As of December 31, 2022.
Source: International Monetary Fund.
The dollar’s dominance as global reserve currency is due to multiple factors, which in totality have yet to be replicated:
- Economic heft—The U.S. economy is the largest in the world, making up 16% of global GDP and approximately 10% of global trade. A much larger 50% of global trade is invoiced in U.S. dollars.
- Debt denomination—Nearly 70% of global debt is denominated in U.S. dollars. Partially as a result of the vulnerability of countries to fluctuation in the value of their dollar-denominated debt, more than 50% of countries anchor their currency to the U.S. dollar.
- Deep, stable, open capital markets—The U.S. has by far the deepest, most liquid, and most stable capital markets in the world, which is critical for attracting foreign capital and demand for dollars. The U.S. is also governed by strong rule of law, which gives foreign investors comfort in the safety of holding dollars.
Recent headlines, China’s growing role in the global economy, and increased tensions with the U.S. have led some to suggest that if the U.S. dollar were to cede its place as dominant reserve currency, it could be to the Chinese renminbi. While a more fractured currency landscape is possible—and certainly one of China’s goals—it is very unlikely that the renminbi would replace the U.S. dollar in the next decade. Even if China were to surpass the U.S. economy in size and manage to settle its roughly $6.5 trillion worth of annual trade in renminbi, the U.S. dollar is currently involved in nearly 90% of global foreign currency transactions, amounting to $6.6 trillion per day.
Perhaps more detrimental to the renminbi’s reserve currency prospects are their capital controls and unpredictable laws. China operates under a “closed” capital account policy, whereby companies, banks, and individuals cannot freely move money into or out of the country. For a central bank to feel comfortable holding significant reserves in a particular currency, it must know it can act without restrictions.
In addition, the unpredictability of China’s policies, as well as the U.S.-China relationship, is a significant detriment to the renminbi. China’s regulatory crackdown in 2021—resulting in the nationalization of the for-profit education industry, strict regulations on platform tech companies, and restrictions on the amount of time consumers can spend gaming—dealt a significant blow to investor confidence. Investors pulled a record amount of assets from the Chinese stock market in 2021. Since then, President Xi Jinping has only further consolidated his power. Threats of securities delistings, trade blacklists, and geopolitical threats between the U.S. and China add to the hesitancy on the part of investors to reallocate to China in sufficient size as to increase the renminbi’s prominence.
Digital currencies are another potential way for central banks to diversify away from dollar reserves. However, when it comes to reserves, we see it more likely that central banks would develop and utilize central bank digital currencies (CBDCs) rather than hold reserves in cryptocurrencies like bitcoin. A digital dollar may cannibalize its fiat counterpart but would not alter the economic risks and benefits associated with the dollar’s status as dominant reserve currency.
The U.S. economy has enjoyed reserve currency status for decades, and with it several privileges including considerable latitude in issuing debt. We don’t expect this status to disappear any time soon. However, a fracturing of the currency landscape is possible over the next few decades. Should that occur, we would expect the U.S. dollar to structurally weaken and the cost of borrowing to increase for the U.S. government.
In the shorter term (next 9–12 months) the direction of the dollar will be dominated by the Fed’s monetary policy relative to other major central banks. Economic momentum improved outside of the U.S. to start the year, resulting in dollar weakness. The market is pricing two rate cuts of 25 basis points,* or bps (0.25%) each in the second half of 2023 as inflation slows and recession risks rise. However, we remain skeptical that the Fed will be in a position to ease policy so soon, so some of the dollar’s depreciation this year could reverse, particularly if economic momentum in Europe or China cools. We focus on international diversification in our portfolios, though we do not explicitly hedge currency risk at the portfolio level (individual managers may do so). At this time, we are positioned defensively in anticipation of a mild recession this year. We hold an underweight to equities, both in U.S. small-cap and international developed asset classes, and an overweight to cash and fixed income.