Archive for July, 2019

USD Reserve Currency Status Eroding Slowly But Surely

Monday, July 1st, 2019

Wall Street Journal reported a few days ago:

Secretary General of the European External Action Service (EEAS), Helga Schmid, held a meeting to announce that Europe has found a way of circumventing U.S. sanctions on Iran. The meeting was attended by representatives of China, France, Germany, Russia, the United Kingdom, and Iran.

The governments of France, Germany and the United Kingdom have developed a special purpose vehicle called INSTEX to enable European businesses to maintain non-dollar trade with Iran without breaking U.S. sanctions.

INSTEX bypasses SWIFT, which includes US banks and US Dollars, was operating and processing transactions on Jun 28.

Bypassing SWIFT is intended to allow those trading with IRAN to avoid US ability to veto transactions because INSTEX does not involve US banks or US Dollars.

INSTEX is open to all EU member states and there is a mechanism in place or contemplated that would allow non-EU states to join (read that China, Russia and others).

China has already been arranging to purchase oil in exchange for their own currency instead of US Dollars.

These two measures are inflection points that  indicate the potential eventual end to the near total dominance of the US Dollar as the world’s reserve currency. More such arrangements may come into play if we over-use our banking system and our currency as a bludgeon to implement and enforce our foreign policy, when our allies are not on our side.

If the US Dollar loses that reserve currency status, we may find that our ability to fund our continual and even increasing national deficit becomes limited in the amount of Treasury debt we can sell, or the price we must pay to borrow the money. Either way, a major change in our way of life and in our markets would surely follow — most likely quite unpleasant.

Of this, ZeroHedge said, “…once those who benefit the most from the status quo openly revolt against it, the countdown to the end of the USD reserve status officially begins.”

This is what Allianz Global Investors said a year ago:

The US dollar has long been the currency of choice for banking and trade, and for valuing all other currencies. This has brought the US enormous economic benefits and significant structural downsides. Yet a shift away from the dollar may have begun, which could help the global economy in the long run.

Key takeaways

  • In years past, the denarii, ducat, guilder and pound each took a turn as the world’s reserve currency. Today, it’s the US dollar. Will the euro, renminbi or yen be next?
  • Central banks hold fewer US dollars than they did in 2004, and fewer international payments are being settled in dollars
  • If the dollar were to eventually lose its reserve status, its exchange rate could fall, US interest rates could suffer, and US equities and fixed income could potentially underperform

Mark Carney Bank of England Governor said this six months ago:

“I think it is likely that we will ultimately have reserve currencies other than the U.S. dollar. … the evolution of the global financial system is currently lagging behind that of the global economy … for example, emerging-market economies’ share of global activity is now 60%, but their share of global financial assets lags behind at around one-third.” He added that half of international trade was meanwhile invoiced in U.S. dollars, even though the U.S. share of international trade was only some 10%. He said further,“As the world re-orders, the disconnect between the real and financial is likely to reduce, and in the process other reserve currencies may emerge.”

Carney does not predict a rapid change, but an inevitable one.

What makes a currency a reserve currency?

Wolf Street pointed out 3 months ago:

“The degree of dominance of the US dollar as global reserve currency is determined by the amounts of US-dollar-denominated financial assets – US Treasury securities, corporate bonds, etc. – that central banks other than the Fed are holding in their foreign exchange reserves. The dollar’s role as a global reserve currency diminishes when central banks shed their dollar holdings and take on assets denominated in other currencies.”

In Q4 2018, central bank holdings of other countries currencies was as follows:

  • Dollar: 61.7%
  • Euro: 20.7%
  • Japanese yen: 5.2%
  • UK pound sterling: 4.4%
  • Chinese renminbi: 1.9% (record)
  • Canadian Dollar: 1.8%
  • Australian dollar: 1.6%
  • Swiss franc: 0.15%
  • Other: 2.48%

The Euro was zero a couple of decades ago, and the USD was a little over 70% at that time.

The USD share has been a lot worse at 46% in 1991, and we are still the reserve currency, but as China trades it own currency for oil with Iran, and the EU INSTEX facility trades non-Dollar with Iran, key adverse trend development is evident.

If nations increase trading in non-Dollar ways, the percentage of other (non-Fed) holdings of US Dollars will decline, and with it our reserve currency status.

QUARTZ reported on the history of reserve currencies 18 months ago:

A team led by Barry Eichengreen said, “From this vantage point, it is the second half of the 20th century that is the anomaly, when an absence of alternatives allowed the dollar to come closer to monopolizing this international currency role,” 

For at least 70 years, the US dollar has been the world’s dominant currency. …This dominance is historically unusual … Eichengreen and his co-authors find that reserve currencies can and do coexist. … In the future, the dollar will be forced to share prominence with the yuan and the euro, in particular. …

…If the policies of the governments and central banks responsible for these currencies remain sound and stable, this can be a smooth evolution. On the other hand, if there is some kind of policy shock… it’s possible to imagine things suddenly changing. …

…There are four things you need in order for your currency to play a global role: size, stability, liquidity, and security. …

…The optimistic path is where globalization continues at a more measured pace than in the recent past, supported by a global financial system that rests on three pillars—the dollar, the euro, and the renminbi.

The pessimistic scenario is that that progress is too slow and something happens to derail confidence in the dollar. Meanwhile, the euro and the renminbi have not had time to step up and a global liquidity crisis develops that takes globalization down with it. We are more inclined towards the first scenario, but we think it’s worth worrying about the second.

The Balance profiled the current Dollar dominance 3 months ago:

The relative strength of the U.S. economy supports the value of its currency. It’s the reason the dollar is the most powerful currency. Around $580 billion in U.S. bills are used outside the country. That’s 65 percent of all dollars. That includes 75 percent of $100 bills, 55 percent of $50 bills, and 60 percent of $20 bills. Most of these bills are in the former Soviet Union countries and in Latin America. They are often used as hard currency in day-to-day transactions.

Cash is just one indication of the role of the dollar as a world currency. More than one-third of the world’s gross domestic product comes from countries that peg their currencies to the dollar. That includes seven countries that have adopted the U.S. dollar as their own. Another 89 countries keep their currency in a tight trading range relative to the dollar.

In the foreign exchange market, the dollar rules. Ninety percent of forex trading involves the U.S. dollar  … Almost 40 percent of the world’s debt is issued in dollars. As a result, foreign banks need a lot of dollars to conduct business.

In 2009, a big panic year, China and Russia called on the IMF for a new global currency based on a basket of national currencies. China was concerned that the trillions it holds in dollars would be worthless if Dollar inflation set in as a result of increased U.S. deficit spending and printing of U.S. Treasurys to support U.S. debt.

[QVM note] It’s been ten years and it hasn’t happened, but the idea is still out there.   On the other hand our liberal use of  Dollar trading sanctions against our allies over Iran, is weakening our alliances and strengthening efforts to supplant the Dollar.]

Dollar (UUP), Euro (FXE), Yen (FXY) and Yuan (CYB) are key currencies in this discussion.