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Reserve Currency Regimes – US Dollar Will Prevail

GMO White Paper – The US Dollar: Still the Cleanest Dirty Shirt?, April 2017

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency. Now that the cost is becoming clear, Chinese policymakers may be realizing they are not willing to do what it takes to maintain a global currency”

“US Treasury securities still remain the instrument of choice in moments of flight to quality and liquidity crunches. The Treasury’s regular and predictable issuance schedule, the plethora of uses of Treasury securities, and the extraordinarily wide acceptance of the securities as collateral allow them to dominate every single other currency’s benchmark security”

Introduction

  • Current metrics of sovereign debt substantially appear to be rather meaningless for a developed country sovereign that issues in its own currency
  • What can change the dominance of the dollar? – “By doing something self-destructive, such as defaulting on our debt”
    • Diminish trade conducted in dollars
    • Deliberately limit or inhibit the usage of the Treasuries market, particularly on the collateral side, by encouraging scarcity of Treasury bills
    • Allow a critical global resource, such as oil, to be priced and traded in another currency
    • Abandon the “strong dollar” language of the executive branch for a prolonged period of time (thus, adding volatility into dollar exchange rates)

Renminbi

  • On 11/30/15, IMF staff endorsed the renminbi as a part of a basket that makes up the Supplementary Drawing Rights (SDR)
    • SDR is defined as a potential claim on the freely usable currencies of IMF members
  • Achieving SDR status has traditionally meant that a currency is in an exclusive club of international currencies, which are currencies held by other countries
    • Member countries of the IMF are allotted an amount of SDRs that theoretically serve as financial assets for those countries
    • Countries with SDRs may use them to obtain the underlying currencies
  • Addition of the RMB to the SDR basket is significant, albeit symbolic, step in the internationalization of the RMB
  • Criteria for the inclusion in the SDR, as defined by IMF, “are the currencies that are issued by members or monetary unions whose exports had the largest value over a five-year period, and have been determined by the IMF to be ‘freely usable’
  • Inclusion within the SDR does not necessarily mean a currency has become internationalized – internationalization does not necessarily mean achieving the status of a reserve currency

sdr composition

But is an SDR a reserve currency?

  • NO – the IMF cannot simply create more SDRs – it cannot take in assets and deliver SDRs through open market operations
  • Without being able to add to the flexibility of the currency or having a central bank that will deliver the basket upon receipt of assets, the SDR is not, and unfortunately for the IMF, cannot be, an alternative currency
  • Even if the IMF were to convince one central bank to accept SDR-denominated assets as collateral, the simple fact is that that particular central bank could only supply an infinite quantity of its own currency, not the other currencies within the SDR

So, why not the euro?

  • The Eurozone is not one country, but rather a group of sovereignties operating with a common currency
    • In effect, each of the sovereign countries is issuing debt in a foreign currency, with a central bank that needs to consider the interests of all members, not any one member
  • In practice, the debt of each sovereign entity is not particularly fungible with another
  • In reality, the fragmentation of the European sovereign market is more reminiscent of the US municipal market for state General Obligation bonds
  • Without a deep, liquid, and fungible market for government securities, the euro has little chance of becoming a genuine reserve currency
    • For the Euro to be considered a genuine reserve currency, it will need to engage in a more aggressive fiscal union

So, why not the yen?

  • Yen exhibits some safe haven characteristics but it lacks several others (i.e. yen is still a relatively small portion of global reserve balances)
  • It is unclear whether the Japanese government actually wants a stronger yen given its export-oriented economy
    • A stronger yen generally leads to more heartburn for Japanese economic policymakers

A quick word on bitcoin

  • Two of the most important features as to whether a currency can be universally used within a monetary system is whether that currency is acceptable for tax payments and whether that currency is acceptable for a central bank to “furnish an elastic currency, and to afford means of discounting commercial paper”
  • In short, can this alternative currency be used to pay my taxes or in transactions with the central bank? If not, then bitcoin is merely a form of alternative commercial paper

Gold

  • Two problems with gold:
    • While physical bullion is not hard to trade, it carries the added headache of storage and custody. Believing in gold as the last resort due to a systemic failure, yet being unable to physically access it due to how it is custodied might be a problem. When household consumption collapsed in the wake of 2008, government had to step in to provide spending to keep the economy afloat and the unemployed fed. A gold standard would merely lash constraints on government finance, cut off this lifeline, and send the world economy into a tailspin
    • Gold prices are actually shockingly volatile for an alleged “safe” asset
  • This does not mean gold has no place in an asset portfolio, but that is simply that: an asset, with all of the associated volatility of an asset (indeed, some research suggests that having gold in your portfolio can have some positive benefits)

How does the RMB compare, and what next?

  • Chinese government’s efforts to increase RMB utilization, despite being in the early stages of a country’s financial market development:
    • Development of the “dim sum” bond market – important step toward a more accessible fixed income market (early participants were highly-rated US corporations such as McDonald’s and Caterpillar)
    • Establishment of the bilateral swap lines between the PBOC and other central banks encourages the use and invoicing of goods and services in RMB
    • Passage of the Enterprise Bankruptcy Law has shown a willingness on the part of the Chinese authority to allow more predictable outcomes in bankruptcy
    • Managing the exchange rate toward a more balanced basket of currencies that reflects China’s actual trading relationships, rather than just the dollar
    • Development of alternative settlement infrastructure, China International Payments Systems versus SWIFT
    • Acceptance as collateral by clearinghouses such as CME
    • Development of a local currency bond market that will be accessible to foreign investors
    • More open capital account that is accompanied by a freely floating or managed float exchange rate
  • One of the many goals of the above steps is to increase the use of RMB in trade – reserve currency can only exist if it achieves a certain scale in financial markets
  • Another goal is to develop more robust internal financial plumbing
  • However, several of the above steps require much deeper institutional reform

What does this mean for investors?

  • Regardless of short-term fluctuations in Chinese equity markets and currency, the government of China has placed itself on the long-term road to attaining an international currency
  • In the long run, if China seeks to move away from being a primarily export-driven economy, it will need to issue more securities that are suitable for both domestic and foreign investors, and move from the status of a purely export-driven country to one with a substantial capital account investment
  • China will have to one day fully embrace an open capital account – if China does not embrace an open capital account, it will need to decide how to get RMB in sufficient quantities to the outside world
  • In order to have securities available for foreigners to purchase, there will have to be continued work on enhancing confidence in the development of private credit markets
    • Chinese government will need to continue to enhance bankruptcy law

Conclusion

  • Highly likely that the dollar will remain the reserve currency of choice for a long time to come
  • Policymakers should not become complacent – critical missteps, such as reducing trade with other countries, abandoning a strong dollar policy, and adding uncertainty to the safety and soundness of Treasuries all would serve as accelerants for a move away from the dollar as a reserve currency, and provide potential benefits to other currency regimes
  • Largest danger of having a reserve currency is a sudden substitution away from it (as England experienced in the post war era)
    • Using the current privileged status of the US to prepare for the future would be useful policy work
    • In the meantime, investors can prepare themselves to deal, over time, with more Chinese securities and asset classes
Image Source: Wall Street Daily
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