The might of the USD and its position as the leading reserve currency has been called into question by numerous analysts over the years.
During periods of political and economic uncertainty doubts about the USD attract a wider audience, prompting further proclamations about its demise.
Some analysts claim a collapse is imminent, others predict that it is just a matter of time and yet it remains the most highly traded currency in forex, the dominant currency in international trading and remains the leading reserve currency.
It has history on its side and is clearly still trusted by its trading partners.
But the question of its future warrants consideration as it comes under threat from the EUR and other currencies who may be ready to challenge the USD as the dominant reserve currency.
TROUBLE FOR TRUMP’S ECONOMIC POLICY
When US President Donald Trump came to power in 2016 he pledged policies that would propel the value of the USD to new levels. The objective was to boost US structural economic growth while at the same time reducing the US trade deficit.
Trump’s plan was going to be achieved by making large investments in infrastructure and extensive tax reforms in combination with a highly protectionist trade policy.
Thus far Trump’s plans have been hamstrung by political division and budget constraints. The US trade deficit continues to grow and there’s been little sign of the promised protectionism.
Concurrently, doubts about the eurozone’s future, following the Grexit crisis and the shock of Brexit, have receded. Germany’s vision of economic convergence is shared by new French President, Emmanuel Macron, a pro-European reformist, and this axis has rejuvenated the EUR. It is pressing a strong claim, similar to when it was first launched, as a rival reserve currency as foreign investors shift capital into the eurozone.
If US trade deficit continues to grow while the eurozone finally delivers on its potential, then a sustained period of EUR performance would follow and prove it might be a viable alternative to the USD as the leading reserve currency. It’s one of the key conditions that would make the prospect of a USD collapse easier to accept and navigate through.
The eurozone is not alone in its ambition to establish the EUR as a reserve currency. China will also look to benefit from uncertainty regarding US’s strength, and Asian countries will be more sympathetic to their offer of a closer relationship.
Gold has also benefitted from the apparent weakening of USD’s status, recently peaking in value after years of slow decline.
Bitcoin has the potential to stake a claim, but it’s too soon to be sure if it can accede to the role.
LESSONS FROM THE PAST
This isn’t the first time doubts have been expressed.
Ten years ago, in the aftermath of the global financial crisis that was triggered by the US house market collapse in 2006-2007, similar doubts about the USD’s status as the leading reserve currency were being voiced, and echoed most notably by billionaire investor George Soros during the Bretton Woods conference in 2009.
Then the US government bailed out financial institutions to rescue the situation.
Incidentally, it was the inaugural Bretton Woods Conference, formally known as the United Nations Monetary and Financial Conference, in July 1944 which formally established the USD as the world’s reserve currency.
Delegates from 44 allied countries concluded the Bretton Wood Agreement where it was decided that central banks would maintain fixed exchange rates between their currencies and the USD, which in turn was pegged to a fixed gold value.
In reality the USD had already established that position by 1919 when it replaced GBP as the world’s leading reserve. Britain had held to the gold standard to maintain its position as the leading reserve currency but had been forced to borrow money for the first time by its draining participation in World War I.
Countries began buying US Treasury securities which were seen as a safe store of money and by default it became the world’s reserve currency.
The Bretton Wood Agreement remained in place until it was broken by the US in 1971. US gold reserves were no longer sufficient to back the USD and President Nixon was forced to flood the market with paper money as the US struggled to meet the combined financial demands of fighting the Vietnam war and Great Society domestic program.
STANDING THE TESTS OF TIME
The USD has been tested repeatedly over time through periods of stagflation then inflation and deflation but its position as the world’s reserve currency continues because of the underlying strength of the US economy and the dominance of US financial markets.
Confidence in the US’s ability to pay its debts maintains US Treasury securities as the safest store of money. This is despite large deficit spending, trillions of dollars in foreign debt and unrestrained printing of USD.
Countries like China and Japan own more than $5 trillion in US debt. If something was to trigger them into dumping Treasury securities then a panic would occur which could lead to a USD collapse. However, China pegs the value of the Yuan to the USD which maintains price competitiveness of its exports to the US. Japan are equally eager to keep their export prices to the US competitive.
Both Japan and China would need to see their holdings in US securities declining rapidly and find a similar sized market to replace their export trade to the US in order to justify offloading their USD reserves.
Despite Japan and China selling in greater volumes to their Asian neighbours, it is the US that remains their best market. It’s not in their best interest for a USD collapse to happen and while this is the case it makes it an unlikely scenario for now.
Only if a situation arises where the likes of China, Japan and the rest of the world are economically better off with a weak USD could it slip from being the leading reserve currency but that would still require central banks to suffer the effects of a USD freefall and not react by printing money to prop it up.
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