What makes a reserve currency?

Here’s an interesting way of looking at the market’s current obsession with public debt and reserve currency status.

Consider, for example, that a large amount of public debt is an absolute necessity to ensure a functional monetary system and a reserve currency position. But also, that the scale of the public debt (to ensure the system works)  must be maintained at a healthy ratio to gross domestic product.

Quid pro quo, some countries’s financial systems may achieve reserve currency qualities, but most of the time it will be countries with the largest public debt (at a healthy ratio) that will have preferred reserve currency status thrust upon them.

Considering that, what determines a switchover?

One factor is obviously a decline in GDP above and beyond the ability to adjust the public debt ratio alongside it. When that happens, the monetary system can quickly become dysfunctional.

It’s a story we’ve seen before, according to HSBC’s Global FX strategy team headed by David Bloom.

Take the United Kingdom. The British pound used to be the preferred currency for global trade as well as a primary currency for debt issuance by foreign governments, according to the team’s Tuesday note. “In terms of the former, it is estimated that between 1860 and 1914 almost 60 per cent of world trade was invoiced and settled in GBP.”

As they explain:

The decline in the dominance of the GBP was triggered by WWI. The conflict took a heavy toll on the UK’s public finances (chart 2), and the strains eventually led to the UK abandoning the gold standard in 1931. Just as confidence in the GBP as store of value began to fade, so confidence in the USD began to rise. This shift to the USD was sparked, in part, by the manufacturing driven expansion of the US economy, which led to an increase in exports, a rise in the USD’s roles as a key invoicing currency, and a strong balance of payments position. This, combined with the establishment of the Federal Reserve in 1913, enabled the USD to take a more prominent international role. At the same time, the demise of other European currencies in the 1920s, in particular the German mark during the period of hyperinflation, also supported the rise of the USD. However, the USD’s advance was slowed by the Wall Street crash of 1929, and it did not emerge as the truly dominant currency until after the Second World War.

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The breakdown of Bretton Woods was a pivotal moment for the USD, putting it rather then gold at the centre of the global monetary system and in a position to be the global reserve currency. Its dominance increased further as many countries adopted it domestically, either as legal tender, via a peg, or through some form of managed exchange rate.It is to this dollarization of global currencies that we now turn.

The issue now, says HSBC, is that many economies are beginning to question the use of the dollar in managing their own monetary systems. And there are a lot of dollarised economies out there that could turn:

One major incentive for dollar pegging has always been the position of the United States as a top oil importer, they say. By pegging to the dollar, any country producing oil immediately benefited from the US’s role as a global price setter.

But things have changed. The US has been replaced in that role by Asia:

HSBC explains that this breakdown has left oil prices high (since Western demand dynamics no longer influence prices) and support for the oil-producing economies strong — despite the fact that US growth is weak and US rates low. It’s a structural shift that marks a permanent downgrade of the utility of the dollar peg.

The problem is that currently there aren’t many workable alternatives — at least on an individual basis. On a trade-weighted basis, China’s renminbi is an obvious candidate but currently there are still too many issues here:

The RMB or any new contender to the throne must have both capacity and liquidity. There must be large numbers of appropriate securities denominated in the currency for it to be a suitable candidate. Today, no asset is available that is easily tradable, low risk, and available in sufficiently large quantities to support reserve demandother than US government-backed securities. In this respect China has a long road to travel down before it can truly challenge the dollar’s supremacy.

Which means, for another currency to overtake the USD as a reserve currency a significant number of changes would have to occur, says HSBC:

*A currency would need to have much greater network externalities (ie, main intervention and invoice currency) than the USD currently has.

*There would need to be a large number of easily tradable, low-risk assets available in the currency.

*Importantly, there would have to be some material loss of confidence in the USD as a store of value, and a loss of confidence in the US economy.

The only workable alternative thus seems to be pegging to a basket of currencies:

Since the crisis, there has been a trend away from currencies that are pegged or tightly managed against the USD to basket pegs. For example, Singapore pegs the value of the SGD to a basket of currencies in which the weights are based on trade relationships. There has also been heightened interest in basket pegs since the 2010 announcement by China that it intends to shift its exchange rate policy away from a USD peg to a basket. In the coming years, we expect to see a trend away from USD pegs.

Using the rationale of pegging based on trade relationships one could argue that for some nations a hard peg to the RMB might be appropriate. However, this would still leave a country highly exposed to the fortunes of a single currency. A basket provides an alternative that helps to limit this risk.

But again, a basket pegging structure would still most likely have to include the US dollar somewhere, which means it would hardly remove the dependence on the underlying debt — which as we noted above is actually the critical problem undermining the system.

A golden solution?

At this point, no doubt, the gold bugs will be screaming — “the answer to all these problems is obviously a return to a gold-backed system!”. But again, the issue here is the scale of investable securities available (or gold bars in this case).

Current gold reserves are dwarfed by USD reserves for a reason, says HSBC, the gold market is not big enough. Furthermore, gold has very limited liquidity and low capacity they say. It is thus not able to fill the hole that would be left by a switchover from a USD reserve currency.

Which means, for the next few years at least, love it or loath it, the USD will remain unchallenged as the world’s only workable reserve currency.

But it’s important to note, things will not be hunky-dory. The GDP problem means there will be an inevitable loss of control of that reserve-currency system — and that really can only be supported by one thing and one thing only. A productivity-focused restructuring of the economy, akin to what happened after the Second World War.

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