Some commentators spent decades predicting that the US dollar would soon lose its special status as world’s reserve currency.
They will eventually be proved right and this day could be very near. China may hold the key, as usual.
The dollar has historically been the preferred reserve currency due to its clear advantages over other possible alternatives.
The US is a country with a solid institutional framework. It has well-established laws and many checks and balances in the constitution. It is a safe and predictable place to invest.
The sheer size of the US Economy, and the depth of their financial markets, have created a pool of liquid assets that are ideal for a global value store.
Many countries still manage their exchange rates to maintain their currencies’ stability against the US Dollar, whether through fixed pegs, or by managing the rate of change. The dollar zone is bigger than the US.
The fact that most global trade is still conducted in dollars also helps. Prices of commodities, such as oil, metals, grains and grains, are set in US dollars. The dollar is widely accepted around the globe.
Cracks are beginning to appear.
The central banks have been diversifying their assets, reducing the amount of foreign currency they keep in US assets.
IMF data suggests that this percentage fell to a low of 59pc by the end 2020, down from 71pc back in 1999.
Since then, the downward trend has halted. However, recent data have been boosted by the strength in the dollar as the US economy outperformed. The Fed has also kept interest rates at high levels.
This has in turn lowered the dollar value held by reserves held in foreign currencies. Diversification of assets out of the US has continued, but not on the surface.
Central banks are adding gold to their reserves as part of the trend. Official data shows that the People’s Bank of China has been leading the way in this area. March marked the 17th consecutive month of net purchases. Insiders in the industry suspect that there was also a lot of covert purchasing by the government.
It is not necessarily something sinister. This could be because the PBOC has a keen eye for investment, and is capitalizing on gold’s appeal as a safe-haven, a hedge to inflation, or a way to diversify risks.
Chinese authorities could have played a growing market very well.
In addition, private Chinese citizens are also enthusiastic gold buyers as a means to circumvent the country’s capital controls and a time of poor performance on domestic equity and real estate markets.
Not only China. According to the most recent official data, Turkey bought more gold than China in the first quarter of this year (30 metric tons), and India was not far behind.
There may be more to the story. China’s diversification away from US assets has clear strategic benefits, especially in light of the rising geopolitical tensions surrounding Taiwan and Beijing’s increasing assertiveness within the South China Sea.
Matthew Henderson has argued that switching to gold helped China accumulate a war chest free from US sanctions. Russia has already made this move, and other countries may follow.
China’s gold stockpiling could also be an indication that the country may use its large holdings in US government bonds to weaponize.
The threat of dumping these bonds would increase borrowing costs, not only in the US, but also throughout the Western world.
The US could be its worst enemy. Recent strength in the markets and economy is partly due to a massive fiscal stimuli that began under President Trump and was continued by President Biden.
It is true that only the country with the dominant reserve currency in the world could do this, but international investors’ patience cannot be taken as a given.
The traditional trust in US institutions, policymaking and the like is also at risk. Both leading candidates for the November presidential elections are a source of serious doubt. Take your pick: at least one candidate is a laughing stock around the world.
Either is likely to move further into a trade war that is protectionist, increasing tensions with China.
This could take many forms. It’s possible that dominance of US dollar will continue to erode, but this could take the form of a gradual shift towards other Western currencies such as the euro and Australian or Canadian dollars.
Bond yields are finally rising to levels that could attract international buyers. The Japanese yen looks cheap. Sterling still makes up a greater share of the global reserves than China’s currency, the renminbi. China’s pool of investable assets is still small.
It is unlikely that the US’s allies would respond to China in a similar way to how they responded to Russia after the invasion of Ukraine.
The gold market simply cannot absorb the amount of capital China has stashed abroad.
In the worst-case scenario, a sudden drop in the dollar’s value could have negative spillover effects in other parts of the West. This includes higher interest rates for the UK and Europe.
Investors should therefore be aware of geopolitical risk and pay attention to the signals coming from Beijing.