The dollar's role under threat.

• Author: Owens, Adrian

The world today is dominated by three currencies: the dollar, the deutschemark, and the yen. Head and shoulders above its main rivals stands the dollar, alone as the true international reserve currency of the world. But for how long can the dollar's dominance continue? Many units of account have played the role that the dollar now does so well; their dominance did not last and neither will the dollar's.

In recent years, there has been clear evidence of an erosion in the dollar's role as the world's number one currency. This process is expected to take a new step forward with the birth of a single European currency, the euro, scheduled for introduction on January 1, 1999. As the euro emerges as a serious challenger to the dollar, the Asian bloc, led by Japan, is increasingly likely to push for its own currency arrangement. The exact form that this might take is open to question, but the clear message is that the dollar is under threat as the world increasingly moves to a more balanced tri-polar currency system.

Further erosion of the dollar's base appears inevitable. Latest data show that the dollar accounts for over half of total world currency reserves yet only makes up approximately one-fifth of world output and only 15 percent of world exports. Exhibit 1 clearly illustrates the dollar's current dominance. Not only does the dollar dominate in terms of official currency reserve holdings, but its international status is further shown by the fact that nearly all U.S. imports and exports are denominated in dollars (96 percent and 85 percent respectively), while 77 percent of Germany's exports and 56 percent of its imports are in deutschemarks. In contrast, only 52 percent of Japan's exports and 26 percent of its imports are denominated in yen.

This article examines the role of the dollar as an international reserve currency, reviewing recent changes in reserve holdings before arguing that the emergence of the euro and yen blocs will step up the transition to a three-currency bloc.

Holding Reserves: Recent Trends

An appreciation of why central banks hold currency as a reserve is important in understanding why demand for the dollar is set to fall. Central banks hold reserves for three main reasons: 1) they need a store of wealth that is relatively liquid, 2) a high level of financial reserves is important to inspire investor confidence and to deal with any foreign exchange turbulence, and 3) importing and exporting firms need to be assured of a ready supply of foreign currency.

In which currencies should reserves be held? The central bank will have a number of prerequisites. The currency will be more attractive if the country to which it belongs holds an important share of world trade, its value is stable relative to other currencies, and it is easily exchanged for other currencies. The dollar, the deutschemark, and the yen meet the above criteria more than any other currency.

Despite the dollar's clear dominance, its...