Dollar as World’s Reserve Currency

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The U.S. dollar has been in the news recently in the context of its status on the world stage and what may happen in the future. We’re keenly aware of these developments and we’re not dismissive of these concerns. But to quote Mark Twain, and using the dollar as an analogy, “Rumors of my death have been greatly exaggerated.”

You may have heard the U.S. dollar referred to as the “world’s reserve currency,” when used in the context of global trade. As international trade has flourished over hundreds of years, the need for a single currency that all trade parties accept has become commonplace, and the need is obvious. The U.S. dollar currently fills that niche and is in fact the “world’s reserve currency.”

Long before the dollar, the British pound was the world’s reserve currency, from 1815 through 1944. Following World Wars I and II, and the related financial burden, the U.K. was nearly bankrupt. The Allies realized that sustainable post-war economic growth, rebuilding, and peace, required a more stable currency.

In 1944, at a conference in Bretton Woods, New Hampshire, the dollar was crowned as the world’s reserve currency, displacing the British pound. Since that time, the vast majority of international trade has been denominated in U.S. dollars. Saudi Arabia prices its oil sales in U.S. dollars, leading to the term “Petro-dollar.”

As a result of the war in Ukraine, the United States passed a bill to freeze, and ultimately seize, certain Russian assets. As other nations looked on, there’s been increasing concern among them that the U.S. has effectively “weaponized” the dollar. This has led to an increasing desire among some foreign countries to move away from U.S. dollar denominated transactions.

As this trend has seemingly gathered some tailwind, some are speculating that the dollar will lose its status as the world’s reserve currency, ultimately leading to out-of-control inflation. The rising power of the “BRICS” countries (Brazil, Russia, India, China, and South Africa) has been a major factor contributing to this concern.

While these are legitimate long-term concerns, we think it’s unlikely to happen any time real soon. The problem is, there has to be a replacement. While there are many flaws with the U.S. economy and its dollar, the other options aren’t very appealing.

There’s some talk about the Chinese Yuan as a possible replacement. We question whether the world is likely to trust China over the United States. At the end of 2022, 58.4% of foreign exchange reserves were denominated in U.S. dollars, compared to 2.7% for China. The second largest currency reserves are denominated in Euro, at 20.5%. Over the last 10 years, dollar denominated reserves have only fallen from 61.5% to 58.4%. We think a coordinated response to the strong dollar will likely be slow in developing and not an overnight occurrence.

It’s fair to observe that the British pound lost its reserve currency status in 1944, and both the U.K. and British pound are still around! The United States is still the largest economy on the planet, followed by China, and then Japan with the third largest economy (and Japan is only one-fifth the size of the U.S. economy).

There’s an increasing chorus of doomsayers directing people to buy gold. At the moment, gold is at or near an all-time record high. And gold coins are trading at an all-time high premium to the underlying price of gold. To buy gold coins, you have to pay approximately 8% to 10% more than the actual price of gold.

While gold prices could continue to rise, we question the wisdom of pouring all your money into gold at these record prices. Historically, foreign stocks have been a good hedge against a weaker dollar. Within our equity portfolios, approximately 35% of the holdings are invested in foreign stocks, denominated in currencies other than the U.S. dollar.

Until relatively recently, foreign stocks had underperformed their U.S. counterparts (as the dollar had strengthened), although that trend has reversed in the last year or so. The purpose of owning foreign stocks is to manage risk and diversify. During unstable times, diversification is your friend!

Above all, we want you to know that we’re aware of these trends and we’re following it closely. It’s certainly possible that the U.S. dollar could lose its reserve currency status at some point, but in our judgment, it’s not likely to happen real soon. After observing Russia’s invasion of Ukraine, it’s difficult to envision the world’s developed countries trusting Russia, or China (their primary supporter), in favor of the United States.

No one can precisely predict the impact on the U.S. economy should this eventually happen, but we agree it wouldn’t be good. The question is, what do you do about it? Let’s be clear that we too are concerned about this, but also wary of over-reacting. Being over-prepared can be just as risky as being under-prepared. Like all things in life, we believe balance is the key, which is why we advocate a high level of diversification!

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