The Double-Edged Sword of Seeking Safety in Dollars

Even when things are uncertain in the United States, the American dollar and U.S. Treasury bonds remain safe havens for parking international wealth. Yet their aura of stability has also created a significant hazard for the rest of the world. In a crisis, the dollar’s dominance can actually make things worse for nations that seek it out.

In a provocative new paper, researchers at Stanford Graduate School of Business argue that the hunger for safety in dollars drives global financial cycles in ways that can make bad situations worse for foreign investors and governments, even when the United States is the source of trouble.

“The dollar is a global risk factor,” says Arvind Krishnamurthy, a professor of finance who teamed up on the new paper with Stanford GSB finance professor Hanno Lustig and Zhengyang Jiang of Northwestern University. “When the dollar appreciates in value, other nations don’t do well.”

In contrast, the researchers write, the demand for dollars in a global crisis often gives the United States more maneuvering room and enables it to emerge in better shape than many other nations.

During the global financial crisis of 2008–2009, which originated with the mortgage meltdown in the United States, foreign investors poured vast amounts of money into Treasury securities. That helped drive down interest rates in the U.S. and increase the dollar’s value.

As a result, the federal government could borrow more cheaply than before the recession, while many foreign borrowers became more constrained. Governments and corporations that had borrowed money by issuing dollar-denominated bonds suddenly faced higher debt burdens because each dollar had become more expensive to repay. That made it harder for those governments to pursue expansionary policies and for foreign banks to make loans.

“If we had been Greece, we would have seen the value of our government bonds plummet and the cost of credit soar,” Krishnamurthy says. “Instead, the cost of borrowing here went down. Our fiscal capacity increased, while every other nation lost fiscal capacity.”

The Bucks Stop Here

It’s hard to overstate the dollar’s role as the de facto global standard, Krishnamurthy says. The United States accounts for 10% of world trade, but 40% of international transactions are in dollars. Likewise, banks outside the United States hold a disproportionate share of both dollar-denominated assets and dollar-denominated liabilities — $13 trillion in dollar assets, compared to only $3.4 trillion in euro assets. Those trends seem to be increasing.

Because U.S. Treasury securities are still considered a safe haven — even though the Treasury market showed signs of dysfunction in early 2020 — foreign investors accept lower yields on Treasuries, after adjusting for differences in currency risk, than they would on bonds issued by other major nations like Germany and France.

In another paper, Krishnamurthy, Lustig, and Jiang estimate that foreign investors receive a non-financial “convenience yield” of about 2% on U.S. Treasury bonds. That yield increases during times of economic stress, and it can significantly impact demand for the dollar. The researchers estimate that changes in the convenience yield accounted for about 25% of quarterly changes in the dollar’s foreign-exchange rate from 1988 through 2017.

They also argue that increases in the dollar’s value create new problems for other nations. That might sound surprising, because a more expensive dollar can boost exports to the United States by making foreign goods cheaper in dollars.

The problem, Krishnamurthy says, is that foreign governments and corporations also borrow a great deal of money by issuing bonds that must be repaid in dollars. The appeal of dollar-denominated bonds is that their interest rates are generally lower than those issued in local currencies. But if the dollar spikes in value — which can happen during a global crisis — those debts become more expensive to repay.

No Free Parking

There isn’t any simple solution, Krishnamurthy says, because there aren’t any rivals to the dollar or the Treasury market. The euro still lags far behind in global usage and has become less of a rival since the financial crisis of 2008. (A team led by Matteo Maggiori of Stanford GSB found that cross-border investors reduced the share of euro-denominated corporate bonds in their portfolios from 38% in 2005 to 22% in 2017.)

Nor does China’s renminbi appear likely to take over. Though China is the world’s second-largest economy, its capital markets are too restricted to give international investors the security they want. Digital currencies and cryptocurrencies don’t offer anywhere near the necessary volumes or stability.

“It’s like the U.S. is running a very large parking garage where the rest of the world can safely park their assets,” Krishnamurthy says. “You need a huge parking structure to accommodate everyone, and nothing else comes close.”

This isn’t a new dynamic. “History suggests that the world concentrates on a single dominant currency,” he says, “First, it was the British sterling. Even though the U.S. was a bigger industrial power than Britain after the 1870s, the sterling remained dominant until the end of World War I. It was only after the war decimated the British economy that the dollar became dominant.”

If anything, Krishnamurthy and his colleagues say, the dollar seems to be gaining ground as a world currency. Looking forward, they warn that the rest of the world will be exposed to more shocks emanating from the United States.

“As demand for dollar assets rises, currency mismatch around the world will inevitably rise,” they write. “The problem of the dollar for the rest of the world will only grow larger over time.”