Since the U.S. government blocked Russian banks from the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system, the world’s main financial transaction gateway, as part of sanctions imposed due to Russia’s invasion of Ukraine, some analysts have cautioned against this “weaponization” of the U.S. dollar. Those analysts believe the freezing of a large slice of Russia’s foreign exchange reserves could prompt some countries to seek alternatives to the U.S. dollar in global trade and investment, and jeopardize the greenback’s reserve currency status.
Reserve currencies by the numbers
Historically, the privilege of global reserve currency status has been reserved for those states with the world’s largest economies. In modern history there have only been two such currencies—the British pound from the early 1800s to World War II, and the U.S. dollar since then. And it’s a testament to the stickiness of reserve currency status that the pound remained the top dog for decades after the U.S. economy overtook Britain’s in the 1870s.
Subsequent events only served to cement the dollar’s hegemony, with the value of the currency tied to gold from 1944 to 1971 before floating freely in 1973. Even the creation of the euro as a global currency competitor in 1999 was unable to knock the greenback off its perch.
Foreign currency reserves are principally used by sovereign nations to smooth over volatility in their own currencies and to pay for imported necessities. The Asian financial crisis of 1997 served as a warning against inadequate foreign reserves, and most central banks increased their reserves in the aftermath to preserve financial stability.
The dollar was the prime beneficiary of this newfound prudence. The currency’s share of global reserves increased to 72 percent in 2001 from a low of 45 percent in the 1960s. Overall growth in the global economy over the past two decades had cut that share to 60 percent of the $12 trillion in total reserves by the end of 2021, according to the Federal Reserve, with approximately one-third of all U.S. government bonds now held by foreign sovereigns for this purpose. Other hard currencies make up the balance, but no single currency comes close to the U.S. dollar, with the euro accounting for 21 percent of reserves, the Japanese yen 6 percent, and the pound at 5 percent. And although China has sought to expand its global influence, only 2 percent of reserves are held in the yuan.
Change in U.S. dollar share of reserves is in line with long-term global economic trends
Share of reserves held in USD vs. U.S. share of global economy
Line chart showing the change in the share of global reserves denominated in U.S. dollars annually from 1999 to 2021, and the change in the size of the U.S. economy relative to the global economy. The dollar share of reserves declined from 71% to 60%; this is still much larger than the U.S. economy's share of the global economy, which declined from 27% to 22% over the same period. The proportion of reserves held in U.S. dollars rose significantly between 2014 and 2017, during the euro liquidity crisis.
U.S. GDP as percentage of global GDP (LHS)
Percentage of global reserves held in USD (RHS)
Note: The proportion of reserves held in U.S. dollars rose significantly between 2014 and 2017, during the euro liquidity crisis.
Source - U.S. Bureau of Economic Analysis, FactSet, RBC Wealth Management
Why reports of the dollar’s demise are exaggerated
The conditions for entry into the reserve currency club are few, but onerous. First, the currency needs to be fully convertible on international exchanges. This means the entity issuing the currency can’t impose broad capital controls that might prevent the export of the currency.
Second, it needs a deep and liquid pool of assets denominated in that currency. In the case of the U.S. dollar, the $23 trillion government bond market provides this liquidity. The euro’s creation briefly promised a similarly competitive bond market, but Germany’s reluctance to borrow combined with Italy’s taste for spending created a liquidity crisis during the last decade that limited the amount of investment-grade bonds available. And the subsequent negative interest rate dynamics in the eurozone reduced the pool of interest-bearing bonds further.
Finally, the currency needs to be insulated from interference by domestic politicians and based in a jurisdiction with a strict adherence to law. Confidence in a currency leads to its stability, which is important if it is to act as a store of value. While the euro meets two of these three criteria, the Chinese yuan is still working toward these goals.
Rating the alternatives
There is no shortage of potential competition for the reserve currency mantle, but we find most come up short. The euro is still the most credible challenger, in our view, but even with a likely increase in bond issuance to fund defense and infrastructure buildout, we believe the absence of explicit fiscal integration in the eurozone makes it a long shot.
China clearly aims for more influence on the global stage, but its currency is not fully convertible, or free of influence from its politicians, and its domestic bond market lacks sufficient depth.
Cryptocurrencies are the new kid on the block, but are arguably too untested as a long-term store of value and in many cases operate in a legal gray area.
Precious metals have long existed as a store of value, but the practicalities of storage and transport in the volumes required limit their use. Other real assets including real estate, farmland, mines, and oil fields may offer strategic benefits but are hardly portable and sometimes difficult to trade. And while emerging market debt has attracted yield-sensitive investors, its lack of stability and liquidity in a crisis counts against it.
Potential reserve assets: grading the competition
Subjective grades based on relative strength in each criterion
|Emerging market debt||D||D||D||D|
Source - RBC Wealth Management
The paucity of alternatives to the dollar comes into sharp focus in Russia’s reserve composition. While its central bank attempted to shield its reserves pre-invasion, it still kept 20 percent in U.S. dollars and 40 percent in euros, with the remaining 40 percent likely held in hard-to-convert assets, which underlines the difficulty of storing reserves in anything other than hard currencies.
Will the U.S. dollar deliver?
We expect the U.S. dollar to keep its preeminent reserve currency status for the foreseeable future. The demand for an alternative to the U.S. dollar has most recently come from institutions seemingly motivated by avoiding accountability to global standards, a constituency without global influence, in our view. In addition, the criteria needed to actually function as a liquid store of value rule out most contenders. While some decline in the share of dollar reserve assets makes sense in a multipolar world, the dollar isn’t going away anytime soon, in our view.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.
Global Portfolio Manager