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How do we mitigate risks such as the USD declining in importance as the reserve currency?
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Samuel Rhee
01 Sep 2020
Chief Investment Officer at Endowus
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That's a valid concern which has been around for decades.
Why hold foreign currency reserves?
These reserves are used to back liabilities and influence monetary policy.
Condition for reserves
Reserves must be invested in safe, liquid securities or other assets that can be readily sold and have low storage costs, such as precious metals.
So what are the alternatives?
The IMF created the SDR as an international reserve asset in 1969. However, SDR is not a currency but a basket of currencies which includes the USD as its largest constituent.
What about emerging economies currency?
Countries like China, Mexico, Taiwan, Brazil could potentially be a replacement in theory as the largest EMs. However, it does not meet the requirements we set at the beginning. For instance, China may lack transparency, Taiwan and Brazil political instability, etc. It will require many years to overcome these obstacles.
Gold?
The gold standard was removed in 1971 due to the scarcity of gold to back the dollar. This will pose an issue to be an effective monetary policy tool.
USD holding on
There are several advantages of USD over other currencies:
Nearly all commodities are priced and settled in dollars
US has the largest, most liquid and most transparent financial markets in the world
Many countries rely on US for military protection
In addition, the lack of alternatives and inertia will result in USD as the major reserve currency.
Currently, the USD (62%, IMF) is still the world's major reserve currency, followed by EUR (20%, IMF).
The way forward
The EU has made plans for the issuance of €750 billion in bonds to fund its COVID recovery program. This will provide ECB, as well as investors, with a new liquid euro-denominated benchmark instrument. I believe a change in major reserve currency will take time, perhaps decades if happening.
If the newly incumbent President of the US still maintains economic sanctions rhetoric and protectionist trade initiatives, the change will occur sooner than expected.
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Hi V, thanks for the question and apologies for the late response. Just took time getting through so many questions. Somehow I missed your question the first time around. Obviously, even being fully aware of the realities of unlimited QE and huge government debt, and the consequences of such a structure, I personally think the long called for demise of the USD as the reserve currency of the world remains quite distant for various reasons. The Yen, Euro, Swiss France, GBP in the past and now the Chinese Rmb have been touted as an alternative but none of them breeds a lot of confidence and if you look at the current geopolitical reality, and the continued importance of the USD in the financial, trade, economic activities, that demise is unlikely to happen any time soon. The movements in Gold and even cryptocurrencies is interesting and the concerns very long term are real, but I still do not see this happening anytime soon. Especially when the global market cap of the equities market in particular is dominated by the US with the biggest and most competitive companies in the US. Currency is always a relative game but specific to your question about the risks to the equities markets, I think the concerns are overplayed. I still remember saying the US has outperformed too much and it will underperform, but it has powered ahead since then. We can never predict what markets will do in the future and even less predict which country will be the best performing market next year. That is why a globally diversified portfolio makes so much sense as we are exposing ourselves to broad market moves and our biggest bets are in the biggest, most competitive and most profitable companies in the world. At Endowus, we are not trying to predict the economy and where markets will head in the future. We believe in the power of markets to continue to deliver growth over the long term as they represent the brightest and best companies in the world.