Passive Diversification and the Role of the Dollar

The dollar’s demise has been predicted often. It is being forecast again now with questions once again raised over its reserve currency status.

Yet one lesson of the last major economic crisis to hit the world economy – the Global Financial Crisis of 2008 – was that in times of trouble there was still a strong appetite to hold the dollar. Will it be different this time and how will this crisis impact the dollar?

Recent weakness can be supportive

Recently the dollar has weakened – not helped by a rise in virus cases in the US that has raised questions about the strength of the recovery. Indeed, in his recent comments, the Federal Reserve’s Chair Jerome Powell touched on how rising health concerns may impact the recovery.

Yet, one has to say that in a vaccine gap phase, it is not just the US but most, if not all, countries across the globe that are vulnerable to localised outbreaks.

From a policy perspective, in an environment where inflation is currently low and there are worries about the growth outlook, a weaker and hence a more competitive currency provides an additional stimulus that supports the macro policy agenda.

The US has already eased monetary and fiscal policy and while the authorities may not be directly trying to weaken the dollar, I wonder whether they are quite relaxed about its recent softening. It hasn’t collapsed, after all, and international appetite for US Treasuries is still firm.

If the economic outlook changed – for example, if the recent sharp acceleration in US monetary growth triggers an inflation shock – then the US approach to the dollar might shift, too. In that case the authorities may be more prepared to talk the dollar up.

The US is recovering

Despite the recent health spike, it is premature to become pessimistic about the US economy. Much of the US is unlocked, the policy stimulus has been sizeable and there are sufficient indicators – including the monetary growth mentioned earlier plus manufacturing and service growth – to suggest the economy is recovering.

But, as in the UK, with confidence vulnerable because of health concerns, and with some firms unable to return to normal because of social distancing, not all sectors of the US economy will be able to rebound strongly, or soon.

The same health and economic challenges confronting the US and the dollar are faced by other major economies and currencies, too. Gold’s recent rally partially reflects this as well as a search for what some see as a safe haven.

The dollar’s longer-term outlook is impacted by structural issues. While this crisis may lead to some significant economic changes it is also important to appreciate that the pre-crisis economic drivers remain in place, and of these the two most important may pose some challenges to the dollar eventually. These two are the technological, digital and data revolution encompassed within the Fourth Industrial Revolution (4IR) and the global shift in the balance of economic power.

Amid change, the dollar dominates

The 4IR is ushering in change across a host of areas – including FinTech and the rise of crypto currencies. In a virtual age this may increase the choice for the payment of trade. Future change in this area is ongoing and could be significant but an overnight change in implications for currencies does not appear imminent.

Indeed, the dollar retains a dominant position in terms of the use of currencies in global transactions. This data, provided by SWIFT, showed that at the end of last year the dollar accounted for 42.2% of global payments. This was an increase of 5.9% compared with the end of 2017. The euro was second, accounting for 31.7% of global payments last December, but down 11.1% since December 2017.

The other major currencies were: sterling 6.96%, yen 3.5%, Canadian dollar 1.98% and renminbi 1.94%. The Chinese currency had slipped from the fifth most used two years earlier.

The shift in economic power

Another key pre-pandemic economic driver is the shift in the balance of economic power, towards the Indo-Pacific, stretching from India in the west to the US in the east. While the US will be a huge beneficiary of this, so too will China. It is already ushering in the emergence of a G2, where China and the US dominate, and the recent increase in geopolitical tensions globally is likely to feed this.

New trade corridors were evident before the Covid-19 crisis. This was reflected in increased flows of goods, services, people and capital. One would expect increased future flows between emerging countries as their economies grow. It is possible that the crisis may trigger some onshoring – with production moving back from low cost economies to western countries.

Although the pace of growth of global trade has slowed, the volume of global trade still rises as the world economy grows. It seems sensible to expect increased growth of trade in services, too.

Passive diversification

The breadth and depth of US financial markets ensures ample liquidity, helping the demand for US assets and the dollar. Moreover, the US’s dominance in the tech space is reflective of its innovative economy which will continue to benefit from the 4IR and the emergence of the Indo-Pacific.

Instead of being the only reserve currency the dollar might well be the first among equals as it has to share more of the limelight. But this change will not happen overnight – and the dollar will be the leader.

A shift will more likely occur via, what I would call, passive dollar diversification.

Instead of actively selling the dollar, and actively diversifying, there will be increased use of other currencies – virtual or real – and so the dollar’s relative share may diminish.

In time, I would expect more countries to seek to manage their own currency against a basket of currencies with which they trade.

Already in recent years we have seen some countries choose to trade commodities in currencies other than the dollar and some central banks to diversify their reserves. This is indicative of longer-term change, albeit gradual, and where the dollar is still in a dominant position.

As we saw with sterling a century ago, a currency can lose its reserve currency status, but it takes time – and sterling remained dominant long after the UK had been displaced as the major global power.

Despite this, I think it is premature to suggest the dollar’s number one position is under threat.

Markets are being driven by a combination of health, economic and policy issues, and more recently, political and geopolitical tensions have come to the fore. These may add to currency volatility in the near term. We are witnessing cyclical factors contributing to a softer dollar now.

Please remember that when investing your capital is at risk.