Appetite to create global reserve bank to issue the currency and monitor national exchange rate is brewing. In early 2009, the BR IC’s proposed replacing the US$ as the main reserve currency following the financial crisis due to the collapse of US mortgage market that led to the worst global recession since World War II.
Also, the economic power is shifting from G7 countries that saw increasing acceptance of the other economies currencies. And if US recovery is weak, rates will remain low, thus pressuring the US$ to stay weak.
Latest IMF report on global reserves currency composition showed USD holding dropped to 62.8% in 2Q2009 from 65.0% in 1Q2009 the lowest since 1995 has some level of exaggeration to suggest liquidation of US$ by the central banks. (Table 1) First, a large portion of the shift in US$ holding is due to weak US$ itself. It boosted the US$ value of those reserves held by other currencies. Second, there is no clear indication that China will turn its back on US$, with US$2trn reserve composition unknown and US Treasuries holdings of US$800bn in July from US$780bn June. (Chart 1) Third, the USD depreciated significantly since 2001 did not trigger large scale diversification.
Lately, the United Nations proposed reducing using US$ in global trade and establish a new currency to protect emerging markets from the ‘confidence game’ of financial speculation. We think this may not happen that soon, although we are not ruling out the possibility of it happening sometime mid-21st century. Tracing back the history of the last switch in reserve currency, UK lost its position to US as the world’s largest economy in 1872 and the largest exporter in 1915. Switch in net debtor/creditor position began 1914 and the US$ emerged as a convertible net creditor currency and used in finance and trade. By 1945, the pound was dethroned.
USD is in a net debtor position like pound after WWII. They will have to maintain it if US$ remains as the global reserve currency. As such, when the global economy expands, demand for reserve assets will increase. It can only be met if US operates in current account deficit. If they stop operating in deficit and reduce supplying of reserves, it results in liquidity shortage and drags down global growth.
Can Yuan surpass the USD? With USD is in a net debtor position, while China as the world’s largest creditor just like pound after WWII, China should surpass US by mid-21st century based on Purchasing Power Parity. While it works on paper, in reality much depends on China’s policy. They must ease restrictions on liquidity flow, continue domestic financial reforms, improve bond market liquidity and make Yuan fully convertible.
Recently, China, Russia, Japan, France and Gulf States plan to dump US$ in oil trades for basket of currency or gold. This may not be viable in our view. If oil price is based on a basket of currencies, the issue will be the mode of payment – how the producers will insist on payments. Currently, USD is used as a single mode of payment. If gold is used as the payment mode, it will be converted into USD for payment.
Now, even if other currencies are used, oil producers will swap some of the proceeds earned in other currencies back to USD. At the moment, oil producers swap their USD proceeds into other currencies.
The US$ looks promising going forward based on the trend line of trade-weighted USD index. (Chart 2) We think the current risk to USD lingers around its high risk policies of quantitative easing (QE) and large government borrowing will debase the USD by runaway inflation. We think it may not happen. Looking at the bond market, yields and break-even inflation rates are still low. Recent economic data are showing the macro policies have started to prop-up the economy. If their recovery becomes firmer, we can expect speculation for an early reversal of QE. It will prompt positive sentiment on US$ and reduce its appeal as a funding currency for carry trades.
And with strong domestic demand in Asia and high US household savings, US trade deficit and reliance of US on foreign capital will ease. Hence, Asian currencies will shoulder bulk of the burden. It will ease pressure on US$ to weaken. The world economy has averted from the fear of Great Depression. But if we assume the global recovery becomes disappointing and risk appetite wanes, appetite for safe haven instruments will rekindle, thus reviving USD. Also, the authorities will not seek a weak USD, fearing loss of confidence and raise risk of financial instability.
To sum up, we are not discounting the possibilities of re-balancing reserves away from USD. We think this may happen sometime in the mid-21st century. Meanwhile, the decision to re-price oil in our view would depend on issues related toinflation and fiscal position as opposed to the weak USD itself. Thus, we continue to hold our view that opportunity for US fundamentals to improve and sentiment swinging back in favor of USD holds.