One common question many of our clients have asked us in recent months is, “I heard the dollar is going away; is that true?” To answer this question, we must answer two questions:
- How exactly is currency, and in particular, the dollar used on the global stage?
- If the dollar “goes away,” or at the very least loses its dominance as the global currency of choice, what is the alternative that will substitute it?
The use of currency evolved out of a need to make trade more efficient. Before currency was used, trade was conducted through bartering. If you needed new tools to help in the vineyard, you would have to give something the blacksmith valued to pay for your tools: possibly grapes. A problem would arise if the blacksmith couldn’t store any more grapes; he would then have to find someone else to trade with to get rid of his oversupply of grapes (I would personally make more wine). This may lead the blacksmith to discount the value of the grapes you want to trade him due to the extra work involved…enter currency as we think of it today.
Currency, in one form or another, has been around for thousands of years. In fact, the Mesopotamian shekel is largely considered to be the first currency. It had a standard weight of about 11 grams of silver and is thought to have been used as early as the 7th century BC. Because it was simple to store, was made of a trusted material valued by society, and was a uniform weight, the shekel was easy to conduct trade with and was preferred to the antiquated bartering system.
While the actual currency used around the world has changed many times since the Mesopotamian shekel, the original concept hasn’t changed much. Over the years the dollar has become the global currency of choice as the US is the most dominant economy in the world. It’s the most trusted and desirable currency, and the dollar is very liquid and easy to trade around the world. It’s also much easier to conduct global trade in one currency vs. hundreds. For example, it’s simpler for a company in Chile to buy and sell goods in US Dollars to a company in Japan, than it is for them to conduct business using the Chilean Peso. Why? Put simply: the Japanese company has no interest in holding large quantities of the Chilean Peso, just like the blacksmith had no interest in holding excess quantities of grapes. However, the Japanese company does have an interest in holding the US dollar because everyone else in the world also does business in the US dollar.
The Chilean company that trades with Japan will sell their peso and buy dollars to use with the Japanese company, and the Japanese company will sell their yen to buy dollars to conduct business with their Chilean trade partner. This store of dollars that both companies have will also open the door to easily trade with other countries around the globe. We take for granted that we live in a country with a stable and desirable currency, but if you operate a business in a country with a very weak or unwanted currency, it makes it very difficult to conduct international trade.
One last reason why the dollar is used globally is because of the wide investment in US bonds across the world. The US has the largest bond market in the world, valued at more than $51 trillion, followed by China at $20.9 trillion. Of the $51 trillion in US bonds, government bonds make up $26 trillion. The largest holders of US bonds are Japan, China, and the UK. Because the US is a reliable borrower of debt, US bonds are seen as a safe and liquid asset, which makes them attractive to investors around the world.
Okay, so we covered how and why the dollar is used in global trade; let’s continue with the second question: If the dollar were to “go away,” or lose its global dominance, what would the alternative be? The US is a major exporter of oil (both crude and refined), fuel, machinery, electronic equipment, vehicles, aircraft, medical equipment, metals, pharmaceuticals, plastics, agriculture, and the list goes on and on. I say all that to suggest to you that whichever country’s currency replaces the US, it would have to have a very diverse export economy so that their currency could be well balanced throughout many industries.
China has the biggest export economy, you might say, and you’d be right. So, let’s review China and why it would not make a good alternative. China’s economy is heavily dependent on its exports, which means that it heavily regulates the yuan to make it cheaper to manufacture goods in China and export them across the globe. China has a history of currency manipulation and their financial system lacks transparency, which erodes trust on the global stage. The Chinese keep the yuan in a very tight range with the dollar. As their currency appreciates or depreciates relative to the dollar, the Chinese will buy or sell dollars to keep it in the range they want. For the yuan to be the leading currency in the world, they would have to let the yuan free float and let the capital markets determine its value. There is no telling what the value of the yuan would actually be, and China is not currently in a position to find out. China also has another issue that hinders the yuan's dominance: its debt is not widely held outside of China. Although the Chinese have the world's 2nd largest bond market, most of that debt is held in China by local commercial banks. China has a lot of work to do before it can dominate the global currency with its yuan. China also has an age demographic issue. They have an aging population with no real solution in sight. They have an extremely low birth-rate, and they are not immigration friendly. They will have to work hard to not end up in a Japanese-style stalled growth scenario.
Outside of China, Bitcoin is the second most asked-about currency (if you can call it that) to replace the dollar, or all fiat currency for that matter. The largest hindrance to Bitcoin even being considered a viable currency at all at this point is its volatility. Last year alone, Bitcoin lost 65% of its value. No serious globally traded currency can be so volatile. You can’t buy something one year and have it be worth 65% less the next because the value of the currency used fell by that much. Secondly, it hasn’t been widely adopted as a currency by most countries. Bitcoin is treated as an investment for tax purposes in the US, and it would have to be accepted by retailers easily. Lastly, Bitcoin is not backed by anything or anyone. The value of Bitcoin is only determined by its buyers and sellers, and at any time a new cryptocurrency could be introduced with better attributes that make Bitcoin antiquated or less desirable. I’d say there are many hurdles to Bitcoin becoming a globally dominating currency.
Most recently, the BRICS currency has come up in client questions due to its recent summit and media attention. The BRICS countries are made up of Brazil, Russia, India, China, and South Africa. Together, these countries make up 40% of the world population and more than 25% of the global economy, so they are a force to be reckoned with. Most recently, the BRICS invited Saudia Arabia, Argentina, Egypt, Ethiopia, Iran, and the UAE to join their coalition. The war in Ukraine has renewed conversation in setting up an alternative currency to the US dollar as sanctions against Russia drove rumors that non-western nations would move away from the dollar. What’s also helped turn the rumor mill is the fact that the dollar has fallen to a 20-yr low of 58% of the share of official currency reserves across the globe in 2022; however, it’s still north of 88% of all foreign exchange transactions. As of now, the BRICS have no currency other than their own individual country currencies, and it would be very difficult for them to even create their own joint BRIC currency let alone dominate over the dollar.
The most successful multi-country currency is the euro. Some reasons why it has worked so far, despite having its problems, is because Europe’s trading goes back thousands of years, they are very close in proximity to one another, and their forms of government are generally similar to one another. It’s not like Portugal is a republic and Italy is a communist dictatorship. Even then, it’s very difficult to manage the currency because the economies vary greatly. Decisions the European Central Bank makes may be great for Germany, but not so great for Greece. The forms of government, the cultures, and even the continents, of the BRICS nations are completely different. Furthermore, some of them have unresolved land disputes with one another. China and India share a disputed border where two dozen soldiers were killed in 2020. It is extremely difficult to form a currency that will rival the dollar if tensions are that high between member countries. Not to mention, India is very friendly with the US and other major economies and wants to continue to be so. Further, the BRICS would have to create a central bank similar to the European Central Bank or the Federal Reserve and set monetary policy for the nations involved. It’s one thing to talk about creating a new currency; it’s a totally different thing to actually do - and do it successfully.
No, I don’t think there is a currency out there, currently, that can challenge the US dollar. In my opinion, the biggest risk to the US dollar is the slow erosion of trust over the next 50 years or so, if US elected officials don’t get their fiscal spending together. Last year, the US had to aggressively raise rates to attack the inflation that resulted from the pandemic shutdowns and the aggressive stimulus payments that resulted, which led to the value of the dollar climbing to a 20-year high in a very short amount of time. This wreaked havoc on foreign nations that were holding US bonds and US dollars - which attributed to some of the anti-dollar narrative. The fact that the US government can’t seem to balance the budget and runs the country at a deficit every year also leads to lower confidence in the dollar. Furthermore, the US must refinance 31% of its debt over the next 12 months at much higher interest rates, which will widen the gap of the annual deficit even more. This led Fitch Ratings to lower the US debt rating to AA+ from AAA.
What may happen if the US continues on this irresponsible spending path, will be that the dollar will continue to erode its share as the reserve currency, but it won’t be replaced by one other currency, it will be spread out between various other currencies like the yen, euro, Swiss franc, yuan, and so on. It may still be the biggest piece of the pie, but the piece will be smaller because the 7 other pieces will all grow. The best thing for the dollar to keep its dominance is for the US government to work to get the budget under control and reduce its dependence on debt spending.
Ricardo Ferreira
Founding Partner, Portfolio Manager
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that the strategies promoted will be successful.