Strategy Note / United States of America

US Dollar as reserve currency after Covid-19? A moot point for EM ex-China

  • Characteristics of a reserve currency are usually self-reinforcing, and therefore resistant to change
  • Potential challengers – Chinese Renminbi, or multinational, central bank-backed cryptocurrency – have their weaknesses
  • Ultimately, this discussion may be moot for emerging markets, with perhaps the exception of China

The US Dollar is still a very long way from being dethroned, and is again the safe haven of choice in crisis. But Covid-19 adds more pressure and raises the question of what we need from a reserve currency.


Characteristics, usually self-reinforcing, of a reserve currency

A reserve currency is usually defined as a foreign currency that is held by a country’s central bank in order to facilitate outbound investments, imports, and international debt repayments, as well as to manage that country’s exchange rate.

The role of the US Dollar (and predecessors such as UK Pound Sterling in the nineteenth century) as the dominant global reserve currency is based on a number of factors, many of which are mutually-reinforcing, or circular:

  • High share of the US economy in global economic activity (trade, investment, finance) although this share does not necessarily have to be dominant;
  • Full convertibility of the US Dollar and a liberalised capital account;
  • Stability, independence and the resulting international trust in the US central bank (the banking supervisory role and inflation control policies of the Federal Reserve) and US financial institutions (systemically important banks);
  • Confidence in the political legitimacy of the US government and the effectiveness of its institutions (rule of law and protection of property rights);
  • Dominant geopolitical influence (which can enforce, via the threat of sanctions, or encourage, via US Dollar-denominated trade access, investment and aid flows, the use of US Dollar); and
  • High incidence of invoicing of international trade in US Dollars and the widespread global perception of assets denominated in US Dollars as relatively safer.

Premature predictions of decline before

The decline of the US Dollar as a reserve currency that some predicted following the rise of the Euro, after the Global Financial Crisis, or even following the wider use of financial sanctions under the Trump administration, has not happened. The argument for that decline was predicated on three points.

  1. Other economies, like the Eurozone or China, would grow to a point where they rivalled or surpassed the US as a dominant global economic power and, in the case of China, the government has attempted to grow the international use of the Renminbi (eg in oil contracts).
  2. The US, in adopting unprecedented monetary easing following the Global Financial Crisis, was at risk of over-extending its “exorbitant privilege” (which refers to the unique ability of the US, because its currency is the global reserve currency, to avoid balance of payments pressure and to enjoy lower risk-free returns on US Dollar assets compared to risk-free returns on assets denominated in all other currencies). “Exorbitant privilege” was a phrase used in France, by politician Valery Giscard D’Estaing, after the establishment of the Bretton Woods system in 1944 of maintaining FX rates of the major currencies, including the US Dollar, to gold, at a time when the majority of gold reserves were controlled by the US.
  3. By restricting access of governments (eg Iran) and individuals (eg in Russia), deemed offside of US foreign policy, to their existing deposits and investments in the US and to the international US Dollar payment system, or, by reducing the sovereign immunity of foreign governments against litigation in the US courts (eg Saudi and JASTA), the US may discourage the ongoing perception of US Dollar denominated and US-domiciled assets as relatively safe for foreign citizens and governments.

There is now a reinvigorated debate over whether the Chinese Renminbi may challenge the US Dollar, based on forecasts of China’s ever-increasing share of global economic activity and geopolitical influence, particularly if the current crisis results in an acceleration of these trends.

Alternatively, there are some, such as former Bank of England governor Mark Carney, who were arguing, prior to Covid-19, that multinational, central bank-backed, cryptocurrency may emerge as a rival to the US Dollar. This argument is based on the need to release all of the excess savings stored by governments globally in the form of US Dollar foreign reserves in order to drive higher growth. (This sort of cryptocurrency should not be confused with the likes of Bitcoin, once described by the IMF chief economist Gita Gopinath as “neither a unit of account nor as a cheap transaction technology, but primarily as a highly risky store of value”.)

We acknowledge that pressure on long-standing systems, like the US Dollar as a global reserve currency, can build for many years and culminate in a rapid change. But given the sheer distance by which the US Dollar dominates other reserve currencies today and our view that Covid-19 is a universal risk for economic growth and governments, it still looks unlikely to us that, on the timeframe of at least the next five years, the US Dollar will be dethroned either by the Chinese Renminbi or by a cryptocurrency backed by multiple governments.

Chinese growth may continue to outpace that of the US, but share of the global economy is merely one of the drivers of global reserve currency status. International confidence in the institutions underpinning the Chinese economy and its currency may have been damaged by the timeliness and transparency of its disclosure of data related to Covid-19.

The post Covid-19 economic policy response may be another instance of an over-extension of “exorbitant privilege” by the US. However, in a global environment where almost every policy authority is doing “everything it takes” to counter the sudden-stop from Covid-19 it is difficult to label accommodative monetary and expansionist fiscal policy in the US as unique.

This matters for investors in emerging markets because currency risk is a major factor for growth and because most foreign institutional investors in EM have to generate superior returns in US Dollar terms than, often, US equities (which, of course, are in US Dollar terms).

A moot point for emerging markets, ex-China

Ultimately, this discussion may be moot for emerging markets, with perhaps the exception of China.

As long as the currencies of emerging markets (and the economies and institutions which underpin those currencies) are perceived as relatively riskier than the global reserve currency (whether that is the US Dollar, the Chinese Renminbi, or a new cryptocurrency backed by multiple governments) then those emerging markets will have to maintain a balance of reserves in the denomination of the global reserve currency.

Essentially, even if the US Dollar was de-throned, it would merely shift the denomination of FX reserves for most emerging markets. The imperfections of transmission of shocks from the underlying economy of the reserve currency (the US, China, or whichever collection of governments supported a future crypto-reserve currency) would persist.

 

Figure 1: Currency share of global allocated FX reserves (Q4 2019)

Source: IMF, Tellimer Research

 

Figure 2: Currency share of syndicated cross-border loans in EM and DM

Source: Brauning and Ivashina (2017), BIS, Tellimer Research


Figure 3: Currency share of global trade and invoicing

Source: Gopinath (2015) using a sample of countries equivalent to c60% of global trade, Tellimer

You can read more on how Covid-19 is reshaping the world in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.


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