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Why U.S. Dollar Will Remain World's Reserve
Currency, Despite Political Brinkmanship
October 26, 2013
by Tatjana Michel
of Charles Schwab
Key Points
The U.S. dollar is not likely to lose its premier world reserve-currency status anytime soon.
But continuing U.S. political brinkmanship could drive foreign countries into other
currencies faster.
With the market focus shifting to monetary policy and growth, we expect a Fed taper delay
to give foreign currencies some time to recover.
How much longer will the U.S. dollar remain the world's top reserve currency? We think that status will
continue to last for some years—even as efforts to dislodge the dollar may gain momentum.
The foreign community has been trying to diversify out of the U.S. dollar and into other currencies for
years, but with limited success. Whereas global central banks allocated 71.5% of their reserves to the
dollar in 2001, they reduced their dollar holdings to 62% in Q2 2013, according to data from the
International Monetary Fund. The diversification process stalled during the global financial crisis that
started in 2008, but seems to have resumed in 2013.
Neither the 2011 debt ceiling crisis nor the recent government shutdown and debt ceiling drama are
likely to have increased international confidence in Treasuries and the dollar. Given that the U.S.
government's tug-of-war has only been postponed to early 2014, the uncertainties are not likely to
dissipate quickly.
Page 1, ©2017 Advisor Perspectives, Inc. All rights reserved.
Source: International Monetary Fund, COFER Report September 2013, as of October 17, 2013.
China and Russia, the countries with the world's largest and fourth-largest foreign exchange reserves,
announced that they may intensify their search for alternative reserve currencies. Others have voiced
similar intentions, and we expect the trend to continue. Adding fuel to the fire, China is working on
making the yuan a world reserve currency and on promoting the use of national currencies instead of
the dollar for bilateral trade and loans.
While we don't expect this to damage the dollar too much in the short-term, it may have larger
implications in the longer-term. If global demand for dollars shrinks while the supply remains steady or
continues to increase (the Fed is currently pumping $85 billion/month into the economy), the dollar's
value should eventually drop.
The dollar is not likely to lose its main world reserve
currency status anytime soon
Just because emerging market economies want to reduce their exposure to the U.S. economy by
shrinking their dollar holdings doesn't mean there is a viable alternative to the dollar. The U.S. boasts
the world's largest and most liquid financial markets with over 45% of world equity market
capitalization. In times of crises, global investors will still want to buy the relative safety of U.S.
Treasuries and the dollar. The next biggest markets are the euro area, the U.K. and Japan with almost
11%, 8.5% and 7.4% of global market cap, while most others range between 0% and 2%.
Page 2, ©2017 Advisor Perspectives, Inc. All rights reserved.
Source: Morgan Stanley International Capital as of December 2012.
Note: Equity market capitalization is expressed as the weight of the country in the MSCI World Index
and denominated in U.S. dollars.
It is true that China is working on making the yuan a world reserve currency. However, this process will
take years and bears many risks and uncertainties along the way. Every new or altered currency first
has to grow up before it is accepted as one of the world reserve currencies, and that takes time. Just
look at the labor pains of the euro.
Focus turns from fiscal to monetary policy
The U.S. government shutdown is widely estimated to have shaved about 0.6% off GDP growth in the
fourth quarter. We expect the U.S. economy to continue recovering moderately going forward, which
raises the question of when the Fed will decide to start tapering its asset purchases. We see a growing
possibility that tapering will be postponed to the end of the first quarter 2014, after a new round of
government budget and debt ceiling discussions, and after Janet Yellen is expected to replace
Bernanke as the new Fed Chairman.
Page 3, ©2017 Advisor Perspectives, Inc. All rights reserved.
Source: SCFR with data from Bloomberg, as of 10/17/2013.
This delay is likely to give foreign currencies time to continue recovering against the U.S. dollar,
especially if foreign economies continue to improve. A recovery could shift monetary policy
expectations in favor of foreign currencies. The graph above shows that battered emerging-market
currencies were able to bounce back after the Fed refrained from tapering at the beginning of
September. It also shows they tanked in late September on the back of rising global risk aversion.
Whether the dollar is able to enter another strong-dollar phase (see "Is the U.S. Entering a StrongDollar Phase?") depends to a large degree on whether the U.S. Fed starts reducing monetary stimulus
before other global central banks. The longer U.S. political brinkmanship threatens to disrupt the U.S.
economy, the longer Fed tapering will likely be delayed, thereby diminishing the probability of another
strong-dollar phase.
Next steps
The dollar is not likely to lose its premier world-reserve currency status anytime soon. But given the
likelihood of further U.S. political brinkmanship and maybe a further Fed taper delay, it can make
sense to diversify a portfolio with some reserve-currency alternatives such as the euro, the Swiss franc
or the British pound. These currencies tend to have safe-haven appeal and have gained ground against
the dollar in recent weeks. Although the Japanese yen also has safe-haven appeal, we would steer
clear at the moment because of the likelihood of further quantitative easing by the Bank of Japan in
Page 4, ©2017 Advisor Perspectives, Inc. All rights reserved.
In addition, for investors who can stomach higher volatility in their portfolios, it can make sense to add
select emerging-market currencies and their assets to increase diversification and maintain the
opportunity for higher returns. However, as emerging-market currencies and their assets remain
especially vulnerable to a possible rise in U.S. rates and yields as well as global risk aversion going
forward, they should take only a small portion in the portfolio's asset allocation.
© Charles Schwab
Page 5, ©2017 Advisor Perspectives, Inc. All rights reserved.