There have been plenty of headlines lately about the decline in value of the U.S. dollar and the potential for the currency to lose its status as the world’s largest reserve currency. However, a look at history suggests such a dramatic shift in the global financial system isn’t likely to take place anytime soon.
Speculation that the dollar may be pushed aside on the world stage is driven by several factors, with two of the most prevalent being the decline of value of the dollar and a movement by a handful of other countries to bolster their positions in the global financial system.
What is a reserve currency?
Before getting into other factors that we believe make it unlikely the U.S. dollar will lose its global status, let’s start with an explanation of what a reserve currency is. In its basic definition, it is a currency held by central banks around the world in significant quantities and is typically used to facilitate global trade. While the U.S. dollar is often thought of as the only reserve currency, there are others, including the euro, the pound, the yen and the renminbi (or yuan).
Changes in value
All currencies fluctuate in value. In this sense, they are like any other financial asset. When you hear the term “dollar strength,” it is referring to the U.S. dollar appreciating in value relative to other currencies across the globe. Conversely, when the dollar is “weak,” it means the dollar is depreciating against other global currencies such as the European Union’s euro or the Chinese yuan (renminbi). The effects on the relative strength or weakness of any currency have many implications within the global economy and in the investment world. However, it is important to remember that the dollar weakening is not the same as the dollar losing reserve status.
From roughly 2011 through 2022 the U.S. dollar was in a bull market, meaning that for more than a decade, the U.S. dollar strengthened. However, as you can see in the chart below, it has also experienced periods of weakening. For example, the dollar’s value compared to other global currencies eroded from 1985 to 1995, when it lost almost 45 percent of its value.
U.S. DOLLAR AND STOCK MARKET PERFORMANCE
The ebb and flow of strength is influenced by various economic and geopolitical factors. For example, the end of the most recent bull market for the dollar was driven by a surge in inflation in the U.S. that followed the arrival of COVID. The point: It is not unusual or uncommon for the U.S. dollar, or any other currency for that matter, to experience prolonged periods of weakness. As such, we believe the recent setback for the dollar is likely to fade over time and will have little staying power as a cause for other economies to look for a substitute for the U.S. currency.
Losing reserve status
While several currencies play a role in the global economy, the U.S. dollar is by far the dominant reserve currency, with about half of all international trade invoiced in U.S. dollars and half of all international loans and global debt securities denominated in dollars. Additionally, almost 90 percent of all transactions in the global foreign exchange markets are dollar based. Because reserve currencies are typically used to facilitate global trade and reduce transaction costs by eliminating the need to convert multiple currencies during transactions, you can see how important the U.S. dollar is in the global economy.
As much as we believe it is unlikely that the U.S. dollar will lose its position on the global economic stage, even if it were to be displaced, the implications may not be as dire as currently anticipated. Before the U.S. dollar became the primary reserve currency, the British pound filled the role. Yet despite the pound losing its status to the dollar in 1944, the United Kingdom continues to play a significant role in the global economy.
Looking at the percentage of allocated reserve currencies around the world also highlights an equally impressive showing of strength by the U.S. dollar. As of the end of 2022, the dollar accounted for 58 percent of all allocated reserves globally. For perspective, the next closest currency—the euro—accounted for 20 percent of all reserves.
U.S. currency reserve position
Throughout the years, various currencies have been heralded as posing a threat to the U.S. dollar’s place in the global financial hierarchy. In the early 2000s, the Euro was viewed by some as primed to knock the U.S. dollar from its leading position. Now the candidates most frequently mentioned are the renminbi/yuan or a yet-to-be-created currency issued by Brazil, Russia, India, China and South Africa (BRICS). However, from a practical standpoint, these currencies face an uphill climb in surpassing the importance of the dollar, including the sheer size and dominance of the U.S economy.
The United States represents almost 25 percent of global gross domestic product. The magnitude of the U.S. economy makes it a logical choice as the largest reserve currency in the world. Second, the U.S. financial markets are widely regarded as efficient, well-regulated and transparent. The level of transparency and liquidity is unmatched by any other country. These qualities provide confidence and ease of use for global trade. Third, the stability of the U.S. government and, by extension, the dollar makes it the logical choice as a major reserve currency. During periods of market stress or uncertainty, global central banks need to know that their money is safe and readily available. Finally, the U.S. currency is a well-known commodity with a history of stability and resilience. While the dollar’s share of the global currency landscape has declined over the past two decades from 66 percent to 58 percent, its primary reserve status has not wavered. Instead, we believe the broadening of the global economy has simply translated to additional currencies being used to hedge against the impact in fluctuations of valuations caused by variability in the economic cycle.
Planning for currency fluctuations
A diversified portfolio comprising both domestic holdings and those of other developed and emerging markets can help combat feelings of uncertainty about the global currency markets. By investing in different economies across the world, an investor has the ability to see consistent equity performance regardless of dollar strength or weakness. Diversification can help to mitigate certain types of investment risk and reduce volatility over the long term, especially when compared against holding just one investment or investment type.
When it comes to diversification, investing and financial planning, you should avoid a one-size-fits-all approach. Your financial goals and situation are unique. While most financial plans use similar ingredients, the amounts—along with how and when each ingredient is used—are based on your goals, objectives and tolerance for risk. A financial advisor can get to know you and make recommendations for your situation, showing you how your investing strategy works with other parts of your financial picture to get you to your goals while also prioritizing what’s important to you today.
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.
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