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The US dollar is not just the official currency used across the United States of America but it is also the world’s primary reserve currency. For over a half century the US dollar has been the dominant vehicle currency which is used in international trade and is considered to be most governments’ first choice of currency to hold in their foreign exchange reserve.
The global financial crisis which occurred in the year 2008 originated in the United States of America. The falling housing prices led to serious problems in the US subprime scene, triggering problems at major US financial institutions leading to a severe credit crunch and affecting the global economy. The economic crisis was so severe that it shook the world economy and was considered to be one of the worst financial crisis to have occurred after the Great Depression.
The economic crisis cast a cloud on the future of United States as the chief economic power in the post-crisis period and the role of US dollar as the most dominant key currency. Even though the financial crisis originated in the US and decreased the command of US dollar as an international currency, the dominance of US dollar as the global reserve currency was barely affected.
This is fundamentally due to the deep, wide and liquid financial market available for the dollar-denominated instruments and the extensive network externalities/wide acceptance. Since the majority of the world’s foreign exchange transactions involve the US dollar, it glories in a large market on a global scale. Foreign investors are ready to invest in the US dollar-denominated financial assets which are allowing the US government and households the privilege to maintain high levels of consumption through cheap borrowing. Despite the rise in the US federal debt, foreign investors have gradually increased their share of the portion of that debt. It has led to strengthening of US dollar as the dominant reserve currency.
Application of Exchange rates theories – Purchasing Power Parity Model:
Purchasing Power Parity refers to the number of units of a nation’s currency that is required to buy the same quantity of goods or services in the domestic market. This technique helps us to estimate what exchange between any two nations is needed to arrive at the accurate purchasing power of the currencies in their respective countries. PPP concept is based on the Law of One Price.
As per the PPP theory, the notion is that one dollar should buy the same amount in all countries, implying that in the long-run the exchange rate between the two nations should move towards the rate that balances the prices of an identical basket of goods or services in the respective countries. It can have an impact on the domestic currency and the supply and demand of the particular goods considered.
We can understand the PPP model better by examining the scenario. In 2015, China’s economy produced $19.13 trillion based on PPP. The European Union produced $19.1 trillion and the United States produced $17.9 trillion. The figures reflect the value of the goods and services produced within the respective nations in that particular year. The above-mentioned GDP of China and the European Union at Purchasing Power Parity exchange rates is nothing but the sum of the value of all goods and services produced in the respective nations valued at prices prevailing in the United States. It is the measure that most economists and financial experts consider when looking at per capita welfare and when they compare living conditions of people across countries.
Theory of Exchange rates – Asset Market Model:
The Asset Market model suggests that a currency will be in greater demand and appreciate in value if the fund flow into other financial markets like equity, bonds, etc. increases. This theory holds good in case of developed nations like United States, Japan, the European Union where majority investors hold their funds in investment products like stocks, bonds and thus reducing the funds that are exchanged as a result of imports and exports.
During the global economic crisis, many experts said that the US dollar could no longer be the world’s reserve currency due to its ever-increasing current account deficit. They said the high debt level would give rise to inflation, affect interest rates and the overall economy of the nation resulting in the withdrawal of funds from US equity and bonds market by the foreign investors. Although the US dollar initially dropped against Euro, however, later it bounced back and continued its winning streak globally. The massive size of the US financial market and the safe-haven nature of the government bonds provided to the investors fueled the rise of the dollar and hence it has strongly continued as the reserve currency.
The Asset market model is a fairly new and needs time to establish the relationship between a nation’s equity market performance and currency performance. As stated above, during the global financial crisis the relation between the financial market and currency performance can become very atypical.
Impact of recent growth of Chinese economy on US dollar
China is the world’s largest manufacturing economy as well as the largest exporter of goods. It has achieved an uncommon economic growth over the past decades. It plays a significant role in the global economy scenario since it is the second largest economy and the second largest importer of both goods and services. Any change in the Chinese economy be it positive or negative can influence the economy on a global scale.
The steady growth of the Chinese economy throughout the years proves that it has the potential to be the world’s largest economy in the near future. Traditionally manufacturing and construction activities were the major growth engines of the Chinese economy, but now the service economy is also playing a prominent role to take the economy forward. It is a remarkable feat by any nation to have a non-bouncy and consistent growth rate in the variable global context. In 2015 China’s economy produced almost $ 19.4 trillion based on purchasing power parity. In the same ranking, the European Union and Unites States occupied the second and third places with the production of $ 19.1 trillion and $ 17.9 trillion respectively.
Manufacturing has primarily been the backbone of China’s economic expansion. Its growth strategy is to assemble and sell cheap goods in the global market. A large portion of these manufactured goods is for foreign businesses including US firms. The raw materials are shipped to China, and once the final product is built using the cheap labour available, it is shipped back to the United States. Consequently, a large quantity of the country’s exports is produced by American companies.
China is among the major foreign holders of the US Treasury notes, bonds. As of October 2016, China owned almost $ 1.1 trillion in US debt, which is about 30% of the public debt held by foreign countries. China influences the United States dollar by loosely pegging its currency – yuan to US dollar. It buys the US debt in order to support the value of the dollar. China undertakes the currency pegging activity to stabilize yuan by fixing its exchange rate to US dollar and thus minimizing the currency risk.
Growth in the Chinese economy in the recent years is something that will bring both challenges and opportunities for markets that are closely related to its economy, like the US economy. Since China has the status of being one of the major export competitors of the United States, any change in the Chinese economy could notably impact the US dollar. Due to the economic growth in China, the large middle-class population will be keen to spend their disposable income resulting in the increase in Chinese imports. Thus the Chinese demand for foreign (including the United States) commodities would increase and companies from the United States will have more opportunity to export goods and services to China. China might start more companies or joint ventures with the United States, thus increasing the number of Americans working for Chinese firms. US companies will face more competition if Chinese brands emerge in the US market.
The rapid economic emergence and development as a major economic power have boosted the confidence of Chinese leadership in its economic model. The consistent growing economic power has made it a crucial and influential player in the global economy. China has been adopting the strategy of devaluing its currency yuan in order to boost its exports and gain a stronger foothold in competitiveness. This devaluation will make Chinese goods less expensive and imports to China more expensive. A weaker Chinese currency means that the goods and services originating from the United States become more expensive overseas and this will hurt the overall US exports. Thus the growth of Chinese economy has both pros and cons for other nations’ economy.