At the turn of the century, currency traders, hedge funds and hard-hitting economists were obsessed with central bank foreign exchange reserves.
The euro was a baby, and backers faced an uphill battle to make it a currency with global impact, enmeshed in international trade and investment. Any data suggesting it was eating away at the dollar’s dominance in the coffers of global central banks was seen as a sign of progress towards that goal and causing sharp changes in the euro’s exchange rate.
It was an obsession, not unfounded, that proved to be enduring. During the Greek debt crisis that peaked in 2012, one of the reasons behind the garish (and erroneous) predictions that the euro would fall below parity against the dollar was that the bank’s reserve managers power could lose confidence in the legal and political framework behind the European currency. , and eject it from their reserves for rainy days.
Diversification of central bank reserves has become an inescapable explanation for any difficult-to-understand intraday currency movement. The euro goes up? Ask a trader and he (it was invariably “he”) would often tell you that “Boris” (meaning Russia) or another central bank was buying. Or maybe China was withdrawing dollars from its reserves.
Russia’s invasion of Ukraine is bringing this market concern, which had largely lain dormant for several years, back to the fore. The United States, in its effort to punish Russia for the Ukraine conflict, has made spectacular use of its “exorbitant privilege”, as Valéry Giscard d’Estaing, the former French president and finance minister, has put it. controversially in the 1960s.
As dollar baiters of two decades ago frequently observed, the global role of the dollar, its outsized share in world trade and its dominance of financial markets, gives the United States enormous power to use sanctions in order to bend geopolitics to their will.
Now you may wonder if this is appropriate. What if a less predictable White House were to use this privilege in far more contentious cases in the future? Should a country have the power to use money as a weapon?
Decent questions. But from a market perspective, what matters is that the sanctions of the United States and its allies against the Russian central bank will cause other countries that are not geopolitically aligned with the United States to rethink the having so many dollars on their books.
Currency analysts at Goldman Sachs said “the result could be dollar depreciation,” adding that they had seen “a lot of client interest” in the theme. This is an area where hedge funds could really bite their teeth.
Again, the US investment bank warns against over-excitement. “We must stress that the structure of currency markets will not change overnight, and there are many interrelated reasons why the dollar retains its dominant global role,” he said.
There is another reason not to bet the farm on an imminent collapse of the dollar: the United States did not freeze Russia’s reserves alone. Officials involved in crafting the sanctions against Russia knew they would work best in conjunction with the EU, UK and other G7 countries.
So, of course, Moscow, or some other dodgy regime, can avoid dollars in the future, but go where instead? Russia cannot switch to the euro, the pound sterling or the yen since the payment sanctions also extend to these. He could avoid them all, but then his funds to buy essentials or defend the ruble would all be in currencies of limited international use. Moreover, opting for the renminbi to avoid politically motivated freezes seems rather naïve.
Yet the potential for this to diminish the reserve status of the dollar is real. The implications are potentially profound and could take years to become fully clear. Gita Gopinath, Deputy Managing Director of the IMF, spoke about the potential for “fragmentation” of the global financial system.
The market’s past fixations on this issue suggest that, despite the tectonic pace of change, traders will carefully spot short-term opportunities.
An IMF study from last month, discussing “the stealthy erosion of dollar dominance,” offers clues as to where those opportunities lie. The dollar’s place in international reserves has clearly declined since the turn of the century, falling from 71% in 1999 to 59% in 2021, the IMF said, reflecting the “active diversification of portfolios” by central banks.
Curiously, the share of reserves in the other currencies of the “big four” – the pound sterling, the yen and the euro – did not take over. “On the contrary, the dollar’s move has been in two directions: one-quarter to the Chinese renminbi and three-quarters to the currencies of smaller countries that have played a more limited role as reserve currencies,” the official said. IMF.
Greater availability of easy-to-tradable assets and better trading technology have made it easier to buy Australian and Canadian dollars, the Chinese renminbi and a handful of Nordic currencies.
“Competition from reserve currencies is generally presented as a battle of giants,” the IMF said. In fact, the question is not whether the dollar will be replaced, but whether the small currencies will take a bigger slice of the pie.
The next time a loose change jumps for no apparent reason, expect that to be offered as an explanation.