Why U.S. Dollar Will Remain World's Reserve Currency, Despite Political Brinkmanship

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.

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%.

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.

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 Strong-Dollar 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 2014.

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

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