Reserve Currency Blues

The “Demise of the Dollar” is a long-running story in hard money circles, and has gotten a recent push by the growth of transactions in the Chinese yuan in international transactions. Although it seems likely that the yuan will grow in importance, this is largely a nothingburger from the perspective of the United States.

Emerging market investor Paul McNamara was recently interviewed by Tracy Alloway and Joe Weisenthal on this topic. His views are better thought out than mine, but I just want to chime in from the perspective of a developed market govvies analyst.

Reserves are for Pegs

If one is in the unfortunate position of reading someone who is hyped up about “reserve currencies,” they will usually point to dramatic historical events about the demise of reserve currencies. The part that is usually glossed over is the fact that those shifts occurred in currency regimes where the major currencies were pegged against each other and/or gold. (If a “reserve currency” has a credible peg versus gold, then a “pure gold peg” by another country is a de facto peg against the reserve currency. The Bretton Woods system featured other countries pegging against the U.S. dollar, and the U.S. dollar had a gold peg. The reason for that structure was that the U.S. ended up with most of the world’s gold reserves after World War II.)

The hard money bugs are saddened by the demise of the Gold Standard, and so their stories about the demise of the dollar typically involve fantasies about the rise of some new commodity/gold-backed currency.

The problem with these stories is that hard currency pegs are now relatively rare (richest countries with them are the Gulf States), although creeping pegs/managed currencies are popular in Asia. If you have a hard peg, you need to keep a reserve of what you are pegging against (foreign currency, gold) in order for the peg to credible. You can diversify, but diversification is only going to be possible if you have a large amount of reserves relative to the potential demand to cover imports (and other emergency funding needs).

But if your currency does not have a hard peg, you have less credibility worries. You might want to accumulate “reserves” to deal with a potential domestic currency crisis, but they are not truly assets held in reserve to defend a peg — it is a liquid sovereign wealth fund. You have an objective of returns maximisation, putting you in the same boat as global bond managers.

Why is the Yuan Rising?

The rise of the yuan in international transactions is not particularly surprising — it is a major manufacturing power. Meanwhile, Russia’s decision to launch a war of aggression and engage in mass war crimes has unsurprisingly got it knocked out transactions with NATO countries, and so it has no choice but to kowtow to China.

To the extent that countries want to protect themselves against American sanctions, they have an interest in moving away from the dollar/euro system.

The problem with the yuan is the closed capital account. If you cannot easily buy or sell the currency, you are not going to use it as an invoice currency (unless you have to).

Barring some unusual shocks, the role of the yuan in global trade should rise over time — but this meets the “So what?” question.

“Reserves” Allocation

Once we accept that most “reserves” are actually low risk sovereign wealth funds, we can then ask: what is their allocation going to be? If the investors wish to avoid default risk, they are going to end up with a hefty allocation to U.S. Treasuries. (Note that some of these countries have riskier investment pools that are there to maximise returns.)

• The main competitor is the euro. The problem is default risk: the structure of the euro allows for sovereign default. Investors are stuck asking the question “Which countries in the euro area are too big to fail?” This means that the investible universe of bonds is smaller than the size of the euro area economy suggests. The problem with countries with low debt-to-GDP ratios is that by definition, they have small bond markets.

• Japan has a large bond market, but QE has made it less liquid. It is not a great diversification choice for other Asian economies. It is also not clear how welcoming Japan would be for large foreign reserves investors.

• The United Kingdom has a somewhat liquid bond market. However, the ruling party is running the economy into the ground, which is a disincentive to invest there now.

• Other developed countries are not deep enough to absorb large foreign allocations, and would have a hard time providing a lot of selling liquidity in a global crisis.

• As soon as we look at developing countries, they either have default/inflation risk, or are export-driven economies without much government debt. Meanwhile, developing currencies tend to tank in global crises — which is exactly what you do not want in your rainy day emergency fund.

The need for liquidity and the desire to avoid default risk means that “reserve” allocations will tend to overweight U.S. dollar fixed income assets relative to debt market capitalisation weights or GDP weights. If euro fans wanted to take that role over, they should have had a less insane monetary structure.

(The debt ceiling loons in the United States is one of the main knocks on USD allocations. However, foreign countries have little choice but to follow U.S. politics. I do not see any sign that the loons are taken seriously.)

Private Debt Issuance is Dollar Biased

U.S. dollar credit markets are deep, which creates a bias to issue and invest there. Although euro markets are also deep, this is not the case for other developed countries. Which means that USD and EUR are overweighted relative to their GDP or trade weights when compared to other developed countries for external debt issuance in the local currency.

Since countries know that their private sectors are borrowing in those currencies, it creates a bias to want to own USD/EUR in their “reserves” portfolios beyond what trade flows might imply.

Should We Care?

The worry about foreign investors is a variant of the ever popular “Who will buy the bonds?” genre of research. Every few months, someone publishes a report poring over government bond ownership, and wrings their hands about buyers not being there in the future.

After seeing that research for a couple of decades, I will just observe that if one pulls out the Flow of Funds, every quarter has shown that somebody owns 100% of Treasury securities. This might have to do something with accounting identities, as well as the observation that for every buyer, there is a seller. To this date, nobody has been able to come up with a convincing evidence that shifts in ownership structure matter for bond yields in any measurable way. (If you cannot guess where the 10-year yield will be in one year within 100 basis points, what exactly does an alleged 20 basis point shift in a risk premium mean?)

Concluding Remarks

It seems likely that as currency pegs to the U.S. dollar disappear, the U.S. dollar will be less dominant in international transactions. However, its market share is not just the result of those pegs — trade flows, liquidity, and lack of default risk are concrete factors that favour an overweight of the U.S. dollar in safe asset portfolios.

Reserve currency shifts used to be important. There are a lot of people who want them to remain important — hard money bugs, international finance researchers. The problem is that we have several decades of free floating currency data pointing in the other direction.