Halfway through 2020, the COVID‐19 pandemic continues, with the United States emerging as a global hotspot. According to The New York Times, over 4 million people in the U.S. have tested positive for the coronavirus, with the number of deaths passing 150,000. The economic fallout has also been severe, with shuttered businesses and the unemployment rate above 10%. The current environment, also fueled by social unrest, political instability and a polarized populace, leaves one with the feeling that we may be in the midst of a period of profound change where the “new normal” that eventually emerges differs in ways we would never have anticipated before the crisis.
Amidst this climate, some pundits and economists have begun to speculate that the relative strength of the U.S. dollar we’ve seen in recent years could start to decline, with even the dollar’s primacy as the world’s reserve currency under threat. While the strength of the dollar ebbs and flows over long cycles as the normal consequence of economic activity and trade, the dollar has been the dominant global reserve currency for nearly 80 years – a shift away from the dollar would have significant impacts on the global economy, though many of these impacts are uncertain. In this letter, we’ll examine the role of currency reserves in the global economy, how the dollar became the world’s preferred reserve currency, how its strength could be challenged, and the potential consequences of a global shift away from the dollar.
What is a reserve currency and how did the U.S. dollar become dominant? A reserve currency is a currency that is held in large quantities by foreign governments and dominates global banking transactions. There are many reasons a country may hold a stockpile of reserve currency including to facilitate international trade, to manipulate their own currency’s exchange rate or to ensure adequate liquidity in an economic crisis. Prior to the 20th century, different currencies went in and out of favor as the preferred currency for international transactions, largely reflecting who had the greatest military and economic strength at the time. For example, during the Renaissance, the Florentine florin and the
Venetian ducato were commonly used, giving way to the Dutch guilder in the 18th century (owing to the dominance of Dutch East Indian Company in international trade). By the mid‐19th century, the industrial revolution and reach of the British empire made the pound sterling the preferred currency – the majority of world trade was invoiced in pounds sterling, and British capital was the biggest funder of foreign investment. When then British adopted the gold standard (that is, backed the value of their currency to a fixed quantity of gold), the national banks of many developed countries followed suit. The pound sterling remained the dominant reserve currency until World War I, when many warring European nations, including Great Britain, were forced to abandon the gold standard in order to fund their costly military expenses with fiat currency (that is, paper money not backed by real assets such as gold). However, as a late entry into the war, the United States retained the gold standard which made the U.S. dollar an attractive reserve currency.
A similar dynamic occurred during the Second World War. With the United States remaining on the sidelines during the first two years of the war, Congress passed the Lend‐Lease Act in 1941 which provided U.S. allies with war supplies, much of which was paid for with gold. By the end of the war, the United States had emerged as the largest holder of gold reserves by far (see Figure 1). In 1944, the Bretton Woods conference officially established an international monetary system among the Allied countries that placed the dollar, backed by the U.S. Treasury’s gold, as the global reserve currency. Under the Bretton Woods system, central banks maintained fixed exchange rates between their country’s currency and the U.S. dollar, and the dollar could be exchanged for gold on demand. As countries accumulated dollars, they began purchasing dollar‐denominated U.S. Treasury securities as a safe haven. This system, ultimately backed by U.S. gold reserves, was maintained through the post‐war boom years until global demand for U.S. Treasuries, along with U.S. deficit spending to fund the Vietnam War, caused the U.S. to greatly increase the supply of dollars. Feeling nervous about the dollar’s stability, many countries began converting their dollar reserves back into gold ultimately forcing President Nixon to abandon the gold standard in 1971. Since then, the dollar has been a fiat currency.
Following the de‐linking of the dollar to gold, the share of dollars held in central bank reserves fell relative to gold for a time, though the dollar eventually reemerged as the preferred currency, overtaking gold in the 1990s (see Figure 2). Today, the U.S. dollar is by far the most widely used reserve currency, accounting for over half (or ~$6.8 trillion) of foreign exchange reserves. The next closest currency, the euro, accounts for 20% (~$2.2 trillion). While no longer backed by gold, the dollar is now backed by the strength of the U.S. economy, and the unmatched scale and liquidity offered by the Federal Reserve – there is over $1.9 trillion in circulation and much of that is used as hard currency outside of the U.S. in places like Latin America and the former Soviet republics. Nearly 40% of the world’s debt is issued in dollars, keeping demand from foreign banks high. The dollar is so ingrained in the international monetary system that it is hard to see how it could fall from grace, at least in the short term.
A change to the status quo? Despite its dominant position, some see signs of a longer-term
trend away from the dollar – a trend that could be accelerated by deteriorating economic conditions and a loss of faith in U.S. governance and its global leadership. In fact, the share of foreign exchange reserves held in dollars has been falling in more recent years, down approximately 10% since 2000. This could be due to several factors including China’s increasing desire to reduce its dollar holdings in order to diversify its currency reserves and the rise of the euro as an alternative (more on that topic below). Over the long term, however, a simple explanation for the decline is that it mirrors the shrinking U.S. share of world economic output. In 1960, the U.S. economy represented approximately 40% of the world economy but now is less than 25% (see Figure 3).
The value of the dollar has remained relatively strong, up nearly 30% in inflation‐adjusted terms since 2011. During periods of global economic crisis, the value of the dollar tends to rise as investors seek to buy U.S. Treasuries as safe haven. In fact, in the early days of the COVID‐19 pandemic and associated equity market crash in March, the value of the dollar increased as measured by the U.S. Dollar Index (see Figure 4). However, the dollar has since weakened, down almost 7% in the past three months, while the euro has gained as the U.S. has lagged in its response and recovery from the coronavirus.
Stephen Roach, former chief economist at Morgan Stanley and senior lecturer at Yale School of Management, predicts a sharp downfall for the dollar over the next few years (forecasting a drop in value of 35%) and sees more ominous signs of a dollar collapse in a piece for Bloomberg. In his view, a currency’s strength is tied to both to the underlying economic health of the country as well as the foreign perception of a nation’s strengths or weaknesses. Mr. Roach cites the decline of the U.S. national savings rate (which includes households, businesses, and the government sector) as one cause for alarm. While the savings rate in the U.S. is typically low, in the first quarter of 2020 it fell to 1.4% of national income – the lowest since 2011 and one‐fifth of the average of 7% from 1960 to 2005. As the economic fallout from the pandemic continues, the national savings rate is likely to see a significant drop into negative territory. Mr. Roach believes that given the huge increase in the federal budget deficit brought on by increased spending in response to the pandemic, the national net savings rate could dip much lower, perhaps as much as ‐10%. For context, the previous low was ‐1.8% during the Global Financial Crisis. This will further increase the already negative U.S. current account deficit, reflecting the country’s vulnerability in its reliance on the surplus of dollars held outside of the U.S. to fund growth. Combine this with a shift in U.S. foreign policy away from the traditional role of the U.S. as a global leader in promoting free trade, and as an advocate for strong international agreements, and other nations may start to more seriously seek alternatives to the dollar.
What could emerge as alternatives to the dollar? When the dollar weakens, by definition, other currencies will gain. Popular reserve currencies beyond the dominant dollar include the Japanese yen, British pound sterling, Swiss franc and Australian dollar. However, over the longer term, some currencies are more likely to pose a threat to the dollar than others.
In 2015, China received official status from the International Monetary Fund as one of five issuers of an internationally significant currency. While economists mostly downplayed this development (Paul Krugman characterized it as “not much more than a minor change in accounting, with trivial economic implications”), it does set the Chinese renminbi on a long‐term path towards greater acceptance as an alternative to the dollar, especially as the Chinese economy continues to increase its share of global GDP. The renminbi still has a long way to go to gain widespread acceptance as a reserve currency as Chinese capital market reforms, among other reforms, are needed to challenge U.S. capital markets and attract
greater foreign investment; however, China is determined to be an important global player and has the will and resources to threaten the dollar over the long‐term.
Gold may also come back into favor at the expense of the dollar. In fact, the price of gold is currently near all‐time highs. However, to state the obvious, gold has a practical problem in that is not very transportable; therefore, a currency that returns to the gold‐standard, or even an alternative currency such as a crypto currency (e.g., Bitcoin) that could value itself relative to some real asset could eventually mount a threat to the dollar. However, like the Chinese renminbi, such a scenario seems implausible anytime soon.
The most likely challenger to the dollar in the short to medium term may be the euro. The euro has gained significant ground on the dollar in recent months as European leaders passed a €750 billion stimulus package which includes the issuance of EU sovereign bonds for the first time. These new bonds offer a new euro‐denominated, highly‐rated and liquid asset for governments that could potentially challenge U.S. Treasury securities; however, the EU stimulus package is only a temporary measure and there are no plans to issue new bonds post‐crisis. Additionally, U.S. capital markets are much more developed than the European capital markets partly due to the uncertainty inherent in a system that combines individual country sovereignty and a shared currency. While the EU may now be on the right path
following the eurozone crisis a decade ago, its capital markets would have to be strengthened for the euro to eventually replace the dollar as the preferred global reserve currency.
What would be the consequences of a global shift away from the dollar? It is hard to predict what would happen if the dollar truly fell from grace, as it would be an unprecedented event in modern times. In general, a weakening dollar is inflationary which, coupled with a weak economic recovery, could lead to a period of U.S. stagflation (the brutal combination of stagnant economic growth and rising inflation that plagued Japan throughout the 1990s). American borrowers could also end up paying higher interest rates, as it is theorized that strong demand from foreign investors for U.S. assets helps to bid down the cost of loans within the U.S. As previously mentioned above, the U.S. trade deficit could also continue to widen, which combined with U.S. tariffs on low‐cost producers, would essentially tax U.S. consumers by forcing them to purchase more expensive goods from countries with a higher cost of production.
But there are also potential benefits to a weakening dollar. Dollar depreciation lowers the price of U.S. exports which could help U.S. manufacturers become more competitive in global trade. Additionally, U.S. companies with substantial revenue from outside the U.S. could increase their earnings due to the more attractive exchange rate. Finally, to the extent that a rapidly weakening dollar relative to other currencies such as the euro is a reflection of the underlying strengths of their economies, investors could flock away from U.S. stocks towards international stocks. Importantly, investors in international stocks during a weak dollar environment benefit not only from a potential asset return, but also from a positive
foreign currency return.
It is our view that the dollar is not under serious threat to be dethroned as the world’s preferred currency anytime soon. The dollar enjoys unmatched scale and liquidity and is too intertwined in the global economy to be quickly unwound without inflecting serious damage not only to the U.S., but to all countries holding dollars as their primary reserve currency. However, we believe that the dollar could continue to weaken in the short to medium term, providing a benefit to investors in non‐U.S. assets. For this reason, and because we believe the best way to achieve growth over the long‐term is to have a diversified portfolio of global investments, we continue to maintain a healthy exposure to non‐U.S. stocks and feel well‐positioned to take advantage of the changing times that are likely ahead.
We hope you remain safe and healthy. As always, we welcome your questions and conversation – please reach out to us anytime you would like to chat.
The Mangham Associates Team
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