Aug 20, 2016

Why is Majority of International Trade Carried Out in US Dollars?

In my previous post, I explained why the net exports of a country are necessarily = its net capital outflow (link here). I used the example of Indian IT exports to the US to make the points I needed to make. The curious reader will ask - when you export goods, which currency do you get paid in? Your own, the importer’s, or a third currency? 

The reality is that most international trade is conducted in US dollars (USD). For context, in 2013, more that 80% of all international trade finance was conducted in USD. Also, ~90% of foreign exchange transactions involved the USD. 

There are a number of reasons why USD is the currency of most international trade. Let me explain.

Why do we need an “International” Currency for Trade at all?

Let’s assume a primitive world where there is no global currency that is used for international trade. Whenever a country, say country A, buys from country B, A will have to pay for B’s products in B’s currency. Suppose India wants to buy cars (Toyota Innova) from Japan. India will pay have to pay for the car in Japanese Yen (JPY). This makes sense. Toyota wants Yen that it can spend in its home market. 

How will India get the Yen needed to pay for the Innova? It can only get Yen from Japan. India offers to sell Japan jewellery, pharmaceuticals and petroleum products in return for payment in Yen. Let’s suppose Japan doesn’t want to buy any of these products from India. Japanese demand for Indian products is nil. In such a scenario, there will be no trade between India and Japan.

If only there was a currency that was acceptable to the both the buyer and the seller i.e. one that the buyer had and one that the seller was willing to receive. What would be the key feature of this currency? It would be a currency that everyone (all nations of the world) was willing to accept, since they’d know they could use it to buy goods from any other nation. There is such a currency today - the USD. 

Why is everyone willing to accept the USD in International Trade?

There are a number of reasons:

1. Historical Pre-eminence: “Reserve Currency” of the world
Historical factors have enabled the adoption of USD as the default currency for international trade. USD is the “reserve currency” of the world. What is a reserve currency you ask? It is a currency that is held in significant quantities by governments/institutions of the world as part of their forex reserves. Today, more than 60% of all foreign currency reserves in the world are in USD. 

Why is this so? This dates back to the Bretton wood agreement of 1944 (following WW2) when all currencies were pegged to the USD (at fixed exchange rates), which itself could be redeemed for gold. So if you (country X) had USD, you could surrender it and get gold in return. (The US held 2/3rd of the world’s gold at that time). The USD was the only currency convertible into gold. 

How did the currency pegs work? Country X would peg its currency to the USD, and then maintain this fixed exchange rate within a band of + - 1% by buying and selling USD. 

Naturally, it made sense for the countries of the world to keep majority of their forex reserves in the form of USD. The USD took over the role that gold played under the “gold standard” system since it was the only currency that was convertible into gold. You could buy any currency in the world in exchange for USD. Other nations were always willing to accept dollars in exchange for their goods. And finally, in the unlikely case that the USD became weak/unstable, you could always redeem it for gold. 

The USD thus became the reserve currency of the world, and the currency in which most international trade was conducted. 

In 1971, the US suspended the convertibility of the USD into gold. By then, the USD was already firmly established. That said, the US still had to ensure that other nations of the world continued to feel confident about the dollar and continued to use it as the “international currency” for trade. To accomplish this, America signed deals with all OPEC countries. I’ll explain below. 

2. The Petrodollar Coup: All oil deals priced in USD
In 1973, the US signed a secret deal with Saudi Arabia according to which: 1) all of it’s oil sales would be denominated in USD i.e. Saudi Arabia would accept payment for all its oil sales only in US dollars, and 2) it would invest all the dollars remaining after it had met its import/ other requirements in US debt securities. In return, the US offered Saudi Arabia military aid and protection from foreign forces. Saudi Arabia readily signed this deal, but under the condition that it be kept a secret, as it didn’t want backlash from its Arab neighbours for lending money to America, Israel’s top supporter (by buying US debt securities, Saudi Arabia was effectively financing US government deficit). By 1975, all OPEC nations had signed similar deals with the US.

The USD became the currency in which the vast majority of the oil trades of the world began to be conducted. Once again, the US was able to put in place an economic system that created strong global demand for the US dollar, just like it had with the Bretton Woods agreement. With every nation of the world needing oil to keep its economy running, the USD continued to remain the international currency of trade - everyone needed it to by oil, and was ready to sell goods in exchange for dollars. 

3. Quantum and Diversity of US Exports
The US exports a huge quantum of goods/services. It is the third largest exporting country in the world with Exports of ~$1.5 trillion (behind China at $1.9 trillion and Germany at $1.55 trillion). Along with the sheer quantum of exports, it is also the wide variety of goods and services that one can buy from the US that gives it supreme status. While China is the manufacturing factory of the world, for high technology products, education, cutting-edge research, defence equipment, pharmaceuticals etc., US is still the top exporter. The US’s range of exports is unmatched. Note: Large high technology product exports from China are an exaggeration. China mainly assembles high-tech products with imported parts, but when it ships these abroad, Chinese customs classifies them as “high tech-exports” regardless of whether China’s contribution is labour or technology1

What this means is that whatever you (country X) want to buy, you’ll most likely get it from the US. So holding USD is desirable. You can import whatever you want from the US in exchange for USD. 

4. Stability
The USD offers stability. It is backed by the largest economy in the world and world’s strongest military. It enjoys robust demand given that it the currency in which most international trade is conducted. About 1/3rd of all US debt is held by foreigners - China and the OPEC nations being large holders. They’ve on occasion made veiled threats about selling their debt, but the reality is that it will hurt them as much as the US. It is not in the world’s interest for the USD to be unstable or fall. This is why despite large amounts of debt and high fiscal deficits over the years, the USD has remained stable. 

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1 I’ve taken this excerpt from “China’s High-tech Exports: Myth and Reality”, a paper written by Yuqing Xing, National Graduate Institute for Policy Studies, Tokyo. Link here

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