After more than 70 years, the dollar’s status as the world’s reserve currency is on borrowed time, writes Alec Marsh
In July 1944, 730 delegates from the 44 Allied nations met at the Mount Washington hotel at Bretton Woods in rural New Hampshire to make a very important decision. Just how on earth was the postwar world economy going to rebuilt and be structured?
Among their number were two voices who spoke the loudest – those of the US representative, Harry Dexter White, and the British delegate, John Maynard Keynes. Keynes, of course, was to economics what Einstein was to physics, but while he pulled rank in terms of prestige and sheer intellectual firepower, his view ultimately did not did not carry the day. As a result, instead of a financial world with a new international currency issued by the World Bank – what Keynes called the ‘bancor’ – the Americans got their way.
The world that emerged from the rubble of the Second World War was a dollarised one – with the greenback as the world’s new reserve currency. Pegged to gold, it was the currency by which all others measured themselves. This continued until 1971, when the Americans unhooked themselves from gold, but the dollar has sailed on – and that’s how it’s been ever since.
But for how much longer will the greenback remain in the driving seat? The economic dynamics that made it the only choice in town in 1944 are at work again. This time the tectonic plates of the world economy, which saw the Old World give way to the New in the 20th century, are shifting East.
Macartney did not kowtow to the Qianlong Emperor but, barring social breakdown (or worse, a third world war), it’s hard to see how the dollar will not one day – and relatively soon – kowtow to the renminbi. For just as surely as the US economy overhauled that of the British Empire, so that of Xi Jinping’s China – quite possibly with him still at the helm – will outstrip the US’s. Whether it takes place in 2025 or 2030 is largely irrelevant. Then there’s the issue of US government debt, which stands at an astonishing $21 trillion and is forecast to swell by another $1.5 trillion over the next decade, thanks in no short order to Donald Trump’s tax cuts.
When I sat down with the economist Jim O’Neill and asked him how long the dollar had left as reserve currency, his reply was initially breezy: ‘Quite a while.’ A couple of decades? ‘Not sure about that long,’ he fired back. ‘Certainly another decade.’
Gregory Daco, chief US economist at Oxford Economics, gives the dollar even less time – another ‘five to ten years’ – but after that it’s less clear. ‘You are seeing indications that Chinese authorities are trying to push up the status of the renminbi but that will take time,’ he tells me. ‘If you continue to see China growing and becoming more important on the international front economically, geopolitically, then it’s likely that you’re also going to see the renminbi grow in importance and that would take away part of the exorbitant privilege that the dollar has benefited from.’
The ‘exorbitant privilege’, an expression coined by the French statesman Valéry Giscard d’Estaing, derives from the fact that the US pays for something like 80 per cent of its imports with its own currency, so it can run larger deficits without incurring the penalties suffered by others. The fact that the exorbitant privilege is one of the struts supporting the US’s spending gap does appear to make its position all the more vulnerable. As Stephanie Flanders pointed out in an article following the financial crisis, when the world tired of holding sterling, ‘it changed British economic policy making for ever. Indeed, we are still seeing the consequences today. Rightly or wrongly, the British government believes it cannot risk borrowing a lot more from international markets.The Americans know they have a lot more leeway.’
But that leeway is fading. Dr David Stubbs, head of client investment strategy EMEA at JP Morgan, thinks so: in fact he has a stark warning for the US. ‘We think that any kind of downturn in the economy in 2020 or beyond will brutally expose the financial-fiscal position of the country in a way which investors are not going to like,’ says Stubbs. ‘It will probably lead to a significantly lower US dollar and will start to make reserve managers question whether the mixture of dollars they have is where it should be.’ Stubbs describes the next downturn ‘as potentially a watershed moment’ for the dollar. While he concedes that neither the euro (because if its fractured political leadership) nor the renminbi (because of China’s command economy and its lack of convertibility) is a suitable alternative, he confirms: ‘Ultimately you want a currency of sound fundamentals to be your reserve currency – and given the fiscal challenges that America faces, the current fiscal policies are, I think, quite reckless.’
President Trump’s fiscal recklessness aside, China’s lack of preparedness also poses serious problems. And the consequences could be grave. That’s what Yanis Varoufakis, the economist and former Greek finance minister, worries about: ‘It is doubtful whether the Chinese want their currency to replace the dollar,’ he tells me over email. ‘They have too many accumulated dollar assets and are well aware of how incompatible their economic model is with reserve currency status. Also, they know that the dollar’s exorbitant privilege requires a military might, projected worldwide, that they neither have nor really want.’
Yet when you look at China’s bold military build-up – the airstrips and artificial islands on disputed territories across the South China Sea – it looks like it has the stomach for it. And whether the Chinese like it or not, the international holdings of renminbi by foreign governments are growing: according to the IMF they almost doubled from 2017 to 2018, from $99 billion to $193 billion (though that’s still tiny compared to $471 billion for sterling, $2.1 trillion for the euro or a whopping $6.5 trillion for the dollar).
Varoufakis is certain that China’s economic model prevents the renminbi becoming the reserve currency, for now at least: ‘Removing capital controls would entail capital flight of 12 per cent of GDP, a highly destabilising tsunami that would export deflation and import inflation levels that would do immense damage to China.’
And to the rest of us: massive deflation exported from China would act like a financial cardiac arrest in the world economy. The days when Uncle Sam sneezing caused a cold over here are passing; now it’s Chinese flu we have to worry about.
Varoufakis sees Trump’s trade wars and rewriting of agreements as based on fears of ‘the loss of US hegemony due to the shrinking share of US output’. Eventually, he thinks, this ‘will force the Chinese or even the euro to bid for reserve currency status, even if they don’t want to’. Meanwhile, Trump is seeking to ‘prolong US hegemony by moving to a series of bilateral negotiating processes whereby the US will remain dominant in each such process even if it is shrinking overall’. But it seems Trump’s economic policies are having the reverse effect: the yawning budget deficit prompted by his tax cuts will weaken the dollar position.
‘The EU are smarting with the experience of dealing with Iran and oil, and that’s something that’s as much as likely to impact the dominance of the dollar – certainly in the near term it’s probably a greater impact than China,’ says Fred Hervey, CIO of boutique London-based wealth manager Lincoln Private Investment Office (see page 60). ‘I don’t think this will be the straw that breaks the camel’s back, but I do think it raises questions. It moves people further down the track of saying potentially an alternative is beneficial.’ In September the governor of the central bank of Iran said that his country, along with Russia and Turkey, had agreed to remove the US dollar from their mutual trade transactions.
So how long will it be until we pay more heed to the pronouncements of the central bank of China than the US Federal Reserve? ‘We’re a long way from investors’ focus being on China’s monetary policy,’ says Stubbs. But he adds: ‘You could argue that they already deserve more focus. The central bank with the largest balance sheet in the world is the People’s Bank of China – their balance sheet is over $5 trillion.’ By comparison the Fed’s is about $4.5 trillion and the Bank of England’s is $800 billion.
All this means it’s about time investors began thinking about the long-term value of the US dollar and their assets denominated in dollars. ‘The dollar on a trade-weighted basis is expensive and I can’t see it would get much more expensive,’ says Hervey. ‘Structurally, you would think with the deficits and the limited firepower left to try to stimulate the US economy, all the chips are down, aren’t they?’
Varoufakis is clear: he says we need international co-operation and ‘a New Bretton Woods’. He is calling new technology to be harnessed to create a digital version of Keynes’s bancor. Varoufakis thinks this could usher in a global, fairer system that would create more stable capitalism. ‘Above all, the new system would reflect Keynes’s view that global stability is undermined by capitalism’s innate tendency to drive a wedge between surplus and deficit economies,’ he writes.
It may point to a solution: in 2016 the IMF included the renminbi for the first time in its handful of currencies enjoying ‘Special Drawing Rights’ – alongside the dollar, euro, yen and sterling. And back in 2009 the governor of the Central Bank of China called for a new global reserve currency, based on an international basket of currencies, ‘to achieve the objective of safeguarding global economic and financial stability’. So who knows, might it be Bretton Woods 4.0 – agreed perhaps at a meeting of the G20? The hotel is still there, and the spa looks lovely. All we’re waiting for is the crisis that pushes the dollar over the edge. That precipice might just be closer than it appears.
Alec Marsh is the Editor at Spear’s