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US isolationism casts cloud over dollar's reserve dominance
THE share of central banks' FX reserves held in US dollars has fallen since Donald Trump was elected US president, in large part due to exchange rate valuation changes.
But US isolationism on the global stage could hasten that decline. As the Trump administration doubles down on its "America First" stance with its trade wars, currency wars, and deepening geopolitical rifts that could threaten actual wars, foreign central banks may be encouraged to reduce their US dollar exposure.
Some countries, like Iran, Russia and Turkey, are already looking at ways of reducing their dependence on US dollars, in part to avoid punitive US sanctions via restrictions on their use of the global reserve currency. Bluntly put, some countries fear the United States is using the dollar's reserve currency status as a stick to beat them with.
Global reserve currency status requires four things: size, stability, security, and liquidity. No other currency comes close to ticking all four boxes like the US dollar, and it has been the world's reserve currency of choice for over 50 years. It is on one side of 88 per cent of all foreign exchange trades, according to the Bank for International Settlements, and is the currency in which internationally-traded commodities like oil, metals and gold are typically denominated. Analysts estimate over 80 per cent of traded oil is priced in US dollars. But its omnipotence is not permanent.
Barry Eichengreen, professor of economics at the University of California, Berkeley, and a recognised authority on central banks and international reserves, outlines a scenario where the US dollar's long-heralded decline gathers momentum. He suggests the catalyst could be fraying diplomatic and military ties between the United States and its allies. Prof Eichengreen estimates that the loss of the US dollar's "security premium" could result in a 30 percentage point reduction in its share of reserves held by US-dependent states.
International Monetary Fund data show that global reserves rose 8 per cent to US$11.59 trillion at the end of March from US$10.71 trillion at the end of December 2016, just weeks after Mr Trump was elected. Reserves are now approaching the record US$11.98 trillion reached in 2014. But the share of global FX reserves held in US dollars fell to 62.48 per cent in Q1 this year, the lowest in over four years and down from 65.34 per cent in Q4 2016.
Currency analysts estimate that much of that was down to the US dollar's 12 per cent decline over the period. US Treasury figures last week showed that Japan, the world's second-largest holder of Treasuries, cut the amount of US government debt it is holding to US$1.03 trillion in June, the lowest level since 2011.
There's no shortage of countries with fractious political and economic ties with Washington that won't need much encouragement to reduce their dollar exposure. China, the US' largest creditor, in January launched yuan crude oil futures which could eventually become a global price benchmark alongside Brent and WTI crude.
That said, a pre-requisite would be liberalising China's capital account to allow the free movement of money. Gulf oil producers peg their currencies to the US dollar and would face exchange rate risks by invoicing sales in other currencies. So, big changes to central banks' FX reserve holdings won't happen quickly. In the world of reserve management, they never do. But there's reason to believe that the US dollar's long reign as global FX reserve king may be more vulnerable now than it has for decades. REUTERS