Friday, March 8, 2013

HKMA - The US dollar as a Vehicle Currency for Trade and Investment in Asia

The US dollar has played an important role in intermediating trade and investment in Asia. In particular, exporters in the region have a tendency to retain their earnings in US dollar assets. There are a number of reasons for this.

The choice of the currency to be used in the payment and settlement of such external transactions as imports and exports of goods between two economies, each with its own currency, is a matter between those party to the transaction. If they are both happy with it and it is not against any domestic law or regulation, they can choose to barter without the use of a currency, or use any monetary unit such as gold or a third currency. In practice, most conducting international trade choose to use either one of the two currencies of the two economies, or an internationally recognised currency, and the most popular of which is the US dollar.
While the choice is theoretically open to those involved, in practice a freely convertible currency, and a currency with a larger and more liquid foreign exchange market is preferred. These are reasons why the US dollar is often used for payment and settlement of international trade between non-US economies. Although there are no statistics on the subject, the impression I have gained from talking to those who are active in import and export business is that this is the case for most of the trade in goods in this region.
The use of the US dollar for trade denomination and settlement promotes, and itself is also helped by, the demand for US dollar assets in the region. The latter of course benefits from a proven record of monetary stability and the large and developed financial market in the US. Readers are probably aware that economies in this region collectively run a substantial current account surplus. For those who are familiar with the balance of payments account, a surplus in the current account must be mirrored by a deficit in the capital account, or what is commonly referred to as "capital outflow". When exporters receive US dollars from foreign importers they either use them for defraying domestic expenses (including the repayment of loans) or they invest the money. In the case of the former, the US dollars are sold for the domestic currency, assuming of course that the domestic currency is the currency in which domestic expenses are paid and settled. In the case of the latter, there is the choice of doing so in the domestic currency or in the US dollar. In an economy in which the credit rating is not high and the choice of financial instruments is limited, the tendency - or "inertia" - in retaining export earnings in US dollar assets, temporarily or permanently, can be quite significant, even though the rates of return available may be lower than that offered by domestic assets. Presumably, the relatively low return on US dollars assets is compensated by their low risks.
I believe this tendency to retain earnings in US assets has become more pronounced with globalisation. The financial turmoil of 1997-98 in Asia, characterised by sharp exchange rate depreciation in Asian currencies, has probably reinforced the appeal of US dollar assets. This points to the possibility of exchange rates not necessarily reacting to shifts in balance of payments positions, or a reduced sensitivity. Indeed, to some extent one may argue that the demand for US dollar assets induce the Asian economies to run current account surpluses in order to finance such capital outflows. This I believe is one reason why, for a given size of the current account deficit relative to the Gross Domestic Product, it is more sustainable in the US than in any other economy. Alternatively, the threshold beyond which the current account deficit as a percentage of GDP becomes worrying, and indeed generates market correction, other things being equal, tends to be higher for the US than for other economies. However, such "inertia" can be eroded by factors including expectations of changes to exchange rate policies. This may involve unfamiliar market dynamics that may be very difficult to handle. Nobody can have an insatiable appetite for anything and this applies to economies with high savings in their appetite for US Treasury securities. So far, to the extent that there have been market adjustments, they have been rather benign, but we have also not seen any sign of narrowing of the US current account balance of payments deficit. I hope the inevitable adjustment will not be too sharp for the global financial system.

Joseph Yam


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