We’ve seen an uptick in “doom” reports about the U.S. dollar of late, both on Fox and CNN. This has likely been brought about by uncertainty over America’s banking sector in the wake of the Silicon Valley Bank failure. Perhaps more related, however, to talks that oil economies are seeking other currencies to conduct energy-related transactions.
Saudi Arabia, for instance, is considering using currencies other than the U.S. dollar for oil payment. China recently announced deals with Brazil, Pakistan, Kazakhstan, and Laos to open up clearing houses to settle yuan-denominated trades. And during China’s visit to the Middle East late last year, President Xi specifically told the kingdom they are looking to use Chinese yuan - rather than dollars - to buy oil and gas.
But currency markets haven’t reacted one bit towards this news at all, and likely won’t for a few reasons, at least for now.
For one, the dollar remains strong against most major currencies. Even against more rapid-growth emerging market economies, the dollar remains strong. Continued threats of U.S. inflation ensure that the dollar will likely continue to put pressure on the Fed to keep rates elevated, which in turn will keep rates higher in the U.S. than other countries. And as long as the Fed remains a credible inflation deterrent, this trend will continue.
Just because the dollar is stronger does not mean the American economy is somehow “stronger.” Currencies don’t work like that. In the current environment, it simply reflects the Fed is faster in its rate cycle than other G10 economies. Meanwhile, Japan and the E.U. are just barely coming off their inflation peak, suggesting dollar strength should continue for the time being. It also suggests that the Fed’s work is not done yet, so we should expect further hikes - and thereby further periodic pullbacks in equity and fixed income markets - in the weeks ahead, recent gains notwithstanding. Yes, recent U.S. bank woes have slowed the plan down, but as long as inflation persists, the threat of hikes will persist.
The exact moment where the U.S. dollar reverses this appreciation trend is hard to forecast. But it will likely be when U.S. Fed begins to slow or reverse interest rate hikes, which could come by the second half of this year. The U.S. 10-year note is hovering at 3.5 percent whereas Germany’s 10-year is at 2.3 percent and Japan’s is at 0.3 percent, illustrating that currency traders can get a hefty carry-trade profit by selling Japanese or German bonds and buying U.S. bonds and pocketing the spread. Once that profit opportunity goes away, either by other countries raising rates, or the U.S. lowering them, the dollar’s appreciation will reverse.
Longer-term concerns over the dollar’s utility may persist but won’t impact the dollar’s valuation for awhile. A big concern is that the world’s largest holders of FX reserves - including China ($3.5 trillion), Japan ($1.38 trillion), Switzerland ($1.0 trillion), Russia ($630 billion), India ($599 billion), and Taiwan ($548 billion) - deciding to park a larger portion of their reserves in currencies other than the U.S. dollars. These are the largest investors in the world, and the decisions they make in where to park their cash can move markets quickly.
The U.S. dollar continues to the dominant currency held in reserve manager portfolios. The U.S. dollar makes up nearly 59 percent of aggregate reserves, still a sizable chunk relative to euros (19 percent), British pounds (4.6 percent), or Chinese yuan (2.9 percent). These trends haven’t deviated substantially over the past few years, although the increase in Chinese yuan reserves is notable. However, just because no movement has occurred does not mean reserve managers wish there were more dollar alternatives.
Remember too that reserve trends tend to work over very long timelines. Small changes today can show more critical trends in the decades ahead. From the graph above, we can see the Chinese yuan made considerable gains starting from 2016 onwards, nearly doubling their space in the aggregate portfolio. China’s currency is making small but meaningful strides.
So why all the fuss for getting reserve currency status?
Well, there are certain unique benefits of having a “reserve” currency like the U.S. dollar. Global liquidity is a key one - you can go nearly anywhere and exchange dollars for X. You can also print money at a rapid rate during emergencies to ease liquidity crunches without spooking the market too much. Easier financing terms is another, as global lenders generally don’t mind lending in dollars, so it’s easier to get a good rate. Less currency volatility is also a benefit. And finally, and perhaps the most controversial, is that it acts as a significant source of geopolitical leverage, e.g. limiting certain countries with contrary interests from accessing their assets, the way the U.S. did with Russia.
A further example is baked in the idea that Russia should bear the cost of the Ukraine war by tapping its foreign exchange reserves frozen by other governments. Recently the World Bank announced the estimated cost of the war’s reconstruction to be $411 billion. The idea is this: why not force Russia to at least partially pay this cost through its nearly $200 billion in frozen reserves abroad, particularly the portion denominated in dollars? Thanks to the dollar’s reserve currency status, the U.S. can compel this to happen.
But having a reserve currency is not all puppy dogs and ice cream. Pundits in the U.S. such as Fareed Zakaria like to extol the benefits of having a strong dollar, but the sad reality is many of the poorest Americans suffer substantially from this.
The biggest caveat is a strong dollar makes it cheaper for companies to outsource work to emerging markets. This is one reason why U.S. companies and their shareholders have done so well over the past few decades while worker wages have been shaved to the bone, a fact proved in research by senior economist Dean Baker of the Center for Economic and Policy Research. While the correlation is not one to one, the dollar’s persistent strength, as well as persistent gains in America’s capital markets, likely has contributed to America’s nagging stagnant wages and widening inequality issues that started back in the early 1980s (the median U.S. income has fallen from $75,672 in 1980 to $70,784 in 2021).
Weak currencies tend to attract manufacturing investment which can lead to a boom in exports. Countries like Japan and China exploded in political and economic growth during times of currency weakness - Japan in the 1970s and 80s, and China is the 2000s. Both countries got there by engaging in policies that deliberately weakened their currency by intervening in the foreign exchange market, which contributed to a boom in their manufacturing sectors (as) exports and ended up giving them huge stockpiles of FX reserves. So America’s - and most other country’s - odd fascination with a strong currency might be misguided.
Regardless of the costs, Chinese authorities are hellbent on achieving reserve status. China’s embarked on its Belt and Road Initiative which promotes regional development through Central Asia, Europe, Southeast Asia, the Middle East, and Africa, infrastructure projects and economic zones which will increase external usage of the Chinese yuan. China also created the Chiang-Mai Initiative to establish multilateral currency swap lines with regional central banks. Then there was the Cross-Border Interbank Payment System (CIPS) which offered clearing and settlement services to facilitate cross-border yuan payments, as well as China’s more recent announcement to issue a central bank digital currency. China is clearly laying the groundwork for which a competing reserve currency can be built upon for the next 100 years.
Will it work? Will foreign governments be interested in using a currency of a totalitarian dictatorship as their reserve currency?
My best guess is, all else equal, no. China’s currency is not freely convertible and is not freely floating. Most governments don’t trust China any farther than they can throw it.
But America’s recent actions may push allies into China’s arms nonetheless.
Let’s go back to the issue of forcing Russia to pay for the Ukraine war. The reasoning is certainly justifiable. After all, Russia invaded Ukraine. They are clearly the aggressor. And since someone has to pay, make the aggressor do it.
But in the long run, this will set a dangerous precedent. A country’s reserves are sovereign assets which should afford it certain rights. By forcibly taking a country’s reserves to pay damages, we are telling countries all over the world: your reserves only belong to you if we agree they belong to you.
Owning the U.S. dollar suddenly switches from being an asset to a liability.
Unless it’s done in a judicious manner, this risks driving away reserve holders to rival currencies and payment infrastructures. Smaller countries with massive reserves like Singapore, Taiwan, and Saudi Arabia may view this as a step too far. Even if the aggressor is clearly in the wrong, taking a country’s reserves is a serious affront on a nation’s sovereign wealth.
Continue down this path, and over the long run, the dollar will lose its safe-haven status.
Tread carefully, America. Exploiting a privilege almost always comes back to bite you.
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