Dollar :-(

We tend to be sceptical of “RIP DOLLAR!!!” chatter, as the US currency enjoys the mother of all network effects. But Stephen Jen’s latest note raises some interesting points.

Jen is a very well-known currency analyst. At Morgan Stanley, he famously coined the “dollar smile” theory, which posits that the US currency tends to do well when the economy is humming or heaving. He now runs money at Eurizon SLJ, and occasionally still publishes fascinating research on the world of FX.

His latest briefing note argues that the US dollar has “suffered a stunning collapse” as a reserve currency, which has seemingly quickened after Washington’s decision to wield its control over the dollar-based international financial system against Russia.

Jen estimates that if you adjust for price changes the dollar’s share of official global reserve currencies has gone from about 73 per cent in 2001 to around 55 per cent in 2021.

Then, last year, it fell to 47 per cent of total global reserves.

FT Alphaville’s emphasis below:

The USD is losing its market share as a reserve currency at a much faster rate than is commonly believed. After steady declines in its global market share for the past two decades, in 2022 the dollar lost market share at a pace 10 times as rapidly. Analysts have failed to detect this big change because they calculate the nominal value of the world’s central banks’ dollar holdings without considering the changes in the price of the dollar. Adjusting for these price changes, the dollar, we calculate, has lost some 11 percent of its market share since 2016 and double that amount since 2008.

This erosion in the USD’s reserve currency status has accelerated precipitously since the start of the war in Ukraine. Exceptional actions taken by the US and its allies against Russia have startled large reserve-holding countries, most of which are from the Global South.  

. . . Without the need for us to take sides in this debate on Ukraine, it seems reasonable to speculate that the main driver of the collapse in USD’s reserve status in 2022 may have reflected a panicked reaction to property rights being jeopardised. What we witnessed in 2022 was sort of a ‘defund-the-global-police’ moment, whereby many reserve managers in the world disagreed with the conduct of both Russia and the US. 

However, before rushing to tweet about how the US needs to embrace bitcoin to remain relevant, there are some important nuances to consider here.

First of all, the narrative about the weaponised dollar is muddied by the fact that the main beneficiaries have been the yen and the euro — whose price-adjusted reserve market share surged 5 per cent in 2022. Those countries obviously joined in on the Russian sanctions.

Perhaps the euro is benefiting from a bit more ambiguity from Europe on whether it would always follow America’s path in these matters (it notably didn’t when it came to Iranian sanctions under Trump). China is the world’s biggest reserve holder, after all, and Macron’s recent brain fart diplomatic gambit might make Beijing feel a little safer in euros.

But if you are a reserve-rich central bank elsewhere that isn’t going to be a lot of comfort. Moreover, would you really feel more comfortable in, say, the renminbi? Even if it was fully convertible and liquid, would you honestly feel more sure that Beijing will behave lawfully than DC? The dollar still looks like the proverbial least dirty shirt in the closet.

Moreover, as Jen stresses, there are actually two pillars that make the US dollar so mighty: its role as the reserve currency of choice, and its dominant use in global finance and trade. “Investors ought not be confused by these two different concepts,” he argues.

While the Global South seems unwilling to continue to hold dollar assets, they do not seem to have the ability to divest from the US dollar as an international currency, particularly for financial transactions. We suspect it will be very difficult to overcome the strong network effects that have been behind the dollar’s international currency status.  

The key to topple the dollar’s throne as an international currency is predicated on the relative developments and stability in the various financial markets. If the financial markets outside the US could thrive (growing in size and becoming ever more energetic, without being unstable), and if the opposite happens in the US, the dollar could very well meet its demise. This is, however, not an imminent risk, in our opinion, though the trends are heading in that direction.

To put some flesh on this: The Bank for International Settlements’s latest triennial FX survey indicates that the US dollar’s share of all currency turnover has actually climbed from 85 per cent in 2010 to 88 per cent last year. In global finance it is similarly dominant.

Indeed, FTAV would argue that denomination of central bank reserves is by far the smaller of the two pillar’s buttressing the US dollar — and in fact is more of a reflection of the fact that the US currency is so utterly dominant when it comes to global trade in both real stuff and financial securities. It’s obviously smart to keep most of your rainy-day stash in the currency you do most of your borrowing or buying in.

However, Jen argues that the US shouldn’t kid itself, things could change, and quicker than Washington might appreciate.

The prevailing view of ‘nothing-to-see-here’ on the USD as a reserve currency seems too innocuous and complacent. Having said this, the dollar still enjoys substantial network advantages as an international currency, mainly because of its huge, liquid, and reasonably well-functioning financial markets. The persistence of these preconditions, however, is not preordained. If the US makes more policy errors and abandons the culture of self-examination, there will likely come a time when much of the rest of the world will actively avoid using the dollar. Finally, what needs to be appreciated by investors is that, while the Global South is unable to totally avoid using the dollar, much of it has already become unwilling to do so.  

Further reading:
Financial warfare: how the west unleashed ‘shock and awe’ on Russia
Financial warfare: will there be a backlash against the dollar?
Crude indicators for dollar’s dominance