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The media is once again presuming that America's financial negligence will result in the replacement of the dollar as the world's reserve currency. As I wrote in The Dollar’s Death, Not So Fast Part I: "Don't hold your breath. Headlines forecasting the dollar's death as the world's reserve currency have been around for a long time." While the case for a new global reserve currency is strong, the replacement options pale in comparison. There are four important reasons why finding a replacement will prove difficult.
The four reasons, the rule of law, liquid financial markets, and economic and military might, all but guarantee the death of the dollar will not occur anytime soon.
The Dollar’s Death, Not So Fast Part I provided background for the dollar's role as the global reserve currency and the inherent flaws in serving that role. The construct of the dollar is an essential foundation for understanding the it position as the reserve currency.
Aside from those four reasons, 60% of global currency reserves are in dollars, and about 90% of trade occurs in dollars. Further, no other currency or block of nation's currencies, gold-backed currency, or bitcoin is a viable candidate to replace the dollar as the global reserve currency.
The rule of law
The rule of law helps ensure that U.S. citizens and institutions are provided human rights, property, contracts, and procedural rights. While many other nations may claim to have similar legal processes, few live up to U.S. standards. The legal system protects foreigners with dollar and other financial and legal interests in the U.S.
From a currency perspective, the court system, not a government decree, rules on financial disputes. It is undoubtedly flawed and biased. As Russia, Iran, and other countries have found, the U.S. government will seize their dollars if they deem it in its best interest. While such acts bend the value of the rule of law, foreign nations are confident that the U.S. system of law and governance ensures their ability to hold and transact in U.S. dollars. Further, laws and regulations provide confidence in the proper functioning of U.S. markets they rely heavily on to meet their borrowing and investment needs.
Hedge fund mogul Mark Mobius is discovering why investing in countries less judicious than the U.S. can be dangerous. Per CNN:
"I have an account with HSBC in Shanghai. I can't take my money out. The government is restricting the flow of money out of the country," Mobius, founder of Mobius Capital Partners, told FOX Business on March 2, 2023.
For those thinking that China, Russia, and Saudi Arabia can cobble together a reserve currency, ask yourself a question: If you were the leader of a nation, would you leave funds in their banking system or trust their government with said funds? More importantly, do you even think those countries trust each other?
Liquid markets
From an operational perspective, the size and liquidity of U.S. financial markets and the ease with which foreigners can borrow and invest U.S. dollars are of utmost importance.
Foreigners enacting global trade need dollars to facilitate exchange. Therefore, they hold and maintain the ability to borrow dollars. International trade requires a financial system with immense liquidity. Further, the more liquid a market, the lower the borrowing, investing, and hedging costs.
In this respect, the U.S. is unparalleled. The U.S. bond markets are considered the world's deepest and most liquid markets. As I cite below, the U.S. bond market accounts for almost 40% of all bonds outstanding globally.
Per the Securities Industry and Financial Markets Association (SIFMA): "As of 2021, the size of the bond market (total debt outstanding) is estimated to be at $119 trillion worldwide and $46 trillion for the U.S. market."
Military might
A key factor allowing Europe and Japan to recover quickly from World War II was their ability to borrow U.S. dollars and use the money to focus on rebuilding. Equally important, they did not have to refortify their military for another war. America “had its back” if another country were to invade. As a result, over 750 US military bases exist in more than 80 countries.
Let's consider Ukraine's situation. Its defense against Russia is being heavily funded and supported by the U.S. What might happen if Ukraine starts trading with Chinese yuan or euros? Do you think America would still give it the support it desperately needs? Can Ukraine forgo using the dollar in trade? The answer to both questions is a definitive “no.”
The graph below shows the U.S. accounts for about 80% of military aid to Ukraine.
With China and Russia flexing their military muscles, other countries are watching the situation and recognizing that the dollar and America's military are a package deal.
Given America's superpower status, for another currency to become the global reserve currency, accepted by an overwhelmingly large percentage of nations, that replacement government will have to defeat the U.S.
Economic power
As shown below, the United States economy is roughly the same size as the next three largest economies combined. Given U.S. economic activity dwarfs every nation but China, a large percentage of global trade involves U.S.-based buyers and sellers. The dollar is the preferred currency to facilitate exchange with these entities.
Current dollar status
According to the IMF, the dollar makes up almost 60% of global foreign exchange reserves. While the percentage has declined by about 10% over the last decade, it is still three times the next leading reserve, the euro, which accounts for about 20% of global reserves. For those concerned about China, its currency, the renminbi (yuan), accounts for 2.5% of all reserves.
Per the BIS, foreign dollar-denominated debt totals approximately $16 trillion. That is up from $10 trillion in 2008. Next in line is foreign euro-denominated debt at roughly $4 trillion. That amount has not changed since 2008.
Data from the BIS and the graph below from @donnelly_brent show the dollar accounts for almost 90% of global transactions. That percentage has been steady over the last 30 years.
Summary
The pundits will be right someday. The dollar's death as the reserve currency will come, and some other nation's currency, cryptocurrency, gold, shells, or something else will take its place. However, that day is not imminent. There is no alternative.
While China is rapidly growing its economy and global trade footprint, it lacks the rule of law and liquid capital markets to sustain a global currency. It's difficult to see how a communist country can overcome those challenges.
The euro is the most viable competitor. The EU has the rule of law, but their capital markets are not nearly liquid enough to facilitate global trade. They also lack the military might to force the usage of the Euro. Its finances are in equally bad or even worse shape than the U.S.
Bitcoin? Forget about it! The government will never relinquish its control over the currency because, with that, they lose control of the nation.
Gold-backed dollars were a mainstay until 1971. However, as we have learned for the last 50 years, gold restricts the ability of the central bank to run monetary policy as it sees fit. A rules-based system, like gold-backed dollars, might benefit the economy. However, regardless of your thoughts, the Fed and government are not ones to give up power.
Michael Lebowitz is the founding partner of 720 Global and partner with Real Investment Advice. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics. For more information about our upcoming subscription service RIA Pro, please contact us at 301.466.1204 or email [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
