An end to the loveless marriage with the US dollar?

Covid-19 represents an unexpected shock that could cause further US dollar decoupling, writes Gary Smith of Tabula Investment Management


The US dollar is overwhelmingly the dominant currency in the world because of a confluence of circumstances during the past century that have reinforcing network effects. There are four key strands.

Firstly, almost all commodities are priced in dollars. This numeraire effect is well entrenched and unlikely to change while resource extraction companies have balance sheets denominated in dollars and often have stock market listings in the US.

Secondly, more than 80% of all foreign exchange trades have the US currency on one side of the equation. Even in Asia, currency pairs are still predominantly quoted versus the dollar, rather than on an Asian currency versus Asian currency basis.

Thirdly, and linked to the first two points, the dollar has an outsized role in international trade invoicing. It is estimated that around 40% of global trade is denominated in US dollars, a number that greatly exceeds both the US share of global GDP and global exports.

Finally, the US bond market is the deepest and most liquid in the world. This helps to explain why US dollars currently account for 62% of central bank forex reserves. To the extent that forex reserves are a pure measure of reserve currency status, the US currency has a dominant position over second-placed euro at just over 20%, the yen at 5%, sterling at 4% and the renminbi at 2%.

The world’s marriage of convenience with the dollar is propped up by inertia and network effects, which argue that divorce is an unlikely prospect. For many commentators, the dollar looks set to maintain its position for decades.  

Covid-19 decoupling?

However, in the natural world glaciers melt slowly, and not much appears to be going on until something big happens, and the glacier calves. An unexpected jolt could also accelerate the speed of decoupling of trade and finance from the US dollar.

The Covid-19 pandemic might provide such a jolt. The use of cash has fallen sharply in all economies. The digital economy has grown at a pace that was unimaginable only months ago. This has served to intensify discussion about the rollout of central bank digital currencies (CBDC) as convenient (unlike bank deposits) legal tender, which are considerably safer than cash.

CBDC could be the most important innovation in the international monetary system for decades. 

Any decoupling could well be driven by events in Asia, home to almost half of all global foreign exchange reserves, and almost half of global migrant worker remittance flows. It is also the region where digital payment plumbing is most advanced (payments via mobile phone account for more than 30% of shop transactions in South-east Asia, which is more than double the rate observed in the US). Digital tokens issued by central banks would encourage a deepening of already well entrenched online banking trends. 

Driven by Asian CBDCs?

The availability of CBDCs would not automatically lead to a reduced role for the dollar. Local-currency CBDCs would merely introduce a new choice for the execution of transactions, which might be at the expense of the US dollar. What could be more damaging for the dollar is if the Fed is slow to follow the introduction of CBDCs by other nations. Currently the Fed is lagging European and Asian nations. Notably, China is pushing towards the forefront, having just launched digital renminbi trials in four key cities.  

Secondly, there has been a well-documented push-back against the weaponisation of the US dollar. Policies introduced by the US Treasury after the terror strikes in 2001 aimed to prevent the financing of global terror networks have been repurposed to pursue a wider list of policy objectives. For the central banks of Russia, China and Turkey, the decision to shift out of dollar assets and into (in particular) gold has been a reaction to this.

For many investors around the globe, even those in countries that are friendly with the US, the attractiveness of the dollar has been tarnished.

Additionally, US dollar dominance should naturally decline as the US economy’s share of global GDP fades, and as other nations (especially in Asia) grow more quickly. In 2019, then Bank of England governor Mark Carney forecast a future monetary system that was multipolar, and that would dampen the “domineering influence” of the US dollar on global trade. 

China’s trade volumes with the Asia-Pacific region are approximately twice as large as those for the US. The increased use of the renminbi would be a logical consequence, especially in nations where Belt and Road projects are in place. The pace of adoption might be faster if the People’s Bank of China offered digital tokens. The more trade that is denominated in renminbi, the greater the argument for adding RMB to forex reserves.

Finally, one should not overlook the effect on investor’s portfolios from the gradual increase in the weights of China in both fixed income and equity indexes.

For many investors around the globe, even those in countries that are friendly with the US, the attractiveness of the dollar has been tarnished

Other currencies have also had their reserve currency credentials burnished. The appeal of the euro has been enhanced by the surge in green bond issuance denominated in the single currency. Germany has just issued its first green Bund and this is likely to push green bond issuance in euros to a record level in 2020. Estimates suggest that more than 50% of all green bond issuance globally will be denominated in euros.

The yen has also enjoyed an uptick in the reserve currency holdings league table, helped by the desire of Asian central banks, as with the renminbi, to hold reserves in the currencies of major trading partners. 

The dollar share in global forex reserves has declined from 72% at the turn of the century to 62% currently, and it is only a question of time before the US dollar’s weight falls below the eye-catching level of 60%. The world will be stuck in this marriage with the dollar, but the foundations of the relationship will weaken gradually.

Cofer data and the 60% threshold

This forecast, however, flies in the face of the International Monetary Fund’s Currency Composition of Official Foreign Exchange (Cofer) data for the first quarter of this year, which showed a small increase in the share of US dollars in the global reserve currency allocation. However, this was helped by a significant valuation effect. Both the US treasury market and the US dollar rallied strongly in the first quarter and, in the absence of rebalancing sales of US securities, this would have the effect of boosting the dollar share in forex reserves. 

Ahead of the release of second-quarter data this month, it is worth highlighting that valuation effects (especially the currency aspect because of dollar weakness) will be working in the opposite direction and, unless there are offsetting rebalancing purchases of dollar securities, the dollar weight in the Cofer database will resume its multiyear decline.

Finally, it is also noteworthy that in countries that establish sovereign wealth funds, the currency allocation will usually be less dollar-centric than is the case in forex reserves. Hence, over time the ratio of dollars in a wider definition of ‘official state assets’ is slowly shrinking.

When Carney raised concerns about the destabilising role of the US dollar, he described a world economy that was being reordered. But he noted, pointedly, that the US currency remained as important “as when Bretton Woods collapsed”.  

Due to the pandemic and the turbo charging of the trend towards digital finance, combined with entrenched discomfort at the dominant role of the US dollar, the ties that bind the world into the loveless marriage with the US dollar may finally be weakening.

Gary Smith is managing director at Sovereign Focus and a sovereign coverage consultant at Tabula Investment Management.

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