Mid-Year Outlook 2023
Explore our “Mid-Year Outlook”, the investment strategy update from Barclays Private Bank.
By Lukas Gehrig, Zurich Switzerland, Quantitative Strategist; Nikola Vasiljevic, PhD, Zurich, Switzerland, Head of Quantitative Strategy
In 1965, French minister of finance Valery Giscard d’Estaing called the US dollar’s reserve status as the world’s currency an “exorbitant privilege”1. While less explicit than at the end of the Bretton Woods era, the hegemony of the greenback has not lost any of its effectiveness to this day.
The dollar’s “privilege” can be seen in the US’ ability to pass the inflationary effects of domestic policies and military expenditures onto others2 and its de facto immunity to balance-of-payments crises, like the one that hit the eurozone periphery in 2012.
It is also the spice that draws investors to a market, despite dysfunction seemingly rife in America’s political system, with the latest chapter being around the debt ceiling.
While the US draws many advantages from its hegemonic position, suggestions that its sources of power may be about to end have repeatedly been dismissed.
Leaning on academic research into the monetary systems and power theory3, three key pillars of power that constitute a global currency can be identified: economic monetary capability, political monetary capability and currency influence. Currency influence summarises the functions of money (such as a medium of exchange, unit of account or store of value) at a global level.
The first pillar, economic monetary capability, is derived from a country’s heft in the world’s gross domestic product (GDP), trade and capital markets. It is the gravitational force that draws the global demand for a country’s currency.
A reserve currency’s pulling power can be explicitly institutionalised – as was the case during the Bretton Woods era, which essentially covered the three decades from the second world war, where a set of rules generated demand for a currency – but it need not be explicit.
While there are challengers to the US’s leading position in global GDP and trade, its lead in (investable) capital markets is gigantic. The second largest “producer” of central government debt, Japan, issues only 17% of central government debt, while America accounts for 41%, according to the International Monetary Fund (IMF, see chart).
High levels of debt are often interpreted as a source of risk and instability. In the case of the established global currency, however, they also represent a globally sought-after good.
US share of global GDP, central government debt and equity market capitalisation
A country’s military power and ability to impose its rules on others reflects the political dimension of monetary capability.
After World War Two, the US imposed the Bretton Woods system on the world. After the fall of Bretton Woods in the 1970s it ensured that oil, the traditional lifeblood of global production, was traded in dollars. More recently, it has sanctioned certain countries, not least Russia, for actions America disapproved of via the dollar system.
Like the first pillar, the second one can occur in a blunt or subtle fashion. Regional challengers have arisen, but for the foreseeable future, the threat of exclusion from the dollar-backed system, or disadvantageous treatment regarding market access, is very real.
Defence spending is a common gauge of military power, though it can be distorted, temporarily, by military operations. The US forces’ might can be seen in annual military spending that trumps the EU, China and the UK combined (see chart).
Annual defence spending for different countries and regions as a percentage of that spent by the US
The next pillar highlights a currency’s ability to fulfil the three roles of money globally. Within a currency area, these three roles are to act as a medium of exchange within its borders, serve as a unit of account and a store of value.
Historically, when one of these roles was not fulfilled properly, others were quick to act and install a commonly-trusted means of payment or storage, such as the greenback itself. The same functions need to apply for a global currency to be successful.
For instance, if institutional investors need to increase their holdings of highly-rated government debt, to cushion for turbulent markets, they will probably need to buy US dollars, as the American government issues over 80% of top-rated sovereign debt globally4.
While not tracking all dimensions of currency influence perfectly, currency reserves are a good indicator for the third pillar. In this respect, the greenback is peerless (see chart).
The shifts in countries’ or regions’ share of global currency reserves since 1947, shows that the US dollar’s ascendancy to be top-dog in the 1950s looks secure for now5
In the aftermath of using the dollar-backed financial system to limit Russia’s ability to trade following the latter’s invasion of Ukraine, many administrations have been investigating ways to establish an alternative to the greenback.
Recent settlements of energy commodity trades in the Chinese yuan, Indian rupee or Brazilian real have stirred much excitement in some quarters. However, looking at the three pillars, no serious challenge to the dollar is on the horizon.
The most established challenger is the euro. Its introduction around the turn of the millennium has seen the currency supersede the greenback as a European invoicing currency.
But to this day, euro capital markets remain fractured without the backing of a fiscal union and the issuance of common debt. It is unlikely that the single currency will surpass its current level of use as an international reserve currency, of around 20%, soon.
Among recent incumbents, China does rival the US in economic dimensions at least when it comes to size of market and trade, and it may even pose a military threat to the throne. Furthermore, while the country has a gargantuan debt market, it is not investable. Instead, the debt is mostly domestic and state-owned.
Investing directly in China over the long term remains a challenge for international investors, as there is no free movement of capital.
Ironically, it is precisely the size of the domestic debt market, that makes it very unlikely that China will open all doors to international investors in the near term. Regarding political power, the country has gained influence in many parts of the world and has institutionalised it as Asia’s largest economy challenges the authority of the US.
Still, without currency influence, the yuan does not pose a substantial threat to the dollar. Currently, China’s efforts to install itself as a lender of last resort are largely concentrated in the countries in its so-called China Belt and Road initiative, with the country responsible for lending equivalent to 20% of the level of IMF lending6.
While undoubtedly still king, the dollar’s grip on currency influence has weakened of late (see chart). Regional challengers are building a foothold. That said, they face major obstacles to be able to spar with the greenback for primacy. As such, a multipolar future, and the potential shifting sands of geopolitics, seem unlikely in the next decade.
Moreover, a currency transition is unlikely to happen overnight. This was seen when sterling lost its status to the US around a century ago7, while staying competitive as a public-debt issuer until 1935 and by currency-reserve usage until the 1950s.
Likewise, turning from a fiat currency, whether dollar-backed, gold-backed or even the distant prospect of using bitcoins as a global reference, is not an option: the history of failing gold-pegs suggests that both economic and financial systems need flexibility and room to inflate.
Analysis, using IMF data, of the US dollar's global usage as based on the Herfindahl-Hirschman index. The index ranges from 1/N to one, where “N” is the varying number of currencies in the sample and one is the highest concentration possible
By excluding the Russian central bank and others from the dollar system in February 2022, the US “weaponised” its currency, but also endangered the one pillar of power where it faces least competition.
The US must tread carefully to ensure it doesn’t deter investors from continuing to buy its biggest commodity. Problems of fiscal management and fears of a US default could not only deter investors, but might also threaten the dollar system, should demand for the greenback plunge.
The gravitational forces which draw investors to the dollar are reinforced during economic slowdowns due to the safe-haven status of the currency, and linked to this, the heightened demand for assets that are perceived (and rated) as being safe. This implies that, at the onset of such a slowdown, taking positions against the dollar would seem unwise, no matter the view on challenger currencies.
For the next twelve months, and beyond, the dollar is expected to weaken from its current, expensive levels. As such, diversifying currency exposure into say Asian hubs might help to reduce portfolio risk (for more information, see Targeting alpha in Asian equities).
Explore our “Mid-Year Outlook”, the investment strategy update from Barclays Private Bank.