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Paradox of the twin-deficit US dollar

WOULD you buy a currency that has clocked up a current-account deficit for almost 36 consecutive years, now topping US$11 trillion? A currency that is also weighed down by a fiscal deficit expected to hit US$1 trillion by 2020? A country that was the source of the 2008 global financial crisis, and yet, its debt was deemed a safe-haven asset? Any emerging-market currency with similar finances would have been decimated by currency markets in no time. Yet, we all hold and trade this twin-deficit currency. It is the US dollar. It is indeed a paradox that the world sells goods and services to the US in exchange for fiat currency or pieces of IOUs.

As the above chart reveals, despite its weak finances, the US dollar is still the dominant reserve currency for central banks around the world. Central banks hold 62 per cent of their currencies in the US dollar. That said, this is an almost 10 percentage-point decline since the introduction of the euro in 1999. The central banks have been diversifying their exposure, particularly to the renminbi, which has been part of international reserves since Q4 2016. At the moment, though, it is only a paltry 2 per cent of the reserves.

The US dollar enjoys an exorbitant privilege - a term coined by French Minister Giscard d'Estaing - of sucking global savings and depending on strangers every year to fund itself. This exorbitant privilege accrues from its status as a reserve and settlement currency. There are just no alternatives. Contenders such as the renminbi and euro have their own flaws. The renminbi is under capital controls while the euro has that EU break-up overhang.

The issue is, how long can the US dollar hold on to its eminent status? Or what can derail confidence in it? The US dollar could become a reserve currency that nobody wants to accumulate. Recall the sterling, which lost its status as a reserve currency over 25 years, from the early 1950s to the mid-1970s. If we use this playbook, triggers for the US dollar's dethronement could include, firstly, foreign central banks diversifying their foreign reserves based on trade flows. This may become more pronounced as the US turns more inward-looking and ends up less of a trading partner to more nations. Secondly, the US dollar undergoes a devaluation somewhat akin to the sterling in 1967. Because it is not pegged, this scenario could only arise if the US "talks down" the US dollar. This happened recently, when some US officials commented that a weak US dollar is good for the country. Thirdly, there is an influx of loans denominated in an alternative currency. The likely currency is the renminbi, arising from sovereign loans issued by China especially to emerging countries. This would then require central banks to accumulate the renminbi for repayment. But in all likelihood, we think what will replace the US dollar is neither the euro nor renminbi, but a combination of both.

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As for its global-settlement function, one way that the US dollar could be unseated is the creation of another SWIFT global cross-border payment system. Germany has openly expressed the need to create such a system, free of the US. With control over SWIFT, the US has the ability to penalise or lock-up nations from the global financial system. The US Justice Department was able to fine BNP Paribas US$8.9 billion for sanctions violations conducted a decade ago because it was conducted through SWIFT. With SWIFT, the US can have better control over any party that violates future Iranian sanctions. China is also taking measures to de-dollarise. It has bilateral currency swaps with multiple nations to support trade payments in renminbi. The inclusion of China into international equity and bond indices will support further use of renminbi. A recent milestone for China was its successful launch of oil futures denominated in the renminbi. As the largest oil importer in the world, this is a prelude to paying all its oil imports in its own currency. After oil, who knows what other commodities have been lined up?

  • The writer is head of research, Phillip Securities Research.

Disclaimer: Chartpoint is provided by Phillip Securities Research for information only, and should not be construed as investment advice.