Dollar's exalted reserve currency status in doubt ? We've heard it so many times before.... but then again.... ?
The FT's Big Read columns are fairly substantial pieces of work and one certainly couldn't point readers to all the ground they cover in a meagre little blog like this one ..... but what we can say is that today's Big Read is definitely worth catching in full, and should reward the time invested. It seems like people have been predicting forever the demise of the US dollar as the overwhelmingly most popular currency in which central banks choose to hold their reserves. In reality, it's only about forty years or so but no matter, it feels as though nothing much has changed in that time.
Actually, the truth is that the proportion of central bank reserves held in dollars has fallen quite a lot .... from 71% in 1999 when the Euro was launched to just 59% by the end of 2020. Intuitively one feels that should hardly come as a surprise. With the majority of a continent's major nations combining to form a new single currency, and with China's phenomenal growth, one wouldn't expect anything else, surely .... especially as China is only the most high-profile nation in a global trend. If the US was responsible for the majority of global (non-Soviet) industrial production post-WW2, the case for the dollar being the currency that everyone needed to trade was unassailable. But now that the US knocks out less than 25% of global GDP, well .... not so much.
Whether a currency is the reserve currency of choice for central banks is not just a dry and dusty topic of interest only to theoretical economists, it has huge practical consequences. It matters ..... a lot. The FT gives an example of both how it benefits the US and of how it can work to the detriment of others :
The US can borrow more cheaply than others because of the greater demand for its government borrowings (Treasury bonds etc) arising from the reserve currency role
Whilst at the same time..
The US central bank, the Federal Reserve, has a mandate (officially at least) that is geared entirely around domestic considerations and sets monetary policy accordingly. But so powerful is the US dollar that the Fed is effectively setting policy for the world, even though that policy may not suit the requirements of many.
Demand for US Treasuries has undoubtedly been of huge benefit to the US, but Treasuries have provided a home for reserves that no other could have. It has long been a market of enormous size, liquidity, and security. If proponents of the Euro have been disappointed that the single currency hasn't challenged the dollar more strongly, they can probably blame bond markets. In the Eurozone, individual nations have issued their own sovereign debt (German Bunds, Italian BTPs etc.), and so there has been no bond market capable of coming close to US Treasuries in those three requirements we're talking about.
But as a result of the pandemic, we now see a European recovery fund, financed by commonly issued EU-wide debt. The first but hugely significant step for a Euro-Bond market that should push reserve holdings of the euro up from its current share of 20% as perception increases that the new debt is a viable alternative to US Treasuries.
US Treasuries may well have some other problems in the pipeline. The Trump era has done enormous damage to faith in the US political system, and whilst Joe Biden presents a more reasonable and cooperative version of a US president he does have some disconcerting protectionist tendencies. Then there were the episodes of liquidity shortages in the Treasury market, in large part driven by forced selling by overgeared hedge funds. Regulation in recent years has meant that it's too expensive for banks to run big enough books to absorb that kind of selling in the way that they used to.
And then there's the big one .... yes, you've guessed it ..... inflation. Bondholders HATE inflation (it erodes their future income which is fixed, of course), but as we know it is the great looming spectre of the day. Cue the likes of Larry Summers (amongst many others), quoting ultra-loose monetary policy, the Fed's laisser faire attitude to possible inflation overshoots, and "the least responsible fiscal macroeconomic policy we've had for the last 40 years".
For Mr. Summers, it's doom for US Treasuries, and by extension if faith in that market that has been built up over so long is undermined, why would central banks remain keen to hold so many dollars? Throw in China's ambitions for the Yuan/Renminbi and even cryptocurrency alternatives, and there are reasons for believing that a paradigm shift could be in the offing. It does assume quite a lot though, and not much of it good ..... though many would say a move away from the over-reliance on the dollar that's been evident for so long would be no bad thing, whatever the short-term difficulties that might have hurried it along. Read "The Big Read"...
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