it usually results in a crisis of confidence among investors who flee from that country’s bond market, and that causes the value of the currency to fall. So you would think that, after 2008 the dollar should have lost ground both in terms of value and in prominence in the world economy.”
Surprisingly, Prasad discovered this was not the case. Instead, the global financial crisis had strengthened the dollar’s role as the premier safe haven currency, one that investors expect will retain its value or even increase its value in times of market turbulence. “Here’s the paradox,” Prasad says. “The one place investors worldwide instinctively turn to for safety in times of great uncertainty is the U.S. government bond market. So even though the United States was the epicenter of the turmoil that released havoc on global financial markets, the net result was that money flowed into U.S. Treasury securities because people still saw it as the safest place to put money.”
“If there were a serious rival to the dollar, there would be reason for concern about the dollar losing dominance.”
Why do investors trust the United States so much and view the country’s bond market so favorably even when circumstances seem to call for caution? Prasad concluded that the United States has a set of factors that make it singularly attractive to investors. “Not only does the U.S. have the biggest economy in the world and the largest and deepest financial markets,” he says, “but it also has a unique institutional framework that engenders the trust of foreign investors.” The framework is made up of an open and transparent government with institutionalized checks and balances; the primacy of the rule of law where even the government has to play by the rules or be taken to court; and an independent central bank, the Federal Reserve, which foreign investors trust to preserve the value of the dollar. Backed by those institutions the United States dollar came out of the global financial crisis in good shape. “The dollar remains, by far, the dominant global reserve currency,” Prasad says.
The Chinese Renminbi
Fresh from his book on the dollar’s dominance, Prasad decided to tackle the Chinese currency, known as the renminbi, in his next book, Gaining Currency: The Rise of the Renminbi (Oxford University Press, 2016). The renminbi was pushing its way to prominence in the mid-2000s, at the same time the euro looked as if it might challenge the dollar’s primacy in financial markets. After the 2008 global financial crisis, the euro was weakened considerably, but the renminbi was still fairly robust.
“The Chinese economy is the second largest in the world,” Prasad says. “It’s about two-thirds the size of the U.S. economy and contributes even more to the growth of global gross domestic product. China has been making it easier for capital to flow into and out of the country, too. So there’s a sense that maybe the renminbi will become a serious rival to the U.S. dollar.”
In his book, Prasad argues that the renminbi could start to gain more importance in international markets if China plays its cards right. That would mean putting in place the right kind of market-related reforms to strengthen the Chinese economy. If China continues to grow and reform, the renminbi might also become a significant reserve currency, one held by foreign central banks as a means to pay off international debt obligations or to influence their domestic exchange rate.
“But that brings up a key question that is related to the theme of my previous book,” Prasad says. “Will the renminbi ever be considered a safe haven currency that can rival the dollar? I think that’s highly unlikely because the factors that cause foreign investors to trust the United States do not seem possible in China. The Chinese government has indicated that it’s going to pursue some economic reforms, but has also made it clear that to foster a more open form of government, freedom of expression, the rule of law, and independent central bank are completely off the table.”
In light of the recent presidential election in the United States, is it possible that investors will become less confident about the dollar? “We’ll have to wait and see,” Prasad says. “If there were a serious rival to the dollar, there would be reason for concern about the dollar losing dominance. But even if the U.S. were to lose some of the trust of investors, there isn’t obviously another place for them to go. On the other hand, if the elements of the U.S. institutional framework that collectively underpin the trust of foreign investors become weakened in the coming years, then we would be in a different state of the world. The true test of my thesis about the continued dominance of the U.S. dollar in global finance is now at hand!”