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The value of a reserve currency

By Economic Strategist, Hottinger Investment Management  

What’s the value in a reserve currency?

Being in possession of a global reserve currency is often seen as a privilege for a country and its citizens. In times of growth, the use of a reserve currency to grease the wheels of international trade can reduce the borrowing costs for that country. In times of panic, investors pile in to buy the currency, pushing its value up and making imports cheaper.

Reserve currencies are an essential feature of a global economy that relies on a basket of national currencies, and are an important asset for investors to manage the risks from their investments.

The best reserve currencies are those that perform the three essential functions of money best. A currency is strong when it acts as not just a medium of exchange and a unit of account, but also as a store of value. When investors choose to store some of their wealth in a foreign currency, they trust the government in charge to keep inflation low and public debts within manageable limits.

Reserve currencies can fall out of favour

Since the end of the Second World War, the United States has managed the world’s dominant reserve currency, the dollar. But today, that status may be under threat as the US government under Donald Trump abuses its privileged status by running large budget deficits and putting trading sanctions on other countries in a way that runs against international agreements.

Are we therefore seeing the beginning of a shift away from the dollar to other global currencies? One way we can begin to form an answer is to look to history. During much of the 19th century and the first part of the 20th century, the British pound was the world’s reserve currency. Many of Britain’s colonies and trading partners pegged their currencies to gold sterling; the City of London was the world’s banker, with the Bank of England its line of last defence. In 1914, according to Barry Eichengreen of the University of California, sterling accounted for almost 90% of global foreign-denominated debt. By the end of WWII, still up to 60% of foreign-denominated debt was in sterling as the US dollar came to ascendancy. Many countries, however, maintained sterling pegs well into the 1950s.

The rise of the United States to prominence in the global economy throughout the 20th century naturally made it both able and willing to provide the reserve currency, and it was essential that it did. Eichengreen claims that the dollar overtook sterling in the 1920s if one excludes Commonwealth countries but well after WWII if one does not.

The political arrangements of Bretton-Woods that followed WWII and paved the way for US dominance as well as the high debts that burdened the UK after the war provided the death knell for sterling. This, alongside the decline of the British Empire, weakened sterling’s grip within the Commonwealth and made it infeasible for the UK to remain the head of a global fixed-exchange rate system, as it required a tight monetary policy at a time when domestically the opposite was called for and demanded.

The chart below shows the effects of the sterling-dollar transition that took place in the 1940s. Since that period, the real value of the British pound has been around 20% lower than what it was during the first half of the 20th century. The nominal value has fallen further. One pound bought five dollars at the start of the 20th century; today it buys less than $1.30, a 70% devaluation that is due both to the loss of sterling’s status as the global currency but importantly also the UK’s higher long-term inflation rate compared to the US.

Dollar reserves rose from 30% of global reserves in 1950 to just under 70% by the mid 1960s. Peak dollar came just after the end of the Bretton-Woods system in 1973, at which 80% of reserves were held in dollars.

Which currency dominates today?

Today, the dollar is still considered dominant part of a basket of global reserve currencies, some of which could grow in prominence in coming decades.  Over 60% of reserves are still held in dollars, with the rest shared across the euro (20%), the yen (5%), sterling (5%), the renminbi (1%) and swiss franc (0.2%).

It’s a diversified mix that suggests that in an age in which most exchange rates float against each other rather than remaining fixed against that of a global leader, there is more scope for competition for leadership as investors can choose which nation offers the most stable currency.

Over the last thirty years, the Japanese Yen and the Swiss Franc have been popular choices, as attested by the real strength (see chart). Sterling did well between 2009 and 2016 as the UK built a reputation for fiscal restraint. However, none of these currencies can serve as the dominant reserve currency as the economies that back them are too small, which means that investors come up against valuation and liquidity issues when these currencies essentially become too popular.

Competition for reserve currency status will ultimately be between the world’s big three economies: the US, the EU and China.

Despite greater competition, the dollar has held its value through most of the post-Bretton Woods period, as the chart above shows. Fluctuations aside, a dollar today buys more or less in real terms what it did in 1980. Indeed, all of the major global currencies have fluctuated around parity over the period, which can be expected for currencies that float against each other – the so called Law of One Price ensures that nominal exchange rates move in opposition to differences in inflation across countries.

The exception is the Chinese renminbi, which has weakened by up to 60% in real terms since 1980, as a result of a conscious decision by the Chinese authorities to peg its currency against others at a weak rate to boost the country’s export sector.

Many consider the Chinese renminbi to be the natural successor to the dollar as China grows to become the world’s largest economy later this century. It’s possible, but it would require China to either open up its financial markets to global capital, providing a safe asset, or impose itself as the new figurehead of a fixed rate currency system. Neither of these looks likely for some time, so the dollar is likely to keep its preferred status over the renminbi.

The fate of the euro is potentially more interesting. With the Trump administration using the dollar’s important role in facilitating international business to impose crippling sanction on adversaries such as Iran, Europe is beginning to consider ways to circumvent the dollar payment system for its businesses.

There is nothing theoretically stopping the euro rivalling the dollar as a reserve currency, especially between those countries that have a close trading relationship with the Eurozone. Emerging market economies may also find a more diversified global reserve system to their advantage, as it would reduce the sensitivity of their economies to US interest rates.

However, until reforms are made to put the single currency on a more sustainable footing, allaying fears that the Eurozone could one day break up, that prospect looks unlikely for some time.

It looks therefore as if the US will continue to benefit from having the most popular global currency. It is in US interests to maintain dollar primacy, keeping funding costs and import prices low, and having what amounts to the best defence against the vicissitudes of the global economy.  One group that does badly from this deal is US exporters and manufacturers, as a strong dollar undermines their competitiveness. This group has the sympathy of the US President, who has a preference for a weak dollar.

Investing in currencies

Having access to a range of currencies with safe-haven status is extremely valuable to investors. While first and foremost, any investor should consider her personal requirements – such as her preferred home currency, the balance of her international investments, her liquidity needs and the nature of her liabilities – there is value in considering which currencies are emerging as safe havens. For example, holding Yen between 1980 up until any time before the financial crisis would have yielded an average real return of over 40% (see chart), excluding any return on the investments held in those currencies. Holding the Swiss Franc between the financial crisis and 2015 would have yielded an average return of close to 40% on the currency alone.

With the global situation more volatile than it has been since the end of the Cold War, and with so many things that we once thought of certainties now in doubt, now is a good time to reconsider where the best places are to hold and preserve capital.  Those places will have strong, responsible governments with open and liquid capital markets, low and stable public debt, and a willingness to accept a strong currency. And in today’s world, all of those things are contingent.

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