The recent developments in shifting tides for the U.S. dollar serving as the global currency has raised concerns, and I have been asked by several clients as to the probability and implications of the event.
Before I get into the nuts and bolts of recent events, I believe it would help to briefly look at the global history of reserve currencies and how the dollar became the medium of global trade.
A reserve currency is a currency that is widely held by central banks and other institutions. Reserves are held to facilitate global trade and to manage exchange rates. According to the Federal Reserve, the largest reserve currencies are: U.S. dollar (58% of total global reserves), euro (20%), Japanese yen (6%), British pound (5%), and the rest being made up of several other nations, of which China accounts for about 2.5%.
The U.S. dollar has served as the world’s reserve currency since 1944. Prior to that, the British pound held the honor but World Wars I and II nearly bankrupted the nation and the Allies realized that sustainable post-war economic growth needed a more stable currency.
Which brings me to some of the key characteristics for reserve currencies. While there are no official criteria, it tends to have:
- Stable economies and political systems so the reserve currency can be an effective store of value and have relatively stable exchange rates.
- Free capital flows so it can be easily exchanged for another currency or asset and easily moved from one country to another.
- A robust financial system with liquid, transparent, and well-governed capital markets in which to invest, including a deep sovereign bond market.
Next, let’s look at the U.S. dollar as the medium of global trade.
The Petrodollar system was created in the 1970s by the United States and Saudi Arabia. The system is an agreement between the U.S. and OPEC (Organization of Petroleum Exporting Countries), which among other things, requires OPEC member countries to use the U.S. dollar when they sell oil. However, for the first time, Saudi Arabia earlier this year announced that they were going to sell oil and receive payments in non-U.S. dollar currencies. Additionally, several non-OPEC countries (Brazil, Russia, India, China, and South Africa) announced they were discussing an alternative currency to the Petrodollar.
And there in lies the problem.
The alternative currency would need to be relatively stable and easily exchangeable for other currencies or assets. The number of currencies that meet these criteria is relatively small. While the Petrodollar system creates a natural demand for U.S. dollars (an obvious reason for discontent for some nations), it continues to score high on the three important reserve currency criteria mentioned above.
The stability of our political system has been called into question with issues around the peaceful transfer of power (in recent history) and the ability of our government to effectively legislate. And high government debt levels have compounded the problem and raised concerns about the strength of our economy.
In the long run and over time, it seems probable that the world is likely to diversify some of its exposure away from the U.S. dollar, but the move is likely to be slow and here’s why:
- The dollar remains the dominant currency for international trade. Outside of Europe, over 70% of exports are in dollars.
- The dollar is also the dominant currency in global banking, with about 60% of foreign bank deposits and loans denominated in U.S. dollars.
- Countries’ supply and demand change slowly. Developed nations like the U.S. tend to have higher domestic demand than developing countries, meaning we import more goods than we export. And the difference needs to be invested in U.S. dollar-denominated assets.
To summarize, while the U.S. dollar will continue to see fluctuations in the short-term, there is no imminent risk of de-dollarization in sight. However, global diversification away from the U.S. dollar seems likely over time, the impact for which on the U.S. economy will be both positive and negative. While China is flexing its muscles and growing at a rapid pace, it comes up short for liquid capital markets and political stability to sustain a global currency.
So, while there are many flaws with the US economy and its dollar, the other options are just not viable, and won’t be at least in the near and intermediate future.