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The Dollar Holds Its Place

The U.S. dollar has begun to recover after weakening relative to other global currencies last year. But worries that the greenback might be in immediate danger of losing its primacy in the world economy were overblown even before this comeback.

In a highly connected world, we need a common language for commerce and science; English often (though not always) fills that role. In the same way, our global financial system needs a primary reserve currency as a sort of common financial language. Since roughly the middle of the 20th century, that has been the U.S. dollar.

The dollar is one of eight major reserve currencies. The International Monetary Fund recognizes it alongside the Australian dollar, the British pound sterling, the Canadian dollar, China’s yuan (also known as the renminbi), the euro, Japan’s yen and the Swiss franc. All of these are currencies that another country’s central bank or treasury may hold as part of its formal foreign exchange reserves. Reserves may help moderate the value of a country’s own currency, allow the country to pay for imports more seamlessly, help to buffer the country against economic shocks or allow it to service debt. While any reserve currency can serve these purposes, in practice much of the world’s international trade happens in U.S. dollars. According to IMF data as of the fourth quarter of 2020, about 55% of global foreign exchange reserves were designated in USD, a level that no other currency approaches. (The runner-up, the euro, represents around 19% of global reserves.) And even this represents a small decline from the dollar’s usual level of about 60% of international reserves.

The dollar’s dominance today does not mean it will be the primary reserve currency forever, of course. The United Kingdom’s pound sterling was once the world’s primary reserve currency. Another currency may one day take the leading spot. But reports that the dollar’s time is already over seem premature.

Last summer, Goldman Sachs told its clients that “real concerns” had emerged about the longevity of the dollar as a reserve currency. Between March and August 2020, the dollar fell 10% against foreign currencies. Some economists worried, and continue to worry, that rising national debt could undermine global faith in the United States’ currency. The dollar’s value has begun to bounce back, but U.S. national debt isn’t going anywhere. So was the alarm misplaced, or at the very least, premature?

Gregory Daco of Oxford Economics told USA Today last August that long-term weakening of the dollar eventually could knock it out of the basket of global reserve currencies outright. But such an outcome, he added, would take years; while this scenario is possible, he deemed it unlikely. Even if the dollar had not strengthened since last summer, similar fears in the Great Recession of 2008-09 turned out to be groundless. Not enough has changed to make this time any different.

Part of the reason the dollar’s throne is safe for now is that the world would need a viable replacement. Scott Pardee, a former Federal Reserve official and monetary economics professor at Middlebury College in Vermont, explained why those are hard to come by in a segment for NBC News. “The country that takes over would have to have a strong central bank, a strong banking system... and securities markets people can come in and out of freely and that are trustworthy.” Few nations can fill this tall order. While Australia, Britain, Canada and Switzerland have trustworthy reputations, their economies are much smaller than that of the United States. Japan has struggled to break out of an economic slump for decades. That leaves two options among the existing reserve currencies: the euro and the yuan.

Eurozone nations collectively represent economic and financial markets approaching those of the United States. But because the European Union’s economy rests on member countries with a variety of outlooks, some economists worry that the euro is too inherently volatile to be a good candidate for a primary reserve currency. We are not many years past the crises that shook nations like Spain and, especially, Greece. And in the wake of the United Kingdom’s exit from the bloc, some observers wonder if other departures will follow.

However, the euro does offer some advantages. During the pandemic, the EU opted to create a pooled recovery fund. This pool offers a deeper supply of bonds to foreign central banks and could serve as a post-pandemic framework if bureaucracy in Brussels does not impede it. Some economists have also suggested that the EU’s more deliberate approach to environmentally conscious business development and regulation could make it relatively attractive to certain foreign governments. But while the euro could someday grow into a larger global role, most observers agree it is not yet ready for prime time.

China’s yuan offers a separate set of challenges. China’s growing economy has brought it into the global spotlight. Some estimates, including the IMF’s, put its gross domestic product ahead of that of the United States. However, the question of the size of China’s economy immediately raises one of the major drawbacks of the yuan: China’s opacity about its economic and financial measurements. Beijing does not allow the free exchange of its currency, and many foreigners have questioned the government’s official economic figures. Between strict government control of the yuan and opacity in economic reporting, outsiders have ample reason for caution. An international reserve currency must be a safe place for governments to park unused cash. History suggests that any cash stored in mainland China is the opposite of secure. Once, Hong Kong may have seemed like a viable alternative. Beijing’s crackdowns there in the past two years have undermined this possibility.

China, too, faces the pressure of a trade war with the United States. While a tough stance toward China is not the talking point for President Joe Biden that it was for his predecessor, at this writing Trump-era tariffs remain in place. Some commentators have speculated that Biden may hope to use the tariffs as leverage in pressuring Beijing on human rights abuses and fair trade practices. However this particular standoff plays out, it seems likely that this will not be the last time China runs afoul of other major economies over ideological differences. The engine of China’s economy, along with future technological innovations, may offer some attractions. Still, it is unlikely many countries will confidently leave their reserves in Beijing’s hands for some time, if ever.

Some observers have proposed even less conventional approaches for a primary global reserve currency – including a couple of options that are not traditional currencies at all. One suggestion has been to use the IMF’s Special Drawing Rights. Special Drawing Rights, abbreviated SDR, is an internal currency the IMF can exchange for hard currency reserves. Its value is pegged to five underlying currencies: the dollar, the euro, the yuan, the pound sterling and the yen. Supporters suggest that a primary reserve currency unattached to any one economy could offer stability. The issuer need not worry about domestic needs in addition to international concerns. But SDR is not currently accepted in private transactions, and the IMF does not control the supply. Both would need to change for SDR to work as a functional reserve currency.

Another option floated by some economists and officials is turning to cryptocurrency. As my colleagues and I have written in the past, cryptocurrency is not currency in the traditional sense. Bitcoin, Ether and other major cryptocurrencies do not function as effective stores of value due to their significant volatility. And, in most situations, they are impractical as a medium of exchange. The Internal Revenue Service’s decision to treat cryptocurrency as property, not cash, reflects this reality.

That said, like SDR, cryptocurrencies appeal to those who think it would be better to decouple the world’s primary reserve currency from any one nation’s economy. Boosters suggest that digital ledgers like blockchains could offer real security in the absence of a central bank overseeing supply. But even cryptocurrency enthusiasts generally acknowledge that none of the major players are so far in a position to take over as a reserve currency at all, much less the primary global reserve currency.

Technological changes could, however, make a move to a new primary reserve currency easier one day. Certain countries, including China, have begun to issue or develop central bank-controlled digital currencies. In a 2020 paper, the IMF suggested that the rise of these digital currencies – which are not cryptocurrencies but do exist purely online – could facilitate changes to reserve holdings in the future. This is possible but unlikely, especially in the short term.

After 2020, we all know that unlikely does not mean impossible. This is part of why diversification remains a key component of a wise long-term investment strategy. Diversification should mean hedging against country-specific – or currency-specific – risks. That said, there is no need for immediate alarm. The evidence suggests it is improbable that the U.S. dollar will lose its status as the world’s primary reserve currency anytime soon. If it does lose that status one day, the change will not come overnight without warning. For now, investors can trust that the greenback will stay the world’s economic lingua franca for some time to come.