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Why the US dollar remains centre stage

By Philip Saunders - Co-Head of Multi-Asset Growth
Russell Silberston - Co-Head Developed Market FX & Rates, Fixed Income
Mike Hugman - Fixed Income Portfolio Manager
Sahil Mahtani - Investment Institute Strategist*

The fast view

  • Despite fiscal weakness and political uncertainty in the US, dollar use remains exceptionally wide and deep.
  • Liquidity, inertia, trust, and the US Federal Reserve’s global role as lender of the last resort, collectively explain why there is no alternative to the dollar on the world stage.
  • Fuller internationalisation of the euro would require far-reaching monetary and economic policy changes within the euro zone.
  • While China’s economic might has grown, the renminbi’s role as a global currency remains limited.
  • Geopolitical, economic and cyclical shifts could see de-dollarisation gaining momentum over the next few years, with a growing global role for the renminbi.

The US dollar has enjoyed a dominant position for almost 30 years. Our paper, Exploring the history of dollar dominance, looks at how the dollar cemented its position since the second world war. This paper focuses on the dollar’s current role in world financial markets.

Dollar use remains high everywhere, with the euro a clear second

Persistent talk of a shift away from the dollar recalls historian AJP Taylor’s comment on the 1848 revolution as a “turning point that did not turn.” Here too, little has changed in recent years. Despite America’s twin deficits, rising national debt levels, a turbulent domestic political environment and disruptive foreign policy, dollar use remains exceptionally wide and deep. In trade invoicing,1 international banking and corporate borrowing,2 simple foreign exchange turnover,3 central bank reserves4 and other measures of currency dominance, the dollar reigns supreme. In short:

Figure 1

  • As a store of value, nearly two-thirds of international debt markets are denominated in dollars, as are nearly three-fifths of cross-border loans.5 Meanwhile, 63% of international currency reserves are denominated in dollars.
  • As a means of payment, 40% of all payments are denominated in dollars, as is 44% of foreign exchange turnover.
  • As a unit of account, petroleum prices are mostly set in dollars, while other commodity prices are quoted in dollars. Moreover, 80% of dollar-denominated imports never enter the US. By contrast, all trade using euros involves at least one euro-zone country.6

 

Snapshot of the international monetary system

Figure 2

Sources: BIS, IMF, SWIFT, ECB, and Gita Gopinath. Data as of the fourth quarter of 2017 or latest available. Empty columns imply unavailable data or negligible values.

Even though the euro’s share of reserves has increased in recent years, fuller internationalisation of the euro requires overcoming an export-driven growth model championed by the euro zone’s anchor economy, Germany, that discourages large currency inflows. It involves changing a financial and legal order that prevents the creation of the required supply of safe assets and going beyond a pure inflation-targeting mandate that prevents the European Central Bank from assuming wider international responsibilities, such as extending swap lines during crises.7

Domestic and international payments by currency share

Figure 3

Sources: SWIFT, 2018

The renminbi remains limited as a global currency

As China’s economic might grows, there is increasing focus on the potential of the renminbi to achieve global currency status. Despite Chinese efforts after the global financial crisis to expand the renminbi’s use, progress has stalled. This stagnation occurred after the bout of volatility in late 2015/early 2016, when China’s stabilisation efforts involved re-closing the capital account to domestic investors.

Today, the renminbi remains limited as a global currency. As a medium of exchange, renminbi use in domestic and international payments fell a whole percentage point between 2016 and 2018 to 1.7%. Even the Canadian dollar is more widely used.8 As a store of value, renminbi assets held by overseas institutions within China finally returned to the levels seen at the beginning of 2015 in renminbi terms, implying a reduction relative to the larger size of the economy.9 True, renminbi use in sovereign reserves rose to 1.84% in mid-2018 from 1.07% at the end of 2016, but that is from a relatively low base.10

Why there is no alternative to the dollar on the world stage:

1
Liquidity. The US remains a huge economy by any standard, meaning the supply of dollars and dollar-denominated assets is large enough to support the demands of global trade and finance. Even today, reserve managers who need to deploy large amounts of liquidity in safe assets with minimal trading spreads only have markets in the dollar and perhaps the Japanese yen as an option.
2
Inertia. Any dominant currency maintains a strong network effect. For instance, research has found that a 1% depreciation of the bilateral exchange rate leads to a mere 0.04% depreciation of the bilateral terms of non-commodities trade. For non-US economies, therefore, the terms of trade of a country are disconnected from its exchange rate.11 Many businesses in non-dollar countries invoice in dollars and are happy to deal in it regardless of the price. Effectively, they ‘think’ in dollars. Exporting firms prefer to keep prices stable relative to competitors and they also use imported inputs priced in dollars in production.12 This advantage in trade then influences the provision of trade finance. Of the US$96 trillion of outstanding over-the-counter currency derivatives, 88% involve the dollar, while just 32% involve the euro.
3
Trust. The willingness of other countries to hold dollars is an important reason for the dollar’s dominance. For instance, studies show that military alliances boost the share of a currency in the partner’s foreign reserve holdings by about 30 percentage points, which is clearly applicable given US geopolitical might.13 Moreover, despite congressional confrontations over the US debt limit, the historical soundness of the country’s governance structure has always been a selling point. Essentially, the dollar is viewed as a ‘safe-haven’ currency. It tends to appreciate during times of stress, which makes holding dollars attractive in normal times as well.
4
Lender of last resort. The US Federal Reserve is ready to assume a global role. It served as a backstop provider of dollars during the financial crisis by pursuing swaps with fourteen central banks, including four in emerging markets.14 This contrasted sharply with the European Central Bank, which in 2008, provided only limited assistance to the central banks of two EU countries, namely Poland and Hungary.15

 

Emerging Asian economies are always looking for ways to reduce the boom-and-bust cycle associated with the dollar.

 

Despite these longstanding advantages, could de-dollarisation gain momentum in the next cycle?

2018 was potentially a watershed year in which countries in the path of sanctions, like Russia, Iran and to some extent China and the EU, began to accelerate ways to protect themselves from the consequences of using the dollar. President Trump’s sanctions are a proximate but not an ultimate cause for the shift.

Meanwhile, other emerging Asian economies are always looking for ways to reduce the boom-and-bust cycle associated with the dollar, and they may get that opportunity as trade in Asia becomes less dependent on the US. Currently, for instance, a 10% US dollar appreciation takes about 1.5 percentage points off GDP growth in emerging market economies.16 Such countries therefore may find it to their advantage to sign swap agreements with the Chinese central bank and conduct trade in a currency like the renminbi, which increasingly reflects their trade patterns. Besides geopolitical shifts, changes in energy market dynamics, structural shifts in China and a dollar down cycle could see de-dollarisation gathering pace over the next few years. We explore these dynamics in more detail in our paper, What is driving de-dollarisation?


1 Gopinath, G., and Stein, J. “Banking, Trade and the Making of a Dominant Currency,” 29 November 2018, Joint European Central Bank / Federal Reserve Board and the Federal Reserve Bank of New York Conference, 30 November 2018.
2 Smith, C., “One more reminder that the US dollar is dominant,” Financial Times, 5 September 2018.
3 Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016, Bank for International Settlements, 11 December 2016, Table D11.1.
4 Currency Composition of Official Foreign Exchange Reserves, International Monetary Fund data.
5 BIS Statistics Explorer, Table C3, All Countries excluding residents, Issue Currency.
  and “The international role of the euro,” Interim Report, European Central Bank, June 2018.
6 Gopinath, G., “The International Price System,” Harvard University and NBER, 2 November 2015.
7 Tooze, A., Odendahl, C., “Can the euro rival the dollar?” Centre for European Reform, 4 December 2018.
8 “RMB Tracker: Monthly reporting and statistics on renminbi (RMB) progress towards becoming an international currency,” SWIFT.
9 Herrero, A.G., Xu, J., Chen, K., “Natixis RMB Internationalization Monitor: Stagnation” Natixis, May 2018, p. 14.
10 Currency Composition of Official Foreign Exchange Reserves, International Monetary Fund data.
11 Boz, E., Gopinath, G., and Plagborg-Moller, M., “Global trade and the dollar,” Voxeu, 11 February 2018.
12 Clement, D., “Interview with Gita Gopinath,” The Region, Federal Reserve Bank of Minneapolis, 20 December 2016.
13 Eichengreen, B., Mehl, A., Chitu, L.,” Mars or Mercury? The geopolitics of international currency choice,” Voxeu, 2 January 2018.
14 Bernanke, B., “The dollar’s international role: An ‘exorbitant privilege’?” Brookings Institute, 7 January 2016.
15 Tooze, A., Odendahl, C., “Can the euro rival the dollar?” Centre for European Reform, 4 December 2018.
16 Martin, F.E., Mukhopdhyay, M., and Hombeeck, C., “The global role of the US dollar and its consequences,” Quarterly Bulletin, Bank of England, Fourth Quarter 2017, p.1.


*Other contributing authors
Greg Kuhnert | Peter Eerdmans | Michael Spinks | John Stopford | Iain Cunningham | Wilfred Wee | Tom Nelson | Michael Power | Imran Ahmed


Important information

This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein. All rights reserved. Issued by Investec Asset Management, March 2019.

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