Is the time up for the USD as the global reserve currency?May 4, 2018

After WWII the Bretton-Woods Agreement introduced a system that was designed to create a new international monetary and financial order. As a result, the US Dollar (USD) was ordained the world’s reserve currency giving the U.S. an “exorbitant privilege”, a term coined by France’s finance minister Valéry Giscard d’Estaing.

This privilege has benefited the U.S for decades as the bulk of world trade is in USD, commercial settlements globally clear mostly through the U.S. banking system, and around 60% of international reserves are held in USD denominated assets. The question now is if the USD is on the road to losing this privilege? If so then what will unseat the USD?

Go east, young man…

Ok the original saying from the 1860s is actually “go west, young man” used to describe the opportunities in the western United States at the time, but times are a changing. China has accelerated plans to open up their economy to foreign investment. China has desire for the Renminbi (RMB) to challenge the dominance of the USD and is already playing the long game. For example, China’s one-belt one-road is a form of vendor financing that allows economic and financial expansion to be funded in RMB. Additionally, the first RMB denominated oil futures began trading earlier this year, allowing buyers and sellers to settle in RMB and by-pass the USD altogether. China and Russia have also set up ruble-yuan swaps to bypass the USD in some energy transactions.

Looking at the Chinese local bond market, they are taking steps to open up and allow more foreign ownership, making it a more viable option for reserve managers around the globe. Major indices are expected to add Chinese local government bonds in in 2019, which should help push demand. Some predict China will carry a weight of about 5% in the Bloomberg Barclays Global Aggregate Index, which puts it on par with the GBP in the graph below.

This at a time when China is under-owned by investors compared to some of their (much smaller) emerging market peers.

The BRICs

Brazil, Russia, India and China have led efforts in the establishment of a new development bank as an alternative to the IMF and World Bank. This new entity which will be heavily influenced by China by-passes similar Washington led institutions and will further reduce the Western influence in these fast growing economies.

Multi-polar world

The likely outcome is more a multi-polar world where, rather than one dominant currency, we have currencies such as the USD, RMB and Euro being used for trade, financing and reserves more equally. Structural shifts like this are rarely a smooth ride and can take some time. The Trump administration may even be hastening this slow moving trend given their more inward looking views on trade and immigration, while China’s Xi is trying to position China as the leader of globalization.

Investment effects

The implications are much more strategic than tactical given this will be a slow moving story. In fact tactically we see some room for more USD upside on interest rate differentials and central bank divergence. However it does confirm the need to review one’s long-term strategic asset allocation framework using the forward looking assumption that countries like China and India will play an increasingly important role in the global economic decisions.

In our portfolios, the strategic asset allocation to emerging markets has increased over the years and in years to come we expect they will continue to increase likely at the expense of development markets such as the US. At some point strategic allocations to the RMB currency and China Government Bonds may also make sense.

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.