Plenty of financial, political or cultural occurrences have, at some point, been considered virtually impossible before they happened. The odds of Leicester City winning the Premier League were 5,000-1 at the start of the 2015-16 season. Shortly after they were crowned champions in May 2016, bookies were placing the probability of the UK remaining in the EU at around 80 per cent.
A big part of investors’ jobs is to assess the likelihood of various risks and to scenario-plan for them. As understatements go, calling this period in markets “extraordinary” would rank alongside describing the reaction of China to the tariffs as “quite irritated”. Events that capital allocators might previously have dismissed as too outlandish to consider are now firmly on the table.
Until recently, the idea that the US dollar might cease to be the world’s reserve currency was given almost no credence by anyone in the City. Last year, however, I started to notice more serious institutions tentatively discussing this possibility. Given the plunging valuation of the greenback and US bonds over the past couple of weeks, the topic has become a much more frequent and serious item for debate. Something is only unthinkable until people start thinking about it.
Last summer, long before this month’s market chaos could have been imagined, the Research & Policy Center of the CFA Institute, the US membership body for the chartered financial analyst profession, published a survey of 4,000 fund managers that found 77 per cent thought US government finances were not sustainable and 63 per cent believed the US dollar would lose its reserve currency status over the next five to 15 years.
In October, JP Morgan published a paper entitled De-dollarization: is the US Dollar Losing its Dominance?, which argued that while the pre-eminence of the dollar would take decades to unwind, some trends chipping away at its primary reserve currency standing were already in train: a steadily decreasing share of global foreign exchange reserves, more energy transactions being priced in local currencies, and new global payment systems enabling cross-border transactions without the use of US banks.
This week, José Luis Escrivá, governor of the Bank of Spain and a member of the ECB’s governing council, went further, publicly suggesting that international investors might re-evaluate the central role of the dollar and that the “stability and predictability … and rule of law” of the EU could mean that the euro emerges as a more attractive alternative.
To be clear, the dollar being dethroned as the global reserve currency remains unlikely, at least in the short or medium term. However, the fact it is being debated at all underlines how much the global economic landscape has altered.
There are signs, too, that if the US administration continues to be highly unpredictable, the status quo in FX markets could shift. The dollar has, for years, been a classic safe haven for investors, typically rising when markets sell off aggressively. During the recent turmoil, it plummeted alongside global indices, leading Deutsche Bank’s FX team to warn clients that the loss of dollar safe-haven status “needs to be acknowledged as a possibility”.
But why does this matter? Essentially, reserve currency status enables the US to borrow money at a far lower rate than any other country or institution. The fact that 59 per cent of foreign exchange reserves are in dollars, with the euro at 20 per cent, along with nearly half of all Swift international payments, means the US government is never short of willing buyers of its debt.
It is the single reason the country can sustain such eyewatering levels of public debt, which, as of this month, stood at $36.22 trillion. Only ten countries, including the likes of Sudan, Eritrea and Venezuela, currently have a higher debt-GDP ratio than the US’s 122 per cent, which compares with that of Bhutan or Cuba.
You don’t need me to spell out how dramatic the consequences would be for US public finances should the dollar lose its long-standing reserve status. If US debt becomes unaffordable to repay, the borrowing power — and spending power — of the world’s largest economy will be placed in the deep freeze.
This doomsday scenario would equate to a full-blown global recession and, even if the euro assumed the dollar’s global reserve mantle, there would be no winners, including the EU.
President Trump’s 90-day pause of reciprocal tariffs shows that the FX and bond markets retain their ability to spook the US government. This hiatus should quieten chatter of global de-dollarisation and, for now, keeps it in the realm of the hypothetical. But it is now no longer unthinkable — and this, and its dire ramifications, should be uppermost in the administration’s thinking in three months’ time when deciding its next move.
Seema Shah is chief global strategist at Principal Asset Management
