by JP Koning, BullionStar:

What is the U.S.’s greatest export? Banknotes. There is probably no other product for which the balance of trade is so tilted in the U.S.’s favour. No foreign bills circulate in the U.S., but U.S. bills are eagerly used all over the world.

According to the Federal Reserve, there are currently $1.74 trillion paper dollars in circulation. How many of these notes circulate in the U.S. and how many are used overseas?

Because banknotes cannot be tracked, this question is particularly difficult to answer. This blog post explores several approaches for determining the location of notes. These approaches offer a wide range of estimates, from as low as 40% of all currency being held outside of U.S. borders to as high as 72%.

The international demand for dollars

There are a number of reasons why foreigners demand U.S. dollars. A few nations including Panama, Ecuador, and El Salvador are dollarized. They no longer have their own currency but are wholly dependent on U.S. dollar for trade. There is an even longer list of countries that are partially-dollarized. While Argentina, Angola, Cambodia, Nicaragua, and Russia each maintain local currencies, it is common for U.S. dollars to be used in a portion of their domestic transactions.

Nations tend to dollarize because they have experienced high domestic inflation. Because the purchasing power of dollars is much more reliable than that of a weak domestic currency, individuals and businesses develop a habit of using dollars for making transactions or hoarding wealth. Even years after the domestic inflation has been contained, this habit remains.

Dollars are also popular in the international drug trade. Criminals require secrecy, and by their nature banknotes are a privacy-preserving form of payment. Because U.S. dollars are so liquid, they have become the preferred medium for illicit international business dealings.

How do notes move overseas?

One of the main channels for banknote exports is via the official banking sector. Banks put in large orders for notes with the Federal Reserve and ship them to branch offices overseas or other foreign banks.

Retail flows are also large. Tourists leaving the U.S. will often bring U.S. currency with them, either changing it at foreign banks or spending it directly into circulation. Immigrants living in the U.S. who support family back home will often physically transport cash over the border or send it by mail.

Smuggling of illicitly earned cash is another channel by which notes leave the border. Finally, the U.S. government itself moves large amounts of cash overseas. For instance, it brought over 300 tonnes of paper dollars into Iraq to help fund the Iraq War.

No paper trail

It is very difficult to measure how many paper dollars are in circulation outside of U.S. borders. This is because currency lacks a paper trail. When notes pass from one person to the next, there is no need for the recipient to register their possession of the note, or for the issuer to validate the transfer. Which means there is no way to directly track where banknotes go.

Ruth Judson, an economist at the Federal Reserve, has spent almost 25 yeas trying to understand some of the mysteries of U.S. banknotes. Along with Richard Porter she has tried to get a handle on the amount of counterfeit U.S. currency in existence. More salient to this post, the duo have written three papers on the international demand of U.S. currency (1996, 2001, and 2004.) Prior to that, Porter published on the topic (1993). Judson has herself authored two more recent papers on dollars overseas (2012, 2017).

Look North

Over the years, Judson has used a number of methods to infer how many U.S. bills circulate overseas. Here is one of the simplest techniques. We already know exactly how many U.S. dollar notes there are globally as of June 2019: $1,738.3 trillion. We then need to generate a good guess about how much of this is held domestically. Once we have this number, we can subtract it from the total stock in order to arrive at foreign holdings.

But how can we determine how much currency is held domestically? Judson’s trick is to assume that Americans are pretty much like their northern neighbours, Canadians. This is a fairly safe assumption. The two nations inhabit the same continent, have common traditions, and share similar wealth levels. It seems reasonable that Canadians and Americans prefer to hold the same amount of banknotes.

Unlike U.S. banknotes, Canadian banknotes do not circulate outside of Canadian borders. So almost all of the $90 billion or so in banknotes that the Bank of Canada has printed up as of June 2019 are held domestically. This gives a good indication of Canadians’ taste for banknotes.

In her 2017 paper, Judson found that Canadians hold around 4% of nominal GDP in the form of currency. Based on the assumption that Americans hold the same ratio of notes-to-GDP as Canadians (and adjusting for Canada’s slightly lower per capita income) Judson estimates that some $600 billion in U.S. currency was held domestically at the end of 2016. See the solid black line in chart 6B below.

Given that the Federal Reserve had issued about $1.5 trillion in currency by that time, the remaining $900 billion in notes must have been held overseas. This amounted to about 60% of all American banknotes (see solid black line above in chart 6A). Judson further estimates that around 70% of all $100 bills are held overseas.

The Christmas note spike

Another trick that Judson uses to suss out foreign demand is to take advantage of U.S. and Canadian seasonal spikes in currency usage, like Christmas, New Year, and Thanksgiving. Below I’ve charted out U.S. cash demand over the decades. The Christmas spikes are quite clear, although they have been getting smaller.

The seasonal spikes in U.S. note demand are likely caused by Americans, not foreigners. Foreign demand for U.S. notes is comprised mainly of $50 and $100 notes. These denominations are too awkward to be useful for making the sorts of transactions one typically makes during holiday time. And international drug dealers aren’t likely to spend their stash on Christmas presents.

The foreign demand for U.S. notes thus dulls the amplitude of U.S. seasonal note spikes. The degree to which U.S. seasonal spikes are muted relative to Canadian ones gives a good indication of how much U.S. currency is held overseas. Using this method, Judson finds that around 70% of all U.S. currency is held overseas.

Note broker information

Banks acting as note brokers go to Federal Reserve cash offices located around the U.S. in order to fill both domestic and foreign orders for banknotes. When these banknotes are no longer demanded, banks import them back into the U.S. and redeposit them at the local Fed cash office.

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