Insight Investment

Executive summary

• The US dollar has been the world’s reserve currency since 1944, but recent events (including the imposition of sanctions on the Russian central bank, the inclusion of Chinese government bonds in global bond indices and genuine European Union (EU)- wide bond issuance) have refuelled the ongoing debate of whether the USD will at some stage lose its reserve status.
  
  
• We analyse the attributes that constitute a good reserve currency and conclude the US dollar still comfortably remains the best choice for a global reserve currency: 
  • Economic relevance and power: the US remains the dominant economic power
  • Liquidity: the US dollar is the dominant currency used for trade in goods and services and US financial markets have the deepest liquidity, making it easy to undertake large transactions
  • Store of value: during periods of financial stress investors frequently shift to the US dollar and the Federal Reserve is the key source of emergency liquidity via its provision of swap lines
    
    

• Although the risks for the US dollar in the short term are limited and its value is likely to be driven by cyclical considerations, the long-term risks to the USD’s hegemony are real and the pressure is building. More specifically, we think two trends could disrupt the US dollar’s dominance as the world’s reserve currency:
  • Historically, there have been few alternatives to the US dollar, but this is evolving. Joint bond issuance within the Eurozone and steps to internationalise in China are both important changes, with central bank digital currencies a potentially disruptive innovation.
  • More recent moves to weaponize the US financial infrastructure – either through the use of sanctions or by limiting access to systems like SWIFT – is likely to be diminishing the appeal of the US dollar as a reserve currency at it is forcing some countries to build competing payment systems and alternative sources of liquidity. This is leading to a fragmentation of global financial infrastructure.
    
    

• While we don’t think we are at a tipping point for the US dollar, our sense is that the share of US dollars held in global FX reserves will continue declining for the foreseeable future. A pronounced tipping point is likely to occur only when the major holders of FX reserves decide that intervening in their currency markets is no longer a desirable policy. As this is unlikely to happen in the short term, we expect FX reserve diversification to be only a very mild negative for the USD.