Is The US Dollar At Risk Of Losing Reserve Currency Status?

Dollar weakness is a topical subject this year, inspiring new forecasts that the currency is in danger of losing its reserve currency status. Advocates of this outlook point to various clues that suggest the end is near. But a careful review of the likely replacements suggest that the greenback will retain is central role in world trade for years to come.

That’s not to say that near-term factors won’t weigh on the buck or that the US dollar’s position as the world’s reserve currency is permanent. Given a long enough time frame, it’s plausible, perhaps even inevitable, that the dollar-centric global economy that’s prevailed post-World War II will give way to something else. But getting from here to there will take time, probably decades. Meanwhile, the dollar’s position as the reserve currency remains secure, albeit battered and bruised relative to post-war history.

Recent estimates find that roughly 60% of central bank reserves are held in dollars. That’s down from previous decades and will likely slip further in the years ahead. But a rapid decline in the short run is unlikely, in part because the alternatives to the buck aren’t particularly attractive for a variety of reasons.

Source: crsreports.congress.gov

I briefly discussed the subject in a podcast earlier this week at The Milwaukee Company and it’s worth developing some of my talking points in more detail. Let’s focus on the would-be replacements to the US dollar as a reserve currency.

China: The economic rise of the country over the past 40 years suggests that the US dollar will hand off the baton to the yuan, echoing the shift from the British pound to the greenback during the first half of the 20th century. But unlike the former changing of the guard, China’s currency isn’t ready for prime time as a reserve currency.

There are several reasons why the yuan isn’t set to displace the dollar as the world’s primary reserve currency. Perhaps the leading factor: China has yet to allow free trade of its currency and substantially reduce or eliminate the peg to the greenback. China also restricts capital flows in and out of the country, which is a non-starter for a reserve currency in the eyes of most institutional investors. Other impediments to the yuan’s rise as a true reserve currency include a lack of transparency in China’s financial markets on par with the US. A distinct lack of clarity and transparency for China’s monetary policies is another challenge.

In time, these and other obstacles may be resolved. But the day when the People’s Bank of China attains the respect and trust akin to the Federal Reserve, the European Central Bank, the Bank of England and others, the prospect for a yuan-led world for the global trading system will remain a distant scenario.

Eurozone: The euro was designed, in part, to be an heir to the dollar’s throne, but the plan ran aground several years ago. True, the euro is the world’s second-most commonly held reserve currency after the dollar, but the days when currency strategists predicted it would soon rise to the top of the mountain are long gone. A key reason is the internal political risk in the Eurozone, which creates the perception that instability is forever lurking. Although the 19-country currency bloc appears intact for the moment, events in recent years highlight the embedded risks that reside in an economy linked by a single currency without the equivalent on the fiscal and financial fronts. Disparate political systems only increase the tension and raise doubts about the euro’s durability in the long run. These and related issues came to the fore following the Eurozone’s sovereign debt crisis in 2011, which triggered fears that highly-indebted countries such as Greece might leave the euro. The bottom line: the Eurozone in its present form is poorly designed to handle financial shocks — a limitation that (unless it’s resolved) will likely keep the euro as a perennial also-ran in the world-reserve currency race.

Japan and the United Kingdom: The yen and the pound are forever on the short list of lesser players for currency reserves, but for various reasons neither is likely to displace the dollar. The yen has long benefitted from its status as a relatively safe haven in Asia, supported by Japan’s economy, which is currently the world’s third largest after the US and China. But Japan’s ongoing challenges, including a rapidly aging population, perennially slow growth and other factors, all but ensure that the yen will remain a consistent but marginal player as a reserve currency. Meanwhile, the slow but persistent fade of the UK from the world stage (relative to its peak more than a century ago) strongly suggest that the pound is unlikely to regain its former reserve-currency status.

Cryptocurrencies: There are fanciful discussions in some corners about replacing fiat currencies with bitcoin, ethereum and other digital currencies. But the odds of this happening anytime soon are virtually nil. There’s a laundry list of reasons, but we can start with the volatility. The risk of massive moves in value over the short term is a deal killer for putting more than a trivial amount of a country’s reserves into crypto. The same risk derails the prospect for using crypto for international transactions. As a thought experiment, imagine the self-inflicted risk that would arise by routinely booking international trade in bitcoin instead of the dollar. The potential for huge, sudden losses in an otherwise profitable dollar-based international transaction will keep crypto on the far margins for reserve currency status.

Gold: Everyone’s favorite precious metal has for centuries been the obvious choice for diversifying away from whatever fiat currency at the top of its game. But gold remains a bit player for reserves, although some countries have been beefing up holdings in recent years. Perhaps some macro catalyst could change perceptions about the metal. But if the various bouts of economic turmoil over the past generation haven’t already unleashed a rush to gold, that’s a pretty good sign that displacing fiat currencies with the barbarous relic remains a low-probability event.

The bottom line: the dollar’s status as the premier reserve currency is precarious, and will remain so, probably for as far as the eye can see. But in order for the dollar to fall from its perch there must be a replacement. China’s currency is in the strongest position to inherit the mantle, but structural and political issues will likely keep the yuan nipping at the dollar’s heels for years, perhaps decades, without taking the crown.

A more likely scenario is that reserve currency holdings continue to diversify at the expense of the dollar. But this trend will be gradual and at times imperceptible. The dollar will likely remain the worst choice as a reserve currency… except when compared with everything else.


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One thought on “Is The US Dollar At Risk Of Losing Reserve Currency Status?

  1. Pingback: U.S. Dollar at Risk to Losing Reserve Currency Status? - TradingGods.net

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