If you’ve been wondering about the sustainability and reliability of the U.S. Dollar as the global default currency, this episode is for you. Tuesday, 04 July 2023
The U.S. Dollar has been the global reserve currency since 1944, when the Bretton Woods Agreement solidified the transition from the British Pound to U.S. Dollars. Recently, several clients have asked whether the U.S. Dollar can withstand challenges from growing currencies, like the Chinese Yuan, or from digital currencies. In this episode, we will review the history of currency markets, along with a deep dive into the strength of the U.S. Dollar compared to other major global currencies.
Hi everyone, Jay Pluimer here with Flourish Insights. As the director of investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. Did you know we have an Alexa Skill? To listen on your Alexa device, just say, “Alexa, play Flourish Insights.”
Today, in response to client questions, we are discussing the Fate of the US Dollar.
I appreciate when clients ask questions that challenge whether or not the foundations of the current market are sustainable in the future. Some of those questions relate to US versus International investments or the opportunities for a portfolio with 60% in Stocks and 40% in Bonds to earn an attractive return. An excellent example of client questions popped up recently when a couple different clients asked questions about the sustainability and reliability of the US Dollar as the global default currency. These questions challenged whether or not the US Dollar could withstand challenges from growing currencies like the Chinese Yuan or from digital currencies. It was a helpful opportunity to review the history of currency markets along with a deep dive into the strength of the US Dollar compared to other major global currencies.
The US Dollar has been the global reserve currency since 1944 when the Bretton Woods Agreement solidified the transition from the British Pound to US Dollars. This was a reflection of the balance of power for the United States as the largest economy in the world in the 1940s, a status that the US continues to hold. Although the definition of a reserve currency can be complicated, the most effective way to explain this status is that countries selling goods and services to the US and are paid in dollars, meaning that the more business a country does with the US the more dollars they have in their Treasury. For example, China is the second largest economy in the world and a major trade partner of the United States, resulting in China holding over 1 Trillion US Dollars. The result is that it would be very difficult for the Chinese Yuan to replace the US Dollar as the global currency because that would significantly reduce the value of one of the largest assets sustaining the value of their own currency.
The US Dollar represents about 60% of global foreign exchange reserves. The closest competitor is the Euro at 20% and no other currency represents more than 6%. A primary reason for the US Dollar to maintain its status as the global reserve currency is that it has consistently represented between 60% and 66% of global foreign exchange reserves, dominating all competitors by a significant margin. This consistency is impressive considering the introduction of the Euro as a global currency in 1999 and the entry of the Chinese Yuan in 2010. In addition, the US Dollar is valued relative to other currencies while the Chinese Yuan has an exchange rate that is controlled by the Chinese Government, an arrangement that has created complications for currency markets on a periodic basis over the years.
A final aspect to consider for a reserve currency is the percent of global transactions that take place in that currency. Each transaction means US Dollars are being bought and sold, resulting in a transition of currency between the two countries. Right now over 96% of transactions in the Americas are in US Dollars and 70% of global transactions are also in US Dollars. Any competing currency would need to surpass these benchmarks to challenge the US Dollar as the reserve currency, something that hasn’t happened over at least the past 50 years. The premise that a digital currency could replace the US Dollar would mean that almost all of the transactions would need to change to a new currency with the understanding that each transaction would effectively reset the currency value because there wouldn’t be a global economy supporting the value of the currency. It would also mean that countries like China would have to be comfortable selling over $1 Trillion of US Dollars in exchange for a digital currency that is effectively controlled by consumers instead of a government or governmental agency. One of the digital currency options referenced in a currency article forwarded by a client was being launched by Russia and Iran, two countries that represent under 5% of the global economy, meaning that the other 95% of the world would need to agree that two of the smaller economies would be preferred over the United States which represents almost 60% of the global economy. Similar to the digital currency question, anything is possible but it would be hard to imagine governments and corporations taking the risk that the value of their goods and services wouldn’t be supported by a recognizable economic infrastructure.
Based on this research, the Fate of the US Dollar is strong. As long as the United States is the largest open trading economy in the world, as long as every country and company wants access to the US economy, and as long as it would be both an inconvenience and a big risk to switch default currencies, the position of the US Dollar as the reserve currency is secure. It was a helpful exercise to review the reasons why the US Dollar is the reserve currency and what would be required for an alternative option to take its place, but it was also reassuring to conclude that a significant change is not visible on the horizon.
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