The Dollar has long been a reflection of the economic might of the US. This has helped it establish an assured position as the global reserve currency and the natural currency for oil trading globally. However, as the geopolitical lines are redrawn and the balance between global superpowers shifts, could this dominance fade?
Today, there appear to be few signs of weakness. The Dollar sits at levels not seen for over 12 months, in spite of the Federal Reserve’s recent decision to pare back interest rate rises. This is due to softness in the Euro, the Dollar’s most important counterpart, as transitory negative factors like changes in Germany’s car emission standards weigh on economic growth in the Eurozone.
However, we believe a decline in the Dollar is likely over the longer term.
The IMF recently released its ‘Currency Composition of Official Foreign Exchange Reserves’ (COFER), which showed a notably gloomier picture for the US Dollar outlook.
Global FX Reserves rose by around $700bn over the 12 months to the end of 2018, but the Dollar’s share of total outstanding reserves fell to 61.7%, the lowest level since 2013 and is the tenth decline in the past 12 quarters. Conversely, the Euro share of FX reserves has steadily risen over the last 3 years. Equally, the Japanese Yen’s share of global FX reserves is now at its highest point since 2002.
Reserve managers, historically, have been an important source of demand, but appear to be growing less inclined to own Dollar assets.
Renminbi as a challenge
Perhaps more notable for those with an eye to history is the increasing share occupied by the renminbi. The tussle between superpowers China and the US is being played out in the currency markets. The renminbi starts from a low base and currently forms just 1.9% of global FX reserves. Nevertheless, its share has doubled in two years and might be expected to grow far faster should the Chinese government allow the currency to float more freely.
There are other reasons to believe the renminbi’s challenge may strengthen. China has made its position clear with the launch of ‘petroyuan’ to rival the petrodollar - China launched its first crude oil futures contract denominated in its own currency in 2018. The government wants to break the stranglehold of the US Dollar as the oil market’s preferred currency.
At the same time, Chinese government bonds are set for inclusion in a number of major global bond indices – the Bloomberg Barclays Global Aggregate Index, the J. P. Morgan Government Bond Emerging Market index and the Citi World Government Bond Index. This should drive global capital flows to the Chinese government bond market. Given that foreign share of the Chinese local currency bond market is just 7%, there is considerable room for them to increase their share.
US private sector basic balance
The US private sector basic balance is calculated as the trade balance plus long-term capital flows, excluding official purchases of treasuries. This measure is often used to gauge underlying global private-sector demand for the US$. The latest data shows it going deeper into deficit - in the 12 months to January, the balance was -$231bn. This is a material deterioration since 2016, when the measure showed a surplus.
That means the US is pumping more Dollars into the global financial system at a time when there is decreasing demand from both the official sector and private buyers. Providing the Eurozone economy recovers, and political risks around the European parliamentary elections are manageable – this is not a given – there is a case for the Dollar to weaken later this year. This weakness has historically been positive for global equities, notably Emerging markets (particularly those who are big dollar borrowers).
For the US Dollar, apparently shorter-term problems – such as changing global FX reserves and the US private sector basic balance – may in fact be symptomatic of a secular shift as global political power adjusts. Dollar strength seems unlikely to endure over the longer-term.
Data source: IHS Markit (https://www.markiteconomics.com/Public/Home/PressRelease/5e809b959ac94d7d90cbdb6569dae3e2)