Assumptions that underpin the US dollar’s status as the world’s primary reserve currency are eroding more quickly than expected. What happens if the tower starts to collapse?
Jenga players know a tower can withstand the removal of many bricks, but in every game, it is a different quantity, and a different brick that precipitates collapse.
As global central banks grapple with a slow-motion decline in the role of the dollar, they might ask: How many Jenga blocks have been removed and could the tower collapse?
Which currencies are set to benefit?
What has occurred in the US since Donald Trump’s inauguration has added spice to the debate and increased the ‘push’ factor for FX reserves to flow away from the dollar. The forecast for 10/10/10 no longer looks particularly bold. However, a key issue with all forecasts of dollar decline is to figure out which currencies (and bond markets) will benefit from resultant inflows.
This represents a change from the long-established pattern in which de-dollarisation had primarily resulted in a redistribution of reserves in favour of smaller, non-traditional reserve currencies.
Speculating on the euro
The euro accounts for around 20% of allocated FX reserves, having been at 24% in the early 2000s. Since the German election in February, however, there has been speculation that the abandonment of the German fiscal debt brake and commitment to defence and infrastructure spending could see the euro finally make gains at the expense of the dollar.
But there are hurdles. The total euro-denominated government bond market – including European Union-issued bonds – is half the size of the US Treasury market.Additionally, the dollar-denominated investment grade credit market is around three times larger than its euro-denominated counterpart. As the credit quality of government issuers continues to slide, investment grade has become increasingly attractive to global FX reserve managers, compounding the US market’s relative advantage.
A key factor that has limited the euro’s potential as a reserve currency has been a lack of supply in high-quality, liquid euro assets. Sovereign bonds in Europe are currently issued individually by 20 member states in a patchwork style and across a range of credit ratings. Joint EU issuance would solve the problem of such a fragmented market and, given the likelihood of a triple-A rating, would provide an attractive safe asset. However, northern European countries have opposed joint debt, pointing to the risks of debt mutualisation, moral hazard and the no-bailout clause. Moreover, current infrequent issuance has had an adverse impact on demand from institutional investors – we are still awaiting the adoption of EU bonds in government benchmark indices. On the plus side, it is hoped that the imminent launch of a Eurex futures contract for EU issuance will facilitate hedging, improve appetite and encourage predictable bond issuance.
Until this happens, the German Bund market remains the first-choice euro-denominated investment for FX reserves managers. However, it is not risk-free. In a conversation with a head of FX reserves from an eastern European central bank, doubts about the suitability of German Bunds were raised. The concern was that, in simple geographic terms, Germany might be too close to Russia. This made clear that being a near-neighbour of Russia has an impact on every aspect of national economic and political policy.
What does the collapse of dollar dominance look like?
So, what would a collapse of the Jenga tower look like? Using the metric of FX reserves, it could be a rapid acceleration in the decline of the dollar: instead of 10% over the next 10 years, it might be 20% in five years. This would be a world where a Chinese sphere of influence is firmly established. China will be important both economically and militarily and the renminbi weight might rise towards 10%. The traditional argument against the renminbi is that the capital account is still restricted, but this would count for less in a world where trade and defence arrangements set parameters for the deployment of FX reserves.
Strangely, in a fractured world with declining dollar dominance, those nations who remain part of the US sphere of influence might be drawn closer. For these close neighbours and allies there might be a need to increase their dollar exposure to prove their friendship and alliance credentials.
For most nations, however, there will be a desire to continue the trend of the past two decades – namely, to diversify FX reserves into a longer list that includes smaller, non-traditional currencies. New instruments such as stable coins and central bank digital currencies will add layers of complexity. However, they will not shift the key conclusion that the world has a latent desire for more currencies in FX reserves, but that trade and national security considerations will influence choices. The investment of FX reserves is no longer only about investment ‘safety liquidity and return’.
The bottom line
The dominance of the US dollar as the global primary reserve currency is waning. Where the balance of power will shift is unknown and predicated not only on issues of financial security but, increasingly, geopolitics. Long-term investors will have to manoeuvre around the falling Jenga bricks, staying nimble as bond yields, credit spreads and currencies bounce around. In such an environment, the expertise of seasoned active asset managers – particularly those with a track record of navigating rapid shifts in capital market valuations – is vital for preserving value and identifying strategic opportunities.
