Since January, the world has seen a lot of change and uncertainty. The Coronavirus outbreak and the financial recession have shaken up our predictions about the future. In the USA it becomes clear that the vast social divide grows larger while Trump continues to steer America closer to a hard trade war with China. It is apparent that America will, due to the issues happening locally as well as the crisis taking place globally, undergo a meticulous reassessment of not only its domestic and foreign policy but inevitably, its place as a player in the global economy. With the US national debt surpassing 26 trillion dollars, many investors might begin to ask: is there a more stable economy present that can establish a new reserve currency?
A reserve currency is a currency of which banks and other financial institutions around the world hold a certain amount and in which trade is conducted. The reserve currency is not something that is legally established, it is a currency that is trusted by the largest number of investors and people conducting international trade.
When one holds a 100-dollar bill, it is legitimate to ask, what gives this piece of paper such a buying power? In the past currency was backed by gold. The paper bill was just a substitute for an equivalent amount of gold held in a bank vault. After time it became clear that there is not enough gold to match the increasing demand for capital. In 1971 after Nixon declared that the US Dollar is no longer backed by US gold, the situation changed. The 100-dollar bill was now worth only as much as the mutual trust in its value. As a consequence, the reserve currency was “established”. Similarly to Gold before, investors were looking for a reserve that is widespread, and stable in its value. According to Forbes magazine in the 1960s the US contributed roughly 40% of the global GDP. The economic and military superiority of the United States made the dollar an obvious choice.
When a trade is being conducted, rather than quoting the price in a currency that can fluctuate and jump into hyperinflation, the price is quoted in US dollars. The US dollar is a strong stable currency that is trusted by the world and is used to set the prices of all the other commodities. This way of thinking results in countries keeping a reserve of US dollar to use when conducting international trade or investing in bonds and other financial transactions.
While it is understandable why in the 1960s the majority of investors looked to the US dollar as a stable hedge for trade, the question arises of whether it is still reasonable to think that way? According to a Goldman Sachs strategist, the status of the US dollar as a reserve currency is beginning to be questioned. It is understandable why Goldman Sachs thinks this way. The situation in America is far from stable, and the economic crisis combined with worsening relations with China, the country with the second-largest nominal GDP, is a reason for concern.
So is the dollar in danger? Firstly, for the dollar to lose its reserve currency label there would have to be a viable alternative. The US dollar currently represents around 60% of the overall reserve. Some 20% of the reserve is held in euro and the remaining 20% is made up of Japanese yen, pound sterling, Chinese yuan, and other smaller contributors. This poses an interesting dilemma. On one hand, there is China with a large unified economy, but a low trust from investors (currently only about 2% of the reserve is held in yuan) On the other hand there is the euro. While the euro contributes 20% and so is relatively trusted, it lacks a unified market. Even though the GDP of the EU is more than 18 trillion USD, which is significantly larger than even the GDP of the USA, the EU is not a federal republic and hence is just not integrated enough fiscally to face potential crisis and carry out actions. All of this amounts to the fact that the US dollar still retains its post as, by far, the dominant reserve currency. It fulfills the requirements of a large and powerful economy, and enough transparency and consistency to please the investors and foreign governments.
Moreover, the US managed to position itself to maintain its dominance in the long run. In the process of monetization of debt, many countries (China and Japan in particular) bought US debt in the form of US treasury bonds. The US debt is a good investment in the eyes of many countries by large because of its economic status. So, if the economic conditions of the US were to worsen to the point where the US dollar would be at risk of losing its status, the US treasury bonds would be at risk of defaulting which would make many countries that have the US treasury bonds worried. This creates a situation where some counties with currencies that are the biggest competitors to the dollar don’t necessarily want the dollar to lose its status because they fear their treasury holdings would lose value.
While the current situations in the USA suggest an increase of volatility of the dollar, and investors and traders might become uneasy about the increasing difficulty to predict the future of the American economy, I believe that the status of the US dollar as a reserve currency is not about to be overthrown any time soon. The world lacks suitable alternatives and the US has positioned itself to be the dominant force in the present-day economy.