Market Reviews

The US dollar has held the status as the world's dominant reserve currency since the signing of the Bretton Woods agreement in 1944.

Under this agreement, in a bid to prevent a repeat of the protectionist monetary policies of the 1930s which lead to a worldwide depression, developed nations fixed the exchange rate of their currency against the US dollar. In turn, the US fixed the value of the dollar against gold and promised to redeem dollars for gold at any time. Being physically backed in this way, the US dollar provided central banks around the world with a liquid “hard” currency that they could keep in reserve to settle international trade accounts. Everyone would accept the dollar as payment.

This regime eventually broke down in 1970, when the United States’ persistent trade deficit lead to fears over dollar weakness and hence run on their gold reserves. In the modern day free float currency world, the role of currency reserves has changed. They are no longer held solely to pay for temporary imbalances in import-export imbalances, but rather used as investment funds that also deter attacks from currency speculators.

Nevertheless, over the past several decades, the US dollar has remained by far the principal de facto global reserve currency; 66% of international central bank currency reserves is held in US dollars. This reserve status also means that every major commodity is priced and traded only in US dollars and traders must buy the US currency in order to access commodities. Therefore, the question of whether the US dollar can maintain its privileged role as the international prime reserve currency is key to assessing future demand, and therefore its value.

In recent years, the size of the United States debt obligations (currently around 65% of GDP) and a continuing budget deficit (currently running at 11% of GDP), coupled with the emergence of the EU as the world’s biggest economy, lead economic commentators to question the sustainability of the dollar’s reserve status.

In 2007 former Federal Reserve chairman Alan Greenspan stated that it was "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." Similarly, at the World Economic Forum in 2008, George Soros opined: "The current crisis is not only the bust that follows the housing boom, it's basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency”.

In January 2009, the Russian central bank announced that the euro based share of its reserve assets increased to the level of 47%, exceeding investments in dollar assets which were 41%.

However, as the contagion of the financial crisis continued to spread in late 2009, and fears over sovereign solvency in the EU and the strength of the economic recovery in the US took hold, dollar sentiment has found renewed strength. Risk averse investors, eagerly seeking “safe haven” assets, flooded back to the low-yielding dollar. This inverse correlation between dollar strength and investor confidence, the so called “risk trade”, was summarised by Martin Wolf of the FT: “In the recent panic, the children ran back to their mother even though her mistakes did so much to cause the crisis.”

So whilst central bank reserve managers today remain nervous over the US fiscal position, essentially they are struggling to find an alternative currency of choice. The sovereign debt crisis in the euro zone has brought into doubt even the survival of the single currency, the financial position of Britain now looks even worse than the US, and Japan’s massive debts loom large over the yen. Shortview in the FT summed up the continued, if hesitant, preference for the dollar: “Investors call it the ugly sisters problem: no one thinks the US dollar is Cinderella, but she’s probably the least objectionable of the bunch”.

Therefore, whilst the US dollar may be currently back in favour, it appears to be due to reasons of relative strength and short term risk aversion, rather than a vote of confidence in long term US economic fundamentals. However, whether there exists a realistic alternative to cause central bankers to shift away from the dollar and into other reserve assets remains to be seen. If, or when, this reserve status shift might happen, and what the consequences will be for the US economy, are the key questions that will drive the long term value of the US dollar.

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