Recent IMF data shows that the dollar remains the world’s dominant reserve currency, accounting for just under 60% of foreign exchange reserves (forex). This is because the dollar is used to invoice the majority of international trade.
The full extent of the power of the US Federal Reserve’s role as the beating heart of the global monetary system, was revealed after the invasion of Ukraine by Russia. The US froze Russia’s foreign reserves, imposed sanctions on Russian firms and individuals, and denied it access to the SWIFT payments system.
Having revealed this capability, the US has also revealed the threat it poses to other countries. This raises new risks to the dollar system, and the dominance of the dollar is therefore by no means assured - China wants to diversify its reserves away from the dollar and by doing so insulate itself from similar sanctions; India is trading with Russia in roubles; Saudi Arabia is exploring being paid in Chinese Yuan for oil exports to China, and many countries will increase their acceptance of Yuan to facilitate their trade with China too.
It is unlikely that the Yuan will become a significant global reserve currency. Doing so would require China’s trading partners to materially increase their limits on holding Yuan reserves, and China to allow much more foreign investment in. Neither are likely to happen.
From the perspective of governments there is little motivation to abandon fiat currencies (government issued currencies not backed by a physical commodity), or return to a gold standard. Fiat currencies enable them to control the money supply and hence to try to control their economies and societies. The Chinese are the least likely to abandon fiat currency given their authoritarian tendencies. If China or other countries attempt to create a commodity backed currency, to be successful it would need to be a commodity whose supply cannot be easily inflated. That could mean a currency pegged to Gold, and that would constrain their money supply.
China will want to maintain economic engagement with the West for as long as possible even as it prepares for a time when it might end. China knows that the US might tow a harder line, but Europe has enough difficulty dealing with Russia and expanding sanctions to China would make their economies suffer too greatly. However China is unlikely to switch from dollar to euro reserves because this would offer little protection from sanctions in the case of a major confrontation future confrontation.
China could sell its US Treasuries and buy more commodities. But that would signal that they are expecting a confrontation with the West in the near future. That would scare foreign investors away from China, and hurt China’s economic growth. The same would apply to any other countries that move away from the incumbent global financial system.
Russia and China have diversified away from the dollar over the past decade, but this has not ended the dollar dominance. International trust in the economies and governments of Russia and China are not high. The euro is less attractive in the face of the Ukraine war and Europe’s energy insecurity. The most likely path forward therefore is a continuation of the status quo over the short term. However, the search for a global monetary system less dependent on the US dollar will continue.
Conclusion
If the US dollar were to lose its global reserve status, there would likely be a drop in the dollar’s exchange rate, US interest rates would likely be higher, and US equities and fixed income would likely underperform.
Any currency/currencies that replace the US dollar will likely experience lower capital costs and a stronger exchange rate. A shift to the Euro for example, would likely cause European countries and companies to have a lower cost of capital, which would provide a relative growth boost, but a move toward the yuan or yen would confer those benefits instead on China or Japan.
As a result, we would suggest that trustees make sure they have properly diversified portfolios, where exposures to the various countries, currencies and asset classes are properly weighted. No one knows for sure what the future holds, but properly diversifying your exposures is the only prudent course of action in the face of that uncertainty.
Glenn Cameron, Investment Consultant, at Cartwright
