The not-so-exorbitant privilege
By Richard Dobbs and David Skilling
17 December 2009
Exchange rate movements over the past year have had a substantial impact on the competitiveness of countries and of companies. Increased exchange rate volatility and uncertainty about future movements are also complicating company investment decisions. The way in which the global exchange rate system evolves is therefore an important issue for boards and executives. We believe that key to understanding this evolution is an assessment of the system’s costs and benefits to the economies of those countries that issue reserve currencies. On this basis, is it likely that the United States will continue to support the dollar as the global reserve currency? Will the euro rise to dominance? Is a fundamental redesign of the global exchange rate system toward one based on a basket of currencies, or target zones for exchange rates, likely or needed, as some observers have suggested? And what would be the impact on competitiveness for companies if any of these changes were to happen?
Since the start of the crisis, substantial cross-border capital flows have generated large swings in exchange rates that only partly reflect underlying economic fundamentals. These movements have placed the dollar-centered exchange rate system under real strain. Companies’ ability to compete is being substantially impacted (see sidebar, “Exchange rates and the competitiveness of companies”). Several Asian economies are intervening aggressively to hold their exchange rates down against the dollar to maintain competitiveness. Brazil has recently reacted by imposing a tax on portfolio inflows flooding into its currency. There is a sense that this world of exchange rate volatility is here to stay – in a recent McKinsey survey of executives only 21 percent expect less volatility over the next five years compared with the level of exchange rate volatility their companies have been exposed to in the past two years.1 And central bankers, thinkers, and politicians from Beijing to Moscow—as well as in the United States—are calling for a system that is less reliant on the dollar and on decisions made in Washington.
Despite these pressures, the dollar remains at the center of the global exchange rate system, accounting for one side of 86 percent of foreign-exchange trades and 63 percent of official foreign-exchange reserves.2 The euro, a secondary reserve currency with 27 percent of official foreign-exchange reserves, has grown in importance only gradually.
To inform a perspective on the likelihood of any change in the reserve currency system and the potential implications for company and national competitiveness, the McKinsey Global Institute (MGI) has undertaken an initial analysis to size the costs and benefits to countries issuing a global reserve currency and to understand how these costs and benefits might evolve.3
In the 1960s, France’s then finance minister Valéry Giscard d’Estaing famously accused the United States of enjoying an “exorbitant privilege” because the dollar was the global reserve currency. Today, it is not clear that the United States enjoys much of a privilege at all. Indeed, MGI’s preliminary analysis shows that the benefits from reserve currency status are relatively modest. In a normal year for the world economy, we estimate that the net financial benefit to the United States is between about $40 billion and $70 billion a year—or 0.3 percent to 0.5 percent of US GDP.
So what are the specific costs and benefits of reserve currency status? First, there is seigniorage revenue for the government—the effective interest-free loan generated by issuing additional currency to nonresidents who hold US notes and coins. Seigniorage is estimated to generate annual income of $10 billion.
Second, the United States is able to raise capital more cheaply because of very large purchases of US Treasury securities by foreign governments and government agencies. We estimate that these purchases have reduced the US borrowing rate by 50 to 60 basis points over the past few years. This lower cost of capital benefits households, corporate borrowers, and the government (although it harms US savers). We estimate that this cost of capital benefit is worth about $90 billion to the United States.
However, there is a large downside to the United States acting as a magnet for the world’s official reserves and liquid assets. Greater inflows of foreign capital mean that the dollar exchange rate is higher than it would be without reserve currency status. Third party estimates suggest that the dollar was overvalued by around 5 to10 percent in 2008.4 By harming the competitiveness of US exporters and companies that compete with imports, we estimate that this disparity imposes a net cost of $30 billion to $60 billion.
There are therefore sharp distributional effects associated with reserve currency status. The US government is the single largest beneficiary, gaining lower interest payments on public debt as well as seigniorage revenue. Household and corporate borrowers also benefit. But reserve currency status imposes costs on exporters and sectors that compete with importers. We estimate that these costs reduce employment by 400,000 to 900,000 in these sectors.5
In the “crisis” year that ended June 2009, we estimate that the net financial benefit fell to between -$5 billion and $25 billion. This decline was driven by an additional 10 percent appreciation in the dollar relative to its trading partners due to the “safe haven” properties of the dollar. This appreciation further reduced the competitiveness of export and import-competing sectors in the United States, generating an incremental cost of about $55 billion.
So what might happen to the costs and benefits of reserve currency status in the coming years? A decline in the net benefits of reserve currency status to the United States is plausible. True, the benefit from a lower cost of capital will grow larger as US government borrowing requirement expands. But the United States could face increased economic and employment costs if maintaining primary reserve currency status constrained the depreciation of the dollar needed to stimulate growth. Which of these effects will prove stronger remains uncertain. It may be that other qualitative, factors will prove more significant in determining the balance of costs and benefits.
Many observers would argue that the United States enjoys significant geopolitical and strategic privileges because of its position at the center of the global economic and financial system—along with the policy autonomy that status confers. Specifically, the United States has been able to run larger fiscal deficits and a looser monetary policy because it has been subject to less market discipline.
But the large accumulation of foreign held US debt in recent years has created a potentially significant responsibility for the US government—one that could potentially constrain future US policy autonomy. Specifically, foreign-government holders of US debt will be more forceful in arguing for tighter US monetary and fiscal policy to protect the value of their assets.
However, the relatively modest benefits derived from the dollar’s status as the primary reserve currency makes it less likely that the United States will be willing to pursue policies to meet the implicit responsibilities associated with that status.6 The costs of maintaining a stable currency through tighter monetary and fiscal policy may become more onerous given the economic challenges that the United States faces. The United States may question whether its obligations to the global system outweigh the desire to run relatively loose monetary and fiscal policies as a way of creating jobs and promoting growth. Indeed, global executives increasingly expect that the world will move away from dollar as the dominant reserve currency, with only 18 percent of executives in our recent survey expecting the dollar to remain dominant in 2025.
And will the eurozone want to assume a share of this responsibility? Our analysis shows that the small costs and benefits of the secondary reserve currency status of the euro broadly cancel each other out. Eurozone economies can borrow slightly more cheaply but there are costs associated with an elevated exchange rate. And if the euro were to become a more significant reserve currency over time, these costs would rise.
We have modeled a range of scenarios for the euro—from today’s slow trend toward reserve currency status to an accelerated trajectory in which the euro equals the standing of the dollar by 2020. In these scenarios, we estimate that the cost of capital may decline by about 50 to 100 basis points and that the euro may appreciate by an additional 10 percent compared to current levels. In our ‘dual reserve currency’ scenario, this would generate a small negative income impact of an estimated 0.1 percent of eurozone GDP.
Given that European policy makers are concerned about today’s euro exchange rate, the prospect of a permanently stronger euro is likely to be unattractive. It would impose a particular burden on member states such as Italy, Greece, Portugal, and Spain that are already suffering from the euro’s strength. And export dependent countries like Germany, that sell over half of their exports outside the eurozone, are also exposed in the event of a structural appreciation in the euro. Perhaps unsurprisingly, the European Central Bank is a supporter of the strong dollar policy. And in a November 2009 interview with Le Monde, ECB president Jean-Claude Trichet said that the euro was not designed to be a global reserve currency.7
With the jobs and growth imperatives dominating in the United States—and the eurozone—the main reserve currency issuers may be increasingly disinclined to pursue policies that are consistent with global exchange rate stability. Rather, there may be an “unmanaged” reserve currency system in which the United States and the eurozone follow a hands-off approach—continuing to place much greater weight on the domestic economic agenda in setting policy than on supporting the global system. So although the dollar is not going away as the dominant reserve currency anytime soon, there may not be a firm hand on the tiller.
In the context of a changing global financial system, with substantial global imbalances and reserve holdings as well very larger cross-border private capital flows, an unmanaged reserve currency system may increasingly cause problems. Indeed, such a system has the potential to contribute to greater exchange rate uncertainty and destabilizing shifts in cross-border capital flows that will be hard to manage for policy makers and businesses alike. The stepped up government intervention in foreign-exchange markets is a sure sign of stress. For companies, sharp movements in exchange rates have generated a significant redistribution of resources as, depending on the geography, companies gain or lose profits and market share.
In response, there have already been several proposals for various reforms based on the International Monetary Fund’s Special Drawing Rights (SDRs)—in effect, a basket of currencies—and for other more negotiated exchange rate arrangements that create a multipolar system that shares the burdens and benefits more broadly.8 And there have been several proposals based on the Tobin tax, aimed at curbing excess currency volatility.
We do not yet have a specific view as to the most likely end-point. And it may be that the current system is able to function tolerably well over the next decade or so. But we believe that there is more uncertainty in the reserve currency system than today’s dollar dominance and the lack of a clear near-term challenger might initially suggest.
In particular, the uncertainty about the behavior of the countries at the center of the reserve currency system may lead to greater volatility in exchange rates. It is this prospect of greater volatility that should concern global companies. They may argue that grand schemes about global financial architecture are the preserve of politicians and none of their business, but exchange rates that are substantially out of line with economic fundamentals coupled with currency volatility will generate real economic costs. Whether the world resolves the reserve currency issue or not is therefore very much the business of businesses.
Exchange rates and the competitiveness of companies
Exchange rate movements in the short- to medium-term are driven by global capital movements and are often decoupled from economic fundamentals. Despite this, these movements have become a primary driver of changes in competitiveness between companies operating in different countries.
Over the past decade, the negative correlation of US dollar levels with exports has been clear (Exhibit). The recent appreciation of the euro has impacted many eurozone companies. According to recent ING research, eurozone companies in the third quarter suffered a 27 percent fall in profits, compared to only a 1.2 percent fall for European companies outside the eurozone. The aerospace company EADS, for example, recently attributed a €1.1 billion net income hit for the previous nine months to adverse currency movements.9
And the competitive position of Japanese companies such as Toyota Motor and Sony, relative to South Korean rivals such as Hyundai and Samsung Electronics, has deteriorated as the Korean won has depreciated (as a result of capital outflows) and the Japanese yen has strengthened (because of its safe haven status). The yen is now 60 percent stronger in won terms than its pre-crisis level, currently trading at around 13 won, compared to below 8 in 2007. Observers attribute to this shift, the fact that Samsung Electronics’ third quarter 2009 operating profits were more than twice the combined operating profits of nine of Japan’s largest consumer electronic companies.10
The sharp volatility in exchange rates is also an issue for businesses trying to plan for the post crisis world. As Nissan-Renault’s CEO Carlos Ghosn said recently: “If we have a trend like a currency getting stronger, manufacturers and industry prepare for it. What we do not like is sudden variation.” 11
These statements are consistent with the results from a recent McKinsey Quarterly survey of global business executives.12 The survey indicates that both the level of exchange rates and exchange rate volatility have a large, and growing, negative effect on company profits and investment decision making. Some 21 percent of respondents report that exchange rate uncertainty has reduced their planned investment over the next two years. And 29 percent of respondents report that exchange rates have an “extremely” or “very” significant effect on company profits. 44 percent of respondents believe that the impact of exchange rates on their companies has increased over the past five years. 43 percent of respondents expect exchange rate volatility to increase over the next two years, 27% expect no change while only 21% expect volatility to reduce. These results confirm that exchange rates have and are likely to continue to have a material effect on company competitiveness.
1 “Economic Conditions Snapshot, December 2009: McKinsey Global Survey results,” McKinsey Quarterly, December 2009
2 A reserve currency provides a store of value, a medium of exchange, and a unit of account. Filling these roles makes the currency an attractive investment location for government reserves as well as private-sector use.
3 A discussion paper with a preliminary version of MGI’s reserve currency analysis will be published around December 17, 2009. Read it and subsequent work on the issue at www.mckinsey.com/mgi.
4 William R. Cline and John Williamson, New Estimates of Fundamental Equilibrium Exchange Rates, Peterson Institute for International Economics, Policy Brief 08–07, June 2008.
5 This reduction in jobs does not necessarily result in unemployment of the same scale because some of the people displaced will find alternative employment in other sectors.
6 This debate has already commenced, notably in a recent essay by C. Fred Bergsten, ”The dollar and the deficits: How Washington can prevent the next crisis,” Foreign Affairs, November/December 2009.
7 “ECB’s Trichet: Euro not designed as reserve currency,” Wall Street Journal, November 17, 2009.
8 See “Reform the international monetary system,” a speech by Dr. Zhou Xiaochuan, governor of the People’s Bank of China, March 23, 2009; and Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, United Nations, September 21, 2009.
9 Peggy Hollinger and Pilita Clark, “EADS hit by weak dollar and airlines downturn,” Financial Times, November 17 2009.
10 Evan Ramstad, “Samsung profit more than triples,” Wall Street Journal, October 29, 2009.
11 Richard Milne, “Carmaker backs government aid,” Financial Times, November 17, 2009.
12 “Economic Conditions Snapshot, December 2009: McKinsey Global Survey results,” McKinsey Quarterly, December 2009.
Words from CEO> “Dollar down Exports Up” will improve the trade imbalance. Morever, under the new divison of labour, much of US trade and services cannot be traced in a systematic mechanism. E.g. US is a popular country for overseas students and much of incomes derived from Education Sector is never correctly reported in statements of any US government. With the new knowledge economy in place in advanced and developed economics, there are so much indirect incomes and benefits derived from knowledge based value added processes. The true picture is of the current status is never accurately reflected when the services industries (such as Education, Health, other professional services) of US derived from overseas exceeds almost of 90% of the whole economy.
With increasing saving rate of general US consumers, the money is back to the banking system as well as other financial institutions. The repayment of emergency of Government supported funds for major US banks will imply a new dimension for the growth of US economy in sectors like infrastructure in wind power generation as well as advance power grid systems of which now the hot topics in the White House connected with the World discussions of zero/lower carbon emission that held in Copenhagen, Netherlands. Our predictions would be a more greener environment and higher concerns for quality livings in terms of air and water quality. It is likely that new industries like water conservation and new types of electric cars plus related solar powererd/wind powered systems will replace traditional energies such as gasoline and alternative energies. It is also anticipated that new innovations within current industries will bring new imaginative product and services that US consumers have never thought of. Imagine that you can fly on a solar mini-plane by the end of 2010. Of course, the biggest challenges of that innovations are how to position and educate consumers and corporations of emerging markets such China, India as well as Brazil. These markets are important that US-led innovation companies must expand channels and business partners in these market timely in order to capture the growth opportunities in these key markets.