Following a decade-long rise in the dollar’s value, declarations of its end as the world’s reserve currency are in vogue.
Even if there were a move away from the U.S. dollar, where would investors and exporters turn?
With the days of zero interest rates giving way to higher rates, elevated inflation and rapidly changing rules of trade, is there anything to this talk?
Our answer is no—factors driving global growth, interest rate differentials and institutional inertia favor the greenback during a time of uncertainty.
So why all the pessimism? Recent commentary has noted that the dollar has gained 31% compared to a basket of foreign currencies since the beginning of the last decade and that U.S. markets seemed to be peaking as a share of global market capitalization.
Yet this rise has happened despite geopolitical uncertainty, slow growth in the United States and a once-in-a-century pandemic. The idea that the global economy can be organized around another currency seems out of place given what has occurred over the past 10 years.
Even if there were a move away from the dollar, where would investors and exporters turn?
Outside of the liberal democracies, the leading contenders for replacing the dollar are unlikely to give up currency manipulation or capital control policies necessary to be the organizing agent for global commerce.
Other than the dollar and the euro, most every currency lacks the liquidity for foreign-exchange transactions without going through the dollar.
Read more of RSM’s insights on the economy and the middle market.
Despite the recurring crises of U.S. governance, the dollar continues to strengthen, reaching levels last seen at the end of the late-1990s.
After briefly backing off during the debt-ceiling standoff this year. the dollar once again appears capable of re-establishing its upward push or, at the least, maintaining its position until its interest rate advantages begin to soften.
This time, the upward push will most likely come from the safe-haven demand for dollars in response to the conflict in the Middle East and the potential of elevated oil prices.
So before calling it quits on the dollar, these factors should be considered:
- The transaction demand for dollars.
- The trade and hot-money demand for U.S. securities.
- The demand for technology stocks.
- The impracticality of using other currencies for trade or foreign-exchange transactions.
- The simple fact that only a few democracies encompass the virtues of a reserve currency.
Transaction demand for dollar-denominated oil
Global demand for oil and the use of the dollar to engage in transactions for it will not fade despite the wishes of emerging markets and petro economies to trade in their own currencies.
Buoyant demand in China, India and Brazil underscores the rising global demand for crude, of which China accounts for 77%. The International Energy Agency anticipates demand growth slowing next year as efficiency gains and a deteriorating economic climate weigh on oil use.
While increased volatility in the price of crude will most likely result in declining U.S. gasoline purchases—preliminary September data suggests U.S. gasoline consumption has fallen to two-decade lows—global demand for oil should maintain the transaction demand for dollars.
Foreign economies will continue selling their local currency to buy dollar-denominated oil. The same logic applies to dollar-denominated food and other commodities.
As for the supplies and the price of oil, the price of the Brent and West Texas Intermediate benchmarks increased by about $6 per barrel in the first two weeks after the attack on Israel.
Should the flow of oil be constrained, International Energy Agency countries in the European Union are holding an average of 150 days’ worth of oil. Japan, South Korea, Australia and New Zealand have an average of 145 days.
That is not to imply an immunity from shortages or oil price hikes. And if there were to be further OPEC cuts, we would expect the transaction demand for dollars and the safe-haven demand for dollar-denominated securities to increase.
While we acknowledge that conflict in the Middle East always poses a risk to the global supply of crude, for now the conflict does not appear to be a potential source of decline in the value of the dollar.
The International Energy Agency finds that the Israel-Hamas conflict has so far not had any direct impact on oil flows. As long as Iran does not try to close the Strait of Hormuz and Israel does not target Iranian oil facilities, this should continue. But the IEA nevertheless cautions that “the Middle East conflict is fraught with uncertainty.”
The IEA also notes that the region accounts for more than a third of the world’s seaborne oil trade, and that Iran is likely to rank as the world’s second-largest source of growth in the oil supply after the United States.
The risk to the global oil supply is not going away and we do not see this as a source of de-dollarization of the international economy.
Demand for U.S. fixed-income securities
Because most international trade involves the transfer of dollars, and because exporters need to park the proceeds from those sales somewhere, there is a built-in demand for dollar-denominated securities.
On top of that there is the so-called hot-money demand for the higher returns of dollar-denominated securities. Japanese investors, for example, who can earn at least 500 basis points more by investing in U.S. money market securities while borrowing at near-zero interest rates on Japan’s constrained yield curve.
While not an exact fit, the dollar has tended to move higher along with the yield pickup of holding a dollar-denominated security versus a basket of yen, yuan, euro, won and euro-denominated securities.
This is evident in two recent episodes: when the Fed began to normalize interest rates in 2016 after eight years of near-zero rates, and then again last year, when the Fed raised rates in response to the twin shocks of rising inflation and the invasion of Ukraine.
In both those episodes, U.S. monetary policy was far more aggressive than in Europe or Asia, rewarding international investors with higher returns on U.S. securities, augmented by the currency returns of a strengthening dollar.
The demand for technology stocks
Is the inflow of capital into technology stocks enough to move the dollar? While we have nothing concrete to point to, it certainly feels that way. Given what we think will be another round of technology growth driven by artificial intelligence and quantum computing that will be based in the U.S., this will most likely become part of the narrative around continuing dollar dominance.
After all, if you want big exposure to tech, you look to the U.S. There aren’t any viable options in the U.K. or even the whole of Europe, according to RSM UK economist Thomas Pugh. Although China can be seen as an alternative, that’s tempered by its own risks of capital controls and currency manipulation.
The relative performance of major stock exchange indices shows the importance of tech represented here by the Nasdaq and tech’s influence on the S&P 500.
There were outsized gains during the pandemic partial, a generalized retreat during the inflation and war shock last year and the subsequent recovery.
While the presence of technology companies in the equity markets is clear, there are enough domestic issues to render the impact of equities on the currency difficult to isolate. For instance, has the lack of alternative investments in Japan’s bond market made the equity market that much more attractive?
We suspect the potential for growth is the cause for capital inflows. For instance, over the past four years, a buy-and-hold strategy in the tech-heavy S&P 500 would have returned 7.5% per year, well above the 4% return on the Dow Jones Industrial Average.
Those returns suggest that the presence of technology in the U.S. economy is an important factor in the demand for dollar-denominated assets.
The impracticality of de-dollarization
History shows that world order is never permanent. The creation of the World Bank and the designation of the dollar as the reserve currency was only 80 years ago. Since then, other economies have ascended.
An example of the rising ambitions in developing economies is the establishment of the New Development Bank in 2015 by the BRICS nations of Brazil, Russia, India, China and South Africa. Its purpose was to mobilize resources for infrastructure and sustainable development projects in emerging markets.
There has also been talk of de-dollarization among developing economies most affected by the dollar’s recent strength and the increased cost of energy. Brazil’s President Lula da Silva proposed creating a BRICS currency.
While there is nothing to prevent the development of emerging market economies, the impracticality of changing the dollar-based system of trade and the foreign exchange market and the global bond market presents a significant hurdle to those ambitions.
And if one still thinks that crypto represents a potential replacement to the dollar, we only need to point to its recent gyrations.
Creation of the dollar-based system of trade and finance in 1945 was possible only in the vacuum left by two world wars and the decline of the British empire. Without similar circumstances, attempts to turn world trade and finance on its head seem far from realistic.
More than 70% of all Swift system international transactions—the messaging network that enables international trade—are denominated either in dollars (48%) or euros (23%). Only 3.5% of transactions are in Chinese renminbi.
Foreign exchange reserves are held by the monetary authorities of all economies to cover liabilities to other nations and as insurance in the case of currency devaluation.
Nearly all, or 96%, of FX reserves are denominated in the currencies of the major economies. The dollar comprises just under 60% of total reserve holdings because of its role in international trade and finance. Euro holdings now comprise 20%, because of its increased trade with Africa. Other currencies with substantial holdings include the Japanese yen (5.4%), and U.K. sterling (4.9%). Only 2.5% of reserve holdings are in Chinese renminbi.
There is little reason to think that these percentages will change, given the confidence in the major currencies and the track record of currency instability and capital controls of developing economies.
Finally, it is not realistic to think that foreign exchange dealers would choose to operate in a non-dollar world. There is little or no liquidity in a cross-currency transaction between two developing currencies. Each side would have to be bought or sold against the dollar.
India’s rupee
India’s rupee has all the makings of the next major currency. India is the world’s largest democracy. But it continues to straddle the line between east and west.
The Reserve Bank of India has a policy of intervening in the foreign exchange market only during periods of instability. But there is intervention, nonetheless.
The financial sector is increasingly moving toward full de facto convertibility. But government policies continue to limit foreign direct investment (purchases of the stock of domestic companies) and on foreign portfolio investment (purchases of domestic securities).
India’s economy is primed for growth, with a labor force that is young, educated and English-speaking. But the government imposes restrictions on the use of foreign intermediate products.
Analysis finds that as India removed its capital controls in the early 1990s, the rupee moved from being pegged to the dollar to what can now be characterized as a managed float.
In fact, foreign direct investment increased from a minuscule amount before 1992 to 1.5% of gross domestic product as of last year. Indeed, the rupee has lost about 86% of its value since 2010, at an average rate of 5% per year. So, market forces have been allowed to work.
The rate at which that liberalization continues will determine how soon investors and businesses are comfortable with integrating India into the western markets.
The takeaway
We expect the dollar to retain its current level of strength for as long as the Fed maintains its aggressive monetary policy stance and U.S. securities hold their interest rate advantage over foreign interest rates.
Other factors likely to support the dollar’s value will be the price of dollar-denominated oil, of which the U.S. is now the leading exporter.
The strength of the dollar and the increase in the cost of energy is particularly harmful for the developing economies, where talk of de-dollarization has increased. We think it is unrealistic that the foreign-exchange markets would or could drop the dollar and the U.S. bond market as their benchmarks.
