Dollar remains the big daddy of global currencies — for now
The prospects of cryptocurrencies or the Chinese yuan unseating the greenback are slim
A frequent topic of both serious investment commentators and some of the darker corners of the internet is the future of the US dollar as the dominant global currency.
While some believe its decline is imminent, evidence suggests it is still very much in a dominant position. As the Fed, the ultimate guardian of its price and purchasing power, is about to cut interest rates, the debate is topical again.
Exactly 75 years ago this month, the Bretton Woods conference resulted in a global fixed exchange rate regime that saw most currencies pegged to the dollar, and the dollar was pegged to gold. This system ended in 1971, and most currencies float freely today, but the dollar remains the “reserve currency” of the world as it is the first choice of central banks, accounting for two-thirds of global forex reserves.
Since president Richard Nixon broke the gold peg in 1971, there have been three big cyclical bull markets, including the current episode.
The dollar’s importance goes far beyond this, and largely derives from the size of US capital markets. US equities account for half of global market capitalisation, according to MSCI, while the US economy is only a fifth of global GDP. The dollar accounts for 60% of international debt and 80% of foreign exchange turnover, according to the Bank for International Settlements, the central bank for central banks. Most commodities, from gold to oil, are priced in dollars.
Research from the IMF’s chief economist, Gita Gopinath, has also shown that most global trade is conducted in dollars and non-US banks hold as much dollar deposits as US banks (about $10-trillion), while corporates outside the US borrow more in US dollars than any other currency.
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Many economists have argued that the US enjoys an “exorbitant privilege”. Moreover, in a crisis, the world turns to the dollar, as we saw in 2008 when investors fled to the safety of the dollar despite the US being the epicentre of the credit crunch.
All this provides structural support for the dollar, but it has also been strong on a cyclical basis since 2011. Since president Richard Nixon broke the gold peg in 1971, there have been three big cyclical bull markets, including the current episode.
The dollar rally since 2011 is broadly due to the stronger US economy relative to its trading partners (particularly the sclerotic Eurozone), which in turn gives rise to higher interest rates. The Fed’s policy rate is almost 2.5%, while that of the Bank of England is 0.75%, the Bank of Japan’s is -0.1%, and the European Central Bank’s is at -0.4%. In theory, an investor can earn a decent spread borrowing in Europe and Japan and buying dollars.
This picture might now be changing, as the Fed aims to reduce rates to pre-empt a slowdown. Though US interest rates would still be higher than in Europe and Japan, the fact that the gap is likely to narrow reduces carry trade support for the dollar.
Taking a longer-term view, the role of the dollar is likely to decline over time but not disappear. Central banks are expected to continue diversifying their reserves, but as long as their economies have dollar liabilities, it makes sense to have dollar reserves.
Another frequent argument is that investors will eventually lose trust in the dollar because of persistent current account and budget shortfalls. After all, money is all about trust. Donald Trump’s tax cuts have further widened the budget deficit, and his trade wars are unlikely to have any success in narrowing the current account deficit, which is largely the mirror image of investors’ demand for US assets.
But apart from a few years in the late 1990s, the US has run budget deficits persistently since 1974. So it is also not clear why the trust will suddenly break — perhaps when the independence of the Fed, under attack from Trump, is fatally eroded.
What is clear is that other countries are taking deliberate steps to de-dollarise. The widespread use of the dollar in global payments gives the US extraordinary power. It basically claims jurisdiction anywhere a dollar is used, even if Americans are not involved. Famously, a New York court fined a French bank $9bn in 2014 for violating sanctions against Cuba, Sudan and Iran.
The previous handover of dominant currency status from the pound sterling to the US dollar had World War 1 as its immediate reason, but it would probably have happened anyway, given that the US had overtaken the UK as the world’s largest economy and financial sector.
China will someday overtake the US economy in size, but China is far away from being the world’s financial leader. It maintains strict capital controls, its markets are not as deep and liquid and, crucially, property rights not as strongly enforced. For this reason, the yuan is still far from being a global currency. In fact, the ultimate proof of the status of the dollar is that it is the preferred currency in forex black markets globally.
What about the cryptocurrencies? Bitcoin has surged again in 2019, but the fact that its value is expressed in dollars says it all. At any rate, Bitcoin and its peers cannot be thought of as proper currencies, since they are too volatile, and are mostly instruments for speculations.
The Facebook-led new digital currency, Libra, promises to solve some of Bitcoin’s most obvious shortcomings (it is pegged to a basket of currencies). But it has been almost universally criticised, and not only because of Facebook’s poor reputation for managing its members’ data. The lack of a central bank backstop in case of a crisis is one fear. The other is the possibility of it being used to hide ill-gotten funds.
For this reason, Bank of England governor Mark Carney spoke for many regulators when he said the Bank would approach Libra with “an open mind but not an open door”. It is very unlikely that any version of private cryptocurrencies can replace the dollar.
What does all this mean for us? A strong dollar implies a weak rand, in other words, which in turn puts upward pressure on local inflation and interest rates.
In fact, it is a double whammy, since a stronger dollar tends to put downward pressure on commodity prices too, SA’s main exports. However, since SA companies and investors have substantial foreign assets, a weaker exchange rate increases the rand value of these assets.
A short- to medium-term cyclical decline in the dollar would likely lead to a firmer rand, ignoring domestic economic and political uncertainty. While nobody expects the rand to surge to overvalued territory, investors in interest rate-sensitive assets would still benefit, while the rand value of offshore assets will come under pressure. However, the rand is never a one-way bet, and it makes sense to be diversified.
What a long-term decline in the dominant status of the dollar means for local investors is uncertain, but it is not something that is likely within the next few years.
• Dave Mohr is chief investment strategist at Old Mutual Multi-Managers and Odendaal is an investment strategist at Old Mutual Multi-Managers