The dominance of the US dollar in global reserves - an average share above 60% over the last 25 years – has been a constant feature of FX reserve management. This is particularly surprising because speculations about the imminent demise of the dollar have become a stable refrain over the past decades.
Challenging the enduring dominance of the USD
Challenging the enduring dominance of the USD
When looking in more detail at the past 25 years, even though the euro devalued versus the USD in the first years of its existence, an impressive rally from 2001 to 2008 drove the share of euro reserves up significantly, from 18.3% in 2000 to 26% in 2010.
Despite the ECB never openly supported the internationalization of the euro, the successful launch of the European currency fueled speculation that the euro could challenge the dominant role of the USD. Some people extrapolated this move at that time and expected the USD share of global reserves to drop below 50% soon and the euro to be at a par with the USD in the international monetary and financial system.
Smaller currencies in aggregate were also not able to offer an attractive investment alternative. With Japan pioneering ultra-low interest rates, the share of yen-denominated assets dropped from 6.1% in 2000 to 3.6% in 2011, before recovering to 5.2% in the last currency composition of official foreign exchange reserves (COFER) survey conducted by the IMF at year-end 2018. Commodity currencies experienced a small increase in allocations over the years, and both the Canadian as well as the Australian dollar are now close to 2% from 1.5% in 2012.
The enduring dominance of the USD reflects several factors including hard factors such as the size and depth of its financial markets, and soft ones such as the US dominance in global affairs. From an investment perspective, the USD is the ultimate safe-haven currency and during periods of heightened global risk, investors fly to the US Treasury market.
This has not changed over the last 25 years and it is still true today as shown by the rise of the USD when uncertainty in global markets rises. It is not therefore surprising that the USD still represents the bulk of global reserves.
Is RMB a long-term challenger to USD?
The big newcomer and recent high-flyer in the group has been the Chinese RMB. In the 2019 UBS survey, 18% of participants picked its introduction into the SDR basket as one of the key events for reserve managers over the last 25 years.
Will we move from a USD dominant currency towards a multipolar financial system?
The majority of central banks believe that the international payment and financial system will gradually shift to a multi-polar currency system with three leading currencies competing.
The shift to a multi-polar currency system is generally seen as a positive development for the international payment and financial system.
Dominance of USD can force central banks to hold excessive USD FX
The US economy represents 15% of the global economy and its exports only 10%.
However, its spill-over effects on the rest of the world are greatly amplified by the dominant role of the USD in international payments, debt issuance and FX reserves.
The dominance of the US dollar, reflected in its role as a global anchor for prices and interest rates, can force central banks to hold excessive USD-denominated foreign exchange reserves to match the significant USD exposure from trade and borrowing of the respective economy.
The dominant role of the USD in credit and investment markets impacts investment flows to Emerging Economies by increasing volatility. Investment flows to emerging markets can reverse much faster than they have built up over time, making them act like very destructive procyclical amplifiers in crisis situations.
Shortcomings of current USD-based system
The shortcomings of the current USD-based monetary and financial system were recently highlighted in a speech given at the 2019 Jackson Hole Symposium by Mark Carney, Governor of the Bank of England. Governor Carney also used the opportunity to discuss the idea of a Synthetic Hegemonic Currency (SHC) as a possible solution. Its main purpose would be to leverage recent technology progress – digitization and blockchain – to accelerate the shift away from a USD-dominated international financial system. Such technology solutions could actually 'disrupt' the network externalities which make the incumbent currency dominant.
Some countries are already working on the issuance of digital currencies and it might just be a question of time for their formal introduction into our payment system.
However, what history taught us is that a shift to a new global currency system can be long and bumpy. This was indeed the case during the intra-war period when sterling and the USD co-existed for a long time; and the coordination problems were relatively small as only two currencies were involved,
both originating from countries with the same language and relatively similar culture and values. In the future, three currencies will likely dominate the global financial system and coordination problems are likely to be higher.
With such considerations also at the core of asset allocation strategies at many central banks, investment processes and FX diversification options might be disrupted much more over the next 25 years than most people would expect today.
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