The dollar is up 14.2% against a broad basket of 26 world currencies weighted by American trade since last June 30.[i] Bond yields are down significantly since the tapering of quantitative easing (QE) was announced in December 2013. IMF data show the dollar’s share of foreign currency reserves rose last year, adding to its position as the world’s leading reserve currency. America’s economy is growing apace and there is no sign, according to The Conference Board’s Leading Economic Index, that will change soon. Take all these factoids and combine them, and you’d probably think few would fear the dollar losing its status as the world’s primary reserve currency. Yet they persist! Some oddly suggest the news China will launch its own mini-World Bank, the Asian Infrastructure Investment Bank, means the dollar’s days are numbered.[ii] Here is the thing though: These fears were overwrought from moment one, and they are even more so now.
As I’ll show, there are three major reasons why. But before I get started, it may be helpful to cut right to the chase and explain what the dollar-won’t-be-primary-reserve-currency fear actually is: Debt doom.
Behind nearly all these fears lies the misperception that America’s debt is unaffordable, absent some artificial force. For many, the artificial force is widespread use of the dollar as the world’s reserve currency—it’s the most-used, with a 62% share of global forex reserves at 2014’s end. Some presume so many nations buying and holding dollar-denominated assets artificially depresses US government bond yields, and if the dollar were the primary reserve asset no more, that force depressing rates goes poof. Rates skyrocket. Government struggles to make interest payments. It defaults. Doom ensues.
That’s the tale dollar-won’t-be-primary-reserve-currency theorists tell. Yet it has major holes. Let’s consider.
Why is the dollar the world’s primary reserve currency?
Some will tell you it’s due to a postwar agreement. But there is more to it than that. According to the IMF, which has a very special interest in this stuff (called the Special Drawing Right, SDR—an official-sector reserve asset tracking the movements of several currencies), liquidity and bond market depth are significant factors. After all, what central bank wants hugely volatile or illiquid reserves? That would defeat the point, friends. The dollar is supremely liquid. The US has no capital controls and an open market, and the dollar is fully convertible the world over. The US also has the world’s deepest, most liquid sovereign bond market. As of Q4 2014, there were about $11.6 trillion worth of official sector reserves, according to the IMF. About $6 trillion can be broken down by currency. That $6 trillion is split among seven major currencies (the dollar, British pound, Japanese yen, Swiss franc, Canadian dollar, Australian dollar and euro). Absent the dollar, there simply isn’t that much liquid, quality sovereign debt to fulfill demand for reserves, particularly when you consider bank, pension and other investors’ demand. There is virtually no way to extricate the dollar from global reserves in a practical sense.
Some suggest China’s yuan could displace it, but when last reviewed in 2010, the IMF said it didn’t meet the liquidity or depth requirements. They’ll revisit that decision this year. But consider: There is very little official sector Chinese debt outstanding. Local? Municipal? Yes and yes, but it’s of dodgy quality and transparency, and the chances many central banks dive into that arena soon is low. And the currency is … ummm … pegged to the dollar. Even if the IMF decides later this year the yuan is now sufficiently liberalized to include in the SDR as a reserve asset, it’s highly unlikely to play a material role in reserves for years. And, hey, don’t set up a false either/or: It is not the yuan or the dollar. If it became a more widely used reserve asset, the yuan could take share from the euro—as the dollar did just last year. Or the Aussie. Or or or. And I'd suggest that if the yuan becomes a reserve asset, whatever share it gains will be gradual and incremental, probably not unlike the euro. Which brings me to my next point.
The dollar's share of global foreign exchange reserves has been falling for 15 years, and no catastrophe has ensued.
The euro was introduced in 1999, and it gradually took share (percentage of reserves held) from the dollar. Yet rates fell. Now that may in part be because the dollar had a smaller share of a far bigger pool of assets (absolute dollars held rose), but it isn’t necessarily so. Exhibit 1 shows this trend since the euro’s 1999 introduction.
Exhibit 1: Currency Composition of Allocated Foreign Exchange Reserves
Source: International Monetary Fund, as of 4/17/2015. 1999 – 2014.
If the dollar gets such huge benefits from being the world’s primary reserve currency, then why are US rates not nearly the lowest in the world?
If a currency’s use as a major reserve asset lowers interest rates so substantially, one may logically presume the dollar’s huge 62% share of global foreign exchange reserves would mean ours are the lowest. Yet this is far from accurate. As Exhibit 2 shows, US interest rates are the second highest of any major nation whose currency is used in reserves.
Exhibit 2: Interest Rates in Major Currency Reserve Nations
Source: Factset, as of 04/16/2015. 10-year government bond yields for major reserve currency nations, 12/31/2013 – 04/15/2015. I realize you can’t tell apart the countries other than the US—I did that to highlight the major point.
This is not because these nations have a smaller debt load than America’s. America currently sports a roughly 79% net debt-to-GDP ratio.[iii] The UK, France and Ireland are all in the 80%-90% range, with lower rates. Italy’s rates are lower, too, and its net debt is 110% of GDP. Japan’s rates are second lowest, but its net debt is highest—127% of GDP. Australia’s net debt is a miniscule 17% of GDP, yet its rates are the only ones exceeding America’s. Heck, Israel, Norway, Sweden and Denmark all have lower 10-year rates than the US. South Korea’s are only a shade above ours. None of those five nations’ currencies are widely used reserve assets. Seems to me there is no correlation between reserve currency status and rates.
In my view, there is nothing to suggest US rates would skyrocket if some of the other currencies’ shares of reserves rose. Nor is there anything suggesting the government can’t afford its debt now! Exhibit 3 plots US debt interest payments as a percentage of tax revenue, showing there is no issue currently in meeting debt payments.
Exhibit 3: US Federal Government Debt Interest Payments as a Percentage of Tax Revenue
Source: Federal Reserve Bank of St. Louis, as of 4/17/2015. Annual interest expense and tax revenue for fiscal years 1940 – 2014.
Ultimately, the notion of a looming, disastrous end to the dollar’s status as the primary reserve currency is theoretically faulty and at odds with observable data. Might I humbly suggest now is the time to put the fear to rest?
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[i] Source: Factset, as of 4/17/2015.
[ii] I say “oddly” because the World Bank has nothing to do with reserve currencies, other than being created at the same time as the IMF, which does monitor reserves and issues the SDR, a reserve asset tracking major currencies. The World Bank lends money to the developing world in an effort to help. The Chinese-led initiative aims to similarly lend, but without the pesky restrictions the World Bank puts on lending to corrupt autocrats and such like. That’s all sociological and not market commentary, though, because whether China or the US leads the effort to lend money to the likes of Myanmar is hugely unlikely to cause stocks to blip.
[iii] Source: IMF, as of 4/17/2015. Figures for 2014. Net debt is the amount of debt outstanding the government itself does not own, as government-owned debt is effectively an accounting entry.