Fiscal Policy | FX | Politics & Geopolitics | US
There is a strong relationship between countries’ dollar share of foreign reserves and their dependency on the US for their security, according to the ‘Mars hypothesis’. For instance, Japan, Korea, Taiwan, Saudi Arabia and Germany, which rely on the US for their security, have a much greater dollar share in their foreign exchange reserves than China, Russia, France and the UK, which are either strategic rivals of the US or possess nuclear deterrents. In addition, a study of 19 countries pre-WWI shows a clear influence of military alliances on their foreign reserves currency composition.
In recent years, the dollar share of global foreign reserves has generally followed the Mars model’s predictions. It declined under the Trump administration’s policy of global disengagement and unilateralism (Chart 1). But the decline partly reflects the gradual inclusion of Chinese FX reserves in the IMF statistics on the Currency Composition of Official Foreign Exchange Reserves (COFER). The inclusion, which started in 2015, saw the share of global reserves included in the IMF statistics rise and the share of the dollar fall, even if the latter is adjusted for exchange rate changes. This likely reflects that China holds a lower dollar reserves share than its global peers. By 2018, the inclusion of Chinese reserves in the IMF statistics was completed, and the share of global reserves reported to the IMF stabilized. Yet, even adjusted for exchange rate changes, the share of the dollar continued to slide.
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Summary
- The dollar share of global foreign reserves declined under the Trump administration’s unilateralism.
- President Biden’s multilateralism alone may be unable to prevent further erosion of the dollar’s global status.
- Meanwhile, contenders for global currency status like the renminbi and euro are strengthening.
Market Implications
- Medium term: bearish USD.
Dollar strength since the start of the year has prompted some reversal in calls for further dollar weakness. But one factor in any bearish dollar view is an expectation for further erosion in the dollar’s status as the global reserve currency. This trend is unlikely to change even under President Biden’s expected multilateralism.
Dollar Share of Global Foreign Reserves Declines
There is a strong relationship between countries’ dollar share of foreign reserves and their dependency on the US for their security, according to the ‘Mars hypothesis’. For instance, Japan, Korea, Taiwan, Saudi Arabia and Germany, which rely on the US for their security, have a much greater dollar share in their foreign exchange reserves than China, Russia, France and the UK, which are either strategic rivals of the US or possess nuclear deterrents. In addition, a study of 19 countries pre-WWI shows a clear influence of military alliances on their foreign reserves currency composition.
In recent years, the dollar share of global foreign reserves has generally followed the Mars model’s predictions. It declined under the Trump administration’s policy of global disengagement and unilateralism (Chart 1). But the decline partly reflects the gradual inclusion of Chinese FX reserves in the IMF statistics on the Currency Composition of Official Foreign Exchange Reserves (COFER). The inclusion, which started in 2015, saw the share of global reserves included in the IMF statistics rise and the share of the dollar fall, even if the latter is adjusted for exchange rate changes. This likely reflects that China holds a lower dollar reserves share than its global peers. By 2018, the inclusion of Chinese reserves in the IMF statistics was completed, and the share of global reserves reported to the IMF stabilized. Yet, even adjusted for exchange rate changes, the share of the dollar continued to slide.
Biden Seeks to Reengage with the World, But Faces Obstacles
In his inauguration speech, President Biden announced a break with his predecessor’s unilateralism. He pledged to ‘repair our alliances and engage with the world once again’ and to ‘be a strong and trusted partner for peace, progress, and security.’ But the incoming administration’s return to multilateralism may be insufficient to promote a stronger global role for the dollar. First, for all its claims of global disengagement, the Trump administration implemented only limited withdrawals of troops from abroad. It also increased military spending by 5% a year on average, against a decline of 50 bp a year under Barack Obama.
Second, while Biden’s foreign policy team and the broader US foreign policy establishment strongly favouring multilateralism and interventionism domestic, opposition to US military interventions abroad is strengthening. Consider the newly created Quincy Institute for Responsible Statecraft, which unites senior diplomats and academics opposed to US military force abroad. Both the Charles Koch Foundation and George Soros’ Open Society Foundation support it. The growing opposition could reflect that the war in Afghanistan will be 20 years old this year with no victory in sight. And while the war in Iraq is ‘only’ 17 years old, it too has resulted in little success. Donald Trump could yet turn out to be a harbinger of a long-term trend.
Third, the recent march on Congress has damaged America’s global reputation. No matter how hard the Biden administration tries to repair his country’s relationship with its allies, it will be unable to erase the collective global memory of Americans trying to take over their legislature because they were unhappy with the election results. These images have weakened the credibility of American exceptionalism (the idea that America is inherently different from other countries), which has inspired much of American foreign policy and interventionism since World War II.
Credible Global Currency Contenders Are Emerging
America’s political weaknesses have been exposed right when contenders for global currency status are strengthening. China has been the first economy to recover from the pandemic, and it is about to leap-frog developed economies with a cross-border digital currency that could greatly increase the global use of the renminbi. Also, the euro is becoming a more credible alternative to the dollar after the pandemic prompted euro area countries finally to relinquish permanent austerity and move towards a common fiscal policy.
At the same time, the Fed and the Treasury have engaged in extraordinarily loose policies. In 2020, the US budget deficit was 15% of GDP. This year, the incoming administration wants to implement a stimulus package representing 9% of GDP that would bring the overall deficit above 20% of GDP. The Fed balance sheet expanded by more during March-May 2020 than during 2009-15. And balance sheet expansion is continuing with monthly Fed purchases of $120bn in government securities.
America’s return to a more rational foreign policy is a welcome development for the world. But that may not be enough, on its own, to prevent the erosion of the global role of the dollar.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)