Executive Summary & Background
Since the end of the second world war, the size and strength of the U.S. economy have supported the U.S. dollar (USD) and helped it become the dominant currency in the global economy, known as the world’s reserve currency.
Recently, though, concerns have arisen that the USD will be replaced as the reserve currency. There are three primary reasons why we believe that the USD will maintain its dominance in the global financial system:
- The USD’s network effects make it difficult to conduct trade in other currencies.
- There is no viable substitute to replace the USD’s liquidity, universal acceptance, availability, or stability.
- The long-term strength of the U.S. economy is due to the three “I” factors—Institutions, Innovation, and Inclusion—not because the USD is a reserve currency.
Accordingly, we expect the USD to maintain its reserve currency status both in the near and longer term.
Lately, many headlines have touted the increased usage of other currencies.
- Saudi Arabia and China announced that they are open to trading in currencies other than the USD. China also funded a $12.2 billion new oil facility in the Kingdom.
- The Chinese renminbi replaced the USD as the most traded currency in Russia.
- Brazil agreed to trade more with China in renminbi, and its renminbi reserves surpassed those in the euro for the first time.
- India and the United Arab Emirates (UAE) are discussing using the Indian rupee for trade.
- Malaysia is rekindling the Asian Monetary Fund idea that died a couple of decades ago.
- France settled its first liquified natural gas (LNG) cargo using the Chinese renminbi.
Therefore, around the edges, these headlines indicate some erosion in the USD's importance on the global stage.
Over the last two decades, the USD's reserve currency status has been questioned multiple times. One of the most memorable episodes was in November 2004 when the popular weekly economic/business magazine, The Economist, ran an article titled “The dollar's demise,” raising existential questions about the USD’s future. The magazine cited Federal Reserve Chair Alan Greenspan's speech where he infamously said, “Given the size of the current account deficit, a diminished appetite for adding to dollar balances must occur at some point.”
Unsurprisingly, the magazine declared Alan Greenspan's words were of a huge moment, not because of the clarity of his message but because a highly credible, right-thinking economist admitted what many had long believed at that time—that the emperor had no clothes. The USD dropped to a record low after this speech, and many believed that the currency was doomed to lose its reserve status not too long in the future.
During the early years of the new millennium, the European Union was on a strong footing, with member countries enjoying strong growth rates, and the common currency reached new all-time highs against the USD nearly every other month. Again, in 2004, the basic assumption was the European Union was an immensely successful political union with benefits of unfettered free trade, capital, and labor mobility so great that the euro would eventually dethrone the U.S. as the world's new reserve currency.
During those years, China was growing at double digits, with many investors stampeding to invest in the country, and it was the top destination for global manufacturing lines. Chinese leadership – under President Hu Jintao and his Premier, Wen Jiabao – was pushing economic equality through the "Scientific Development Concept" – aiming for a socialist, harmonious society that was prosperous and free of social conflict. In foreign policy, China practiced soft power in international relations and, more importantly, diplomacy that promoted a business-friendly environment. At the time, the basic assumption was that China's economic growth rate would continue at that pace for many years, making it the world's largest economy and eclipsing the U.S. in a decade or so.
In Japan, reformist Junichiro Koizumi was the prime minister and was preparing the country for its next influential leader, Shinzo Abe. Shinzo Abe had a grand vision for his country with his three arrows strategy—also known as Abenomics—that involved (1) aggressive monetary policy, (2) fiscal consolidation, and (3) a growth strategy. Due to health reasons, Shinzo Abe couldn't finish his first term, but later in 2012, he implemented his transformative policies and became Japan's longest-serving prime minister.
Fast forward nearly two decades to today from Greenspan’s infamous 2004 speech, and the world looks very different than the basic assumptions or projections many had back then.
We acknowledge that there are near-term challenges to the USD's dominance, but there is no viable alternative to replace it, at least not yet. Countries are free to trade with any currency they wish. As a matter of fact, they do not even have to use any currency; they can barter. An oil-rich country can send barrels of oil to a banana-rich country to get a container full of bananas.
The question is, what happens if one country sells more goods or services and there are extra savings or reserves? Where are those savings stored? Is it in the USD or any other currency? If it is not stored in the USD, an alternative must exist. The apparent options are the euro, Japanese yen, and, more importantly, the Chinese renminbi.
If the Chinese renminbi is the alternative, then the questions become:
- Would savers trust Chinese institutions?
- Is the Chinese renminbi liquid enough to store excess savings?
- Are financial markets in China open to all and offer the same sophistication as the U.S. markets?
We believe the answer to all questions above is a resounding "No." On the other hand, Europe has an opportunity to gain market share, which it has done since 2000—as a matter of fact, Europe has gained much more than China has. Since the COVID-19 crisis, the European Union (EU) has shown unprecedented solidarity by issuing a significant amount of jointly-backed debt. Even with that, the EU's integration is nowhere near that of the U.S., where 50 states formed a fiscal and military union.
The USD’s network effects
The USD is bought or sold in about 88% of global foreign exchange (FX) transactions, based on data from the latest Triennial Central Bank Survey conducted by the Bank for International Settlements, and the USD’s share has remained stable over the past 20 years. In contrast, the Chinese renminbi, which was non-existent in FX transactions outside of China, gained a 7% market share over the last decade (slide 8).
The USD is the preferred currency for foreign debt issuance and has been gaining market share in the issuance market since the global financial crisis. For debt issuance by sovereigns, quasi-sovereigns, and corporations in a currency other than that of their home currency, 64% have preferred to issue bonds in USD, which is 4% higher than during the global financial crisis. On the other hand, the Chinese renminbi’s share is only at 2% (slide 9).
There is almost a trillion dollar’s worth of paper banknotes used in countries overseas—or 44% of all U.S. physical banknotes—according to estimates by the Federal Reserve. There are two main benefits of paper currency held by foreigners. First, in order to accumulate USD, foreigners must sell goods and services, and in return, they receive money in only paper form. Second, the U.S. government does not have to pay interest on paper currency, and annual inflation erodes purchasing power of the banknotes that are floating around (slide 10).
Lastly, in the U.S., a common misconception is that most U.S. government debt is owned by foreigners, where there is a risk of them suddenly selling all the bonds at once. Domestic entities, including the Federal Reserve, own the majority of U.S. government debt, and the level of that ownership has moved back to 1999 levels, increasing with rates moving higher.
Foreign owners of U.S. debt will receive USD in electronic or paper form if they decide to sell, and the Federal Reserve can choose to buy excess debt offered in the market as it did during the pandemic. As of January 2023, China’s U.S. Treasury holdings were valued at $860 billion and were 3.5% of total outstanding U.S. government bonds (slide 11).
No viable substitutes to the USD
To replace the USD’s dominance in global finance, there must be an alternative to use in its place. The obvious ones include the euro, Japanese yen, and the Chinese renminbi.
1. Euro: The EU went through an existential crisis during the European financial crisis of 2015-16. Greece was forced to restructure its external debt and introduce capital controls. For three years, its citizens were forced to follow strict cash withdrawal limits from its banks. Greek equity indices were downgraded from developed markets status to emerging markets—and to this day, it is still a member of the emerging markets index. The banking system failed in Cyprus, and many depositors lost their savings. At one point, Greece was at the precipice of an abrupt departure from the EU. Thankfully, Greece did not exit from the EU, but a year later, the U.K., Europe's second-largest economy, did. The U.K.'s exit, known as Brexit, shook the EU at its foundation, and the unexpected trade frictions that it created slowed European and U.K. growth rates and productivity. In short, while many were expecting the euro to replace the USD as the world's new reserve currency, the euro muddled through very tough waters over the last two decades. Last year, the currency traded well below parity, 30% lower than at the end of 2004 (slide 12).
2. Japanese yen: Since 2004, the transformative leader, Shinzo Abe, managed to implement his three arrows strategy during his second—and much longer—term, but the result was a Japanese yen that was much lower than the USD with little economic growth or productivity gains to show for it. Japan’s economy has grown by 17% in real terms since 2000, while the U.S. has grown 58%. Japan is in a steep population decline, losing one person every minute, which is faster than any other developed country. It is hard to find a good reason to keep extra savings in a country that is in a permanent decline in terms of growth or population (slide 13).
3. Chinese renminbi: During the early years of the new millennium, the hope was that China would eventually adopt Western-style capitalism that would benefit all parties involved. Instead, Chinese capitalism is looking more like “Surveillance Capitalism,” where every move is recorded, and without warning, wealth can be taken away from participants with no legal protection against the state. For local citizens and entities, China runs strict controls on capital mobility, where there are limits to sending money overseas. These limits are there for a reason—to stop savings flowing to other currencies, mainly to the USD. It would be hard to convince foreign investors to keep their savings in renminbi when the local savers want to do the complete opposite. Since 2004, the Chinese currency has appreciated against the USD. However, this is not because it was gaining market share in reserve balances or global trade, but because the currency was pegged to the USD for a long time at an undervalued level. This allowed the currency to gain competitive market share against export-oriented economies in Asia and Europe. Once the peg was removed, the currency started to gain. Last year, Xi Jinping appointed himself for an unprecedented third term with no apparent end to his presidency. In foreign policy, the country adopted what is known as “wolf warrior diplomacy," replacing the previous President Hu Jintao's use of cooperative rhetoric and the avoidance of controversy. Over the last decade, the Chinese growth rates dropped to low single digits, surveillance capitalism shackled private enterprises, and the common prosperity drive curtailed the optimized capital allocation. While China achieved an active role on the world stage, the fault lines with the West became much more visible. Distrust between China and the West, especially with the U.S. but also with India, Australia, and the EU, grew to worrisome levels (slide 14).
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