News in Charts: Will the dollar stay the global reserve currency?

As a trusted, safe-haven asset, the US dollar is the currency that people want during a crisis. It is widely accepted as a medium of exchange, even in transactions outside the US (especially in emerging markets) and when neither counterparty is a US entity. For these reasons, economists refer to the dollar as the world’s ‘reserve currency’. This status affords certain privileges to both the citizens of the United States and its government. However, there are now signs that the dollar’s status could be under threat, partly due to domestic factors and also to the rise of potential challengers like the euro and renminbi.

Refinitiv’s latest white paper, compiled by Fathom, evaluates the dollar’s status as reserve currency. For over a century, the US dollar has been the benchmark against which all other currencies have been judged. The status of reserve currency is conferred informally on whichever currency attracts the largest share of economic transactions and official reserves globally. As the chart below shows, no other currency is even close to the dollar’s share of total transactions in the world’s two principal FX trading exchanges.

Although an informal title, reserve currency status comes with benefits. The US enjoys a significant financial windfall in the form of lower interest rates. Strong demand for USD-denominated assets raises their price and means that the yields, or interest rates, required to secure loans are correspondingly lower. Indeed, the average return earned by non-US holders of US liabilities has been substantially lower than the average return earned by US holders of non-US liabilities. Since 1960, the return gap has averaged 111 basis points. In other words, the rest of the world is net financing the US.

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Strong demand for US-denominated assets partly explains why the US can consistently finance a wide trade deficit. The US trade deficit rose to be worth almost 6% of US GDP in the late 2000s, and was largely funded by inflows of portfolio investment. The US can borrow from the rest of the world at favourable rates due to the high demand for USD-denominated assets.

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Another characteristic of the country with the world’s reserve currency is that it historically tends to be the primary military power. The US tends to devote around two percentage points of GDP more to military spending than the average NATO member. One could almost argue that the rest of the world, by accepting lower returns on US assets, is paying the US to provide global security. However, it must be noted that the choice of how to spend fiscal revenues remains a US decision.

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Part of a reserve currency’s allure is that it serves as a store of value. But trust in that store can be eroded, and the white paper goes on to identify three factors that could weaken the dollar’s position going forward. The surge in inflation during the recovery from the COVID pandemic eroded trust in the value of USD – the first of these factors. A period of above-target inflation was always likely post-pandemic, but one reason that the overshoot was so severe was the perceived delayed response in tightening monetary policy. However, rates have now not only caught up but are now above inflation, strengthening the dollar once more.

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The second chip in USD’s armor is caused by the uncertainty generated by the debt ceiling discussions. Almost every year, there is a fight in Congress about raising the debt ceiling (the total permitted outstanding stock of government borrowing). Although an agreement is always reached, there is a risk that the ceiling will not be raised, and that the US government might default on its debt. The uncertainty spreads to other US financial instruments, destabilising markets and increasing the possibility of an ‘accident’. For example, the anxiety generated by the 2023 debt-ceiling standoff in April and May was quickly transmitted, as the pricing of shorter-dated credit default swaps at the time shows. Indeed, while the US typically has narrow CDS spreads, spikes in short-term CDS spreads have repeatedly occurred around the times of previous debt ceiling standoffs. The 2023 stand-off created turbulence at a period when a banking crisis seemed probable, threatening widespread panic among investors.

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A third and final concern is the threatened ‘weaponisation’ of the US dollar, which could see numerous countries deciding to reduce the leverage US has over them through its currency. An example of that was Russia’s strategic reduction of its holdings of US sovereign debt in the lead up to its invasion of Ukraine in order to reduce the effect of future sanctions.

The US continues to derive what has been described as an ‘exorbitant privilege’ from the dollar’s status, one that enables it to finance its borrowing from the rest of the world cheaply. The threat to the dollar’s status is not imminent but it does exist. Independently of the three factors discussed above, there is the overhanging risk that complacency will undermine the dollar’s status in the longer term. This scenario, along with others, is discussed in Fathom’s Global Outlook, Summer 2023 – charts and analysis will be available to Refinitiv subscribers soon through Chartbook.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.