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Article | 22 May 2023 | Market updates
Seamus Lyons, CFA,
Senior Investment Manager
The US dollar has held the position of global reserve currency, dominating the international payments system, for the last 80 years. As the world’s largest economy, with 25% of global GDP in 2022, it is perhaps not surprising that the currency of the US should command this position. The dollar represents 58% of global central bank reserves. The currency also dominates global foreign exchange and bond markets, which drives a virtuous circle of demand for dollars.
Nonetheless, trends have arisen over recent decades that could eventually challenge the dollar’s preeminence. The creation of the European Union established a significant trading bloc, which accounted for over 16% of global GDP last year. The rise of China as an economic superpower, now with 18% of global GDP, could also present a significant challenge.
The Russian invasion of Ukraine and the trade sanctions that followed, caused a jolt to the global trading system. China and India, both major importers, have continued to trade in oil and other commodities with Russia, with little need for these transactions to be priced in dollars. Separately, China has recently held talks with Saudi Arabia over settling oil transactions in renminbi.
And in recent weeks, the threat posed by the US government debt ceiling stand off, risking a default on debt payments, could chip away at the dollar’s safe haven status. It’s likely any such default would hasten the move towards dedollarisation.
The euro, the yen and the renminbi trail the dollar in the reserve currency league table. The euro is the closest contender with 20%, while the share of the yen and the renminbi remains in single digits. Why do these disparities persist? The capital markets could provide a clue. Markets in the US and Europe are particularly accessible and well regulated, with no capital controls in place, which makes them very attractive to international investors.
China is the world’s biggest exporter and therefore a major player in global trade. Indeed, it was recently reported that the renminbi’s share in the trade financing market had doubled to 4.5%. This puts the renminbi just behind the euro. The dollar meanwhile accounts for around 80% of global trade finance and half of all trade invoices. However, China has now established a 15% share of global goods trade and it is expected the renminbi’s position will steadily advance.
Despite recent shifts in global trade, the dollar remains backed by its enormous liquidity and the openness of the US trading system. This indicates that the dominance of the greenback in global trade and reserves looks set to continue into the medium term.
We should never say never, however, particularly as the pound sterling held that position less than a century ago. Confidence in the US currency could be dented by domestic episodes such as the regional banking crisis and the debt ceiling negotiations. Bigger threats are hard to predict, although wider acceptance of digital currency might one day play a part.
At Architas, we do not tend to take large active foreign currency positions in our portfolios, not wishing to lose returns via currency fluctuations. Although active foreign exchange can offer a small diversification effect, we look to a portfolio diversified among other major asset classes to help us navigate volatile markets.