What Triffin dilemma?!

Time and again you read these days many a commentator arguing that the recent global imbalances have been the inevitable corollary of the dollar’s role as a reserve currency.

It’s the Triffin dilemma, they say, after economist Robert Triffin, who, back in the 1960s, maintained that the country issuing the global reserve currency must be willing to run trade deficits, in order to supply the world with enough of its currency to meet the global demand for reserves. The “dilemma” arises from the fact that, the more dollars, say, are supplied to the world through US trade deficits, the more the value of the dollar is undermined, threatening its role as a reserve currency.

So, as it happens, I disagree both with Triffin (notwithstanding his Yale credentials)… as well as with the premise that it’s that very dilemma that has led to the global imbalances we still see today. Here is why…

First, probably a lesser point but, as a matter of principle, the supplier of the reserve currency (let’s call it United States) doesn’t have to run trade deficits. Countries wishing to accumulate FX reserves can do so by accumulating foreign liabilities. China’s central bank, for example, can buy the dollars entering China through foreign direct investment, and invest these in US Treasuries. Alternatively, countries can borrow dollars long-term from the official sector or even the private sector, and keep them invested in Treasuries in case there is a crisis.

Understandably, the latter (ie borrowing) option is anathema to most countries, due to the implicit or explicit conditions attached to these loans. Similarly, countries may need to hold more precautionary reserves than the foreign currency entering their market in the form of more stable, long-term liabilities such as FDI. So what’s the alternative?

It’s what some emerging markets have been doing in recent years: Namely, accumulating reserves partly through running trade surpluses. But is that sufficient to undermine the value of the US dollar? Not necessarily.

The presumption that it “should” rests on the concept of external debt sustainability—i.e. the fact that a country cannot accumulate liabilities for ever. Countries that do, usually end up with their currencies depreciated, which helps correct the external imbalances through valuation effects on their external balance sheet. But here are a few caveats for the case at hand:

First, if it’s precautionary reserves that we’re talking about, emerging markets reaching the desired/”optimal” level of reserves would stop accumulating further dollars (beyond an annual “maintenance” amount proportional to the capital and trade flows into the country).

Second, even if the stock of (precautionary) reserves is large, this doesn’t mean that there are “too many” dollars floating around. Countries demand reserves for insurance purposes—i.e. the stock of dollar reserves is not used to splurge in European luxury goods or Brazilian bikinis, which could lead to the dollar’s depreciation. Instead, dollar reserves are saved (e.g. invested in Treasuries) and are ready to be employed if there is a sudden stop in capital inflows.

Even (even) if the dollar depreciated somewhat, that wouldn’t matter anyway—again, if it’s precautionary reserves we’re talking about; and if the bulk of a country’s external obligations (e.g. imports or debt payments) are also denominated in dollars. In other words, even if the dollar were to depreciate, this should not undermine its role as a reserve currency.

So done with the Triffin dilemma?

Not yet... we still we need to answer the question… has the dollar's status as reserve currency encouraged the circulation of “too many” dollars around the world? And if yes, was that inevitable, as per Dr Triffin?

To see if there are “too many” dollars on would need to check whether (a) the foreign private sector is flushed with more dollars than it wants or needs; (b) the foreign official sector (i.e. governments) hold excess reserves (ie reserves that would eventually be spent on goods and services). So what has been the situation in recent years?

Abstracting here from the post-crisis period, and the Fed’s massive dollar-supply operation, (a) does not seem to have been the case in recent years. Looking at the US international investment position, the net amount of dollars in private foreign hands (i.e. the US net liabilities to the foreign private sector) had actually been declining in US GDP terms since 2002 (and more so in global GDP terms, which is more relevant).

What have ballooned instead are America’s net liabilities to the foreign official sector. And provided that some of these reserves are “excess”, yes, there are “too many” dollars floating around.

But surely that’s not the result of a Triffin dilemma and the dollar’s role as reserve currency. That’s the outcome of another (well-known) dilemma altogether: The growth-model dilemma of some emerging markets (and their fixation with exports).

I shouldn't let the US completely off the hook here... Countries do not accumulate any types of foreign assets as reserves. Instead, they prefer assets that are safe, with deep and liquid markets. And the US for decades has offered the perfect product for FX reserves, namely US Treasuries (unlike the eurozone, where debt markets are liquid but fragmented due to the different creditworthiness of each eurozone member).

In this sense, the return of the US fiscal deficits post-2002 (and associated rise in the supply of Treasuries) facilitated reserve accumulation. And so did the (not-so-implicit) guarantee on the GSEs, which offered a tremendous pool of spready products with the kind of government backing that FX reserve managers love. But still, that should not divert attention from the fact that these assets were accumulated as a result of policy intent.

So where do we go from here? Well, first of all, China’s ongoing accumulation of Treasuries is only delaying the inevitable down the line. Second, its slow asset shifting from dollar to non-dollar assets (e.g. using its dollars to acquire companies in the resource sector in Africa, etc) is not really a sustainable solution: At some point, you begin to irritate the recipients of these flows, as their currencies appreciate vs. the dollar (and the renminbi for that matter), hurting exports and encouraging voices of protectionism.

Ultimately, part of the solution rests on what has become the consensus call by Western policymakers and academics alike: A conscious decision by China to replace its fake Prada bags for the real deal!