Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me |
It’s been a busy time for the US dollar. On the one hand, it has featured heavily in commentary on the future of the global monetary system. On the other hand, it has surged in foreign exchange markets.
In other words, even as many commentators question the future of the dollar as global reserve currency, participants in foreign exchange markets have scrambled to buy more dollars.
Dominant dollar
Let’s deal with the first issue. The role of the US dollar in global finance has always generated a lot of debate, giving rise to many misconceptions and even conspiracy theories about its imminent decline.
The Russian invasion of Ukraine has given fresh impetus to these debates given that the Russia’s foreign exchange reserves were seized and its banks sanctioned. Russia is now attempting to conduct more trade in other currencies, including demanding rouble payments for gas from Europe and possibly selling oil to India in rupees.
The dollar is still the dominant global currency across many dimensions. One of these is as the global reserve currency, which simply means it’s the currency that foreign central banks prefer as part of their foreign exchange reserves.
Chart 1: Currency composition of global foreign exchange reserves
Source: International Monetary Fund
This is still a legacy of the post-World War II Bretton Woods system, where other currencies were linked to the dollar while the dollar was pegged to gold.
President Nixon broke the link between the dollar and gold in 1971, but many countries still maintained a hard or soft peg to the dollar for several years. The East Asian crisis of 1998 saw many pegs fail spectacularly with devastating consequences – the Indonesian rupiah lost 80% of its value in the space of 12 months – and dealt a near mortal blow to the idea of managing exchange rates.
China is the notable exception. It still manages its exchange rate quite tightly. To maintain this managed exchange rate, China has built up a huge piles of foreign exchange reserves including $1 trillion.
Most other countries with large forex reserve holdings do this not so much to manage the exchange rate but to ward off a speculative attack. If speculators know the central bank has a war chest, they will give it a wide berth.
For countries that rely on imports but lack a strong export engine, managing reserves is of much more practical importance. Without reserves as a rainy-day fund, the economy can quickly run out of hard currency to pay for key imports and to make payments on foreign debt. This is where Sri Lanka is currently.
South Africa’s forex reserves are quite low relative to the size of the economy, but generally adequate and enough to cover about five month’s imports. As a big commodity exporter with large open capital markets, South Africa does not really run the risk of running out of hard currency today as was the case in the mid-1980s. The Reserve Bank’s current policy is not to use reserves to influence the rand and allowing the currency to adjust quickly to forex market flows, explaining a lot of its remarkable volatility. But one consequence is that the Reserve Bank tends to keep interest rates on the high side to attract capital inflows and avoid undue pressure on the rand.
Preferred choice
In all these cases, the dollar is still the preferred choice of reserves, though its share has gradually declined over the last 30 years from around 70% to 60% as chart 1 shows. This share will probably keep declining over time, but the lack of alternatives means it is likely to be a slow process.
At its creation in 1999, it was hoped that the euro could challenge the dollar’s role, but the euro’s share of global reserves have remained around 20%.
The fear of eurozone fragmentation that first surfaced with the Greek debt crisis in 2011 has not gone away since there is no shortage of anti-euro populist politicians (such as Marine le Pen in this weekend’s French presidential run-off vote). The eurozone also lacks a large common bond market, with the bond markets of individual countries (Germany, Italy, France etc.) dominating. The European Union’s €800 billion recovery fund is funded by the issuance of common bonds, so this is at least a step in the right direction.
The currencies who’ve gained the most market share include Australia, Korea, and Canada. They are US allies and beneficiaries of dollar swap lines with the Federal Reserve. Even the European Central Bank has depended on such swap lines from the Fed during times of crisis. In other words, rather than competing with the dollar, they form part of the broader dollar system.
The one currency outside this system that has seen modest gains as a reserve currency is China’s renminbi (or yuan), but its share remains a fraction of the dollar’s.
When we say investors or central banks hold a currency, they typically don’t own cash but rather debt securities that pay some interest. They need to be able to buy and sell these quickly and easily and repatriate any proceeds or swap them into other currencies. Therefore, until Beijing takes concerted steps to open its financial markets to the world by abolishing strict capital controls, the yuan cannot be a major reserve currency.
Trade and finance
While the question over reserve currency status dominates, the role of the dollar in global trade and finance is probably even more important.
Most cross-border financial and commercial transactions are conducted in dollars, even when neither counterparty is American. Dollar-denominated bonds and equities dominate global benchmarks, and most commodity trading and debt rising is still in dollars. Even the Bitcoin price is in dollars! As a result, in foreign exchange markets, the dollar accounts for 80% of turnover. This role is out of proportion with the US share of global economic activity as chart 2 shows.
Chart 2: International role of the dollar
Source: Bank for International Settlements (2020)
On the one hand, the dollar is the obvious choice: the US has the unique position of having the deepest capital markets, most innovative economy, strongest military, and entrenched rule of law.
The simplest test of the latter is whether an investor can sue a government in its own courts and hope to get a fair hearing. The answer is yes in New York and Boston and no in Shanghai and Moscow. Foreign investors know they will be treated equally to locals under American law.
But on the other hand, it is simply the network effect. It is a massive convenience and cost saving to most companies and investors using the same currency just as there is a convenience to using a common language.
English is not a better language than French or Mandarin or Zulu, but because it is so widely used, it makes sense to learn it. The more people that speak English, the more valuable knowing the language becomes to each individual speaker. Social media is another example.
The value of one platform versus another is not necessarily technological superiority but simply that your friends and the famous people you admire already use it. Shifting to a new platform, or a new global currency, will require enormous effort, cost and trust and enormous potential benefits to become a reality. So, the status quo likely prevails.
It is true that China and Russia’s governments want to reduce the dominance of the dollar in the global monetary system because it gives the US tremendous power to wage economic war as we’ve seen.
Even some US allies in Europe are uncomfortable with this power such as when then-US president Trump unilaterally pulled out of the Iran nuclear deal. However, it is likely to be a very long journey especially since individuals and businesses everywhere still see the dollar as a better currency to use and hold, irrespective of what governments want. It is no coincidence that Chinese companies went on a dollar-denominated borrowing spree in recent years (whether they can pay back those loans in the years ahead is another question).
The big fear
The big fear underlying many of the articles and social media posts on the supposed death of the dollar is that US bond and equity values will crash if foreigners no longer see the necessity of using US dollars. This misses the point that these asset values are quite capable of rising and falling on their own in line with the economic cycle – witness the equity crash in March 2020 and the bond slump in March 2022 – and based on the attractiveness of the underlying assets.
Apple’s $3 trillion market value is not based on dollar hegemony but on customers’ belief in the superiority of its products and investors’ belief that it can keep producing. These cycles will continue regardless, driven by changes in sentiment in the short term, and economic fundamentals such as profit growth, interest rates and inflation in the long term.
Similarly, regardless of long-term changes in the use of the dollar in global finance and trade, the value of the dollar will continue to experience cycles in foreign exchange markets.
For instance, at the height of the economic and military might of the US early in the century, the value of the dollar fell significantly against other currencies.
On a tear
Recently, the dollar has been on a tear higher as market expectations of Fed rate hikes have risen sharply.
The Fed is now likely to push short-term rates up past 2.5% by the end of the year. In contrast, the European Central Bank will at best raise its policy rate from negative to zero. The Bank of Japan is not expected to hike rates at all, while the People’s Bank of China is actively easing with new cuts announced last week.
A strong dollar is rarely good news for the global economy. Since the world runs on dollars as noted above, a more expensive dollar weighs on global commerce. Since other currencies fall as the dollar rises, particularly emerging market currencies, central banks are often forced to hike rates.
A strong dollar also tends to signal stress and anxiety, since it remains the ultimate safe haven. The good news is that the trade-weighted dollar is nowhere near historic extremes as chart 3 shows, but this also means there is potentially more room to run.
Chart 3: US trade-weighted dollar index
Source: Refinitiv Datastream
Pummelled by Powell
In this context, the resilience of the rand until recently has been unusual. Normally during a global crisis such as the Ukraine war it would fall, as we saw in March 2020.
Similarly, prospects of higher US interest rates would have the same result, as we saw between 2012 and 2016. In 2022, the rand has benefited from strong commodity prices, along with other major commodity producers such as Brazil. It shows then that the medium-term outlook for the rand is tied to the outlook for commodity prices which is uncertain.
The past few days has, however, seen a sharp pull-back in the rand, possibly because of the spate of negative headlines on the devastating floods in KZN, renewed load shedding, downgrades to global growth forecasts from the IMF and World Bank and comments from Fed Chair Jay Powell that the next increase is likely to be bigger than the usual 0.25% increments.
Not going away
The rand remains unpredictable and volatile and trying to time investments based on its moves is virtually impossible to do consistently. With regulations now allowing greater offshore exposure for local investors, this volatility is going to loom even larger in portfolios over time and will need to be carefully managed.
The rand usually falls when global markets sell off, providing a natural hedge, but this doesn’t always happen.
It worked well during the market crash in March 2020 but not this year when it strengthened even as global equities and bonds fell. Over the long term, the tendency of the rand to depreciate is likely to remain intact given relatively high inflation in South Africa, but the rand will still appreciate or move sideways for long periods. It is not a one-way bet.
As for the dollar, it is best to ignore articles that proclaim its end is neigh. These claims have been made for several decades now. They might be interesting but are unlikely to be of any practical value to investors. For better or worse, the dominant role of the dollar, like the rand’s volatile nature, is not going away any time soon.
