Gold's gain has been the US dollar's pain as currency debasement fears amidst the battle against the pandemic have fueled concerns over the US dollar's demise as the world's reserve currency. While the US dollar may have passed its peak, it will not lose its grip over global foreign exchange markets any time soon. Only a defeat in the US-China trade (read: tech) war precipitating a loss of military supremacy combined with the emergence of a credible currency alternative could push the greenback over the edge and accelerate the downward spiral.
Those who already see the vultures circling over the US dollar as the dominant force in global foreign exchange markets are mistaken. The greenback's recent weakness is rather a consequence of declining economic conditions supporting the currency.
The US resorted to fast and aggressive monetary policy stimulus to stabilize its virus-stricken economy by flooding the markets with liquidity via lowering rates and extending its asset-purchasing programs. This raised red flags with investors who fear an increase in inflation eroding the currency value in the future. As the U.S. Federal Reserve (Fed) had more room to ease policy rates than the European Central Bank, US dollar spreads against European currencies almost vanished, so one of the major arguments for buying the US dollar disappeared. Positioning data shows that global investors increasingly use the US Dollar as a funding currency for carry trades which points to interest rate differentials putting the US dollar market at a disadvantage in relation to other currencies. Moreover, investors have started to pile into gold, the currency of last resort, when real interest rates plunge and currency debasement fears loom. While the liquidity flood could indeed feed inflation, the surge in prices should be much more pronounced in the asset than in the consumer market, which is why US dollar debasement fears linked to inflation are likely unjustified.
One of the main factors that could break the greenback would be a US defeat in the US-China trade war which is rather a battle for technological and military supremacy. Losing military dominance never bodes well for the longevity of a currency. For example, the British Pound lost its global reserve currency status in the 1920s in the aftermath of the break-up of the British Empire. After losing its overseas territories and foreign assets, the Empire's geopolitical dominance diminished, which pushed the pound sterling to the brink of irrelevancy for global trade contracts.
While the US's withdrawal from key international organizations and treaties like the World Health Organization or the Paris Agreement has raised concerns over the US leaving a geopolitical vacuum that China is happy to fill, it is unlikely to threaten the USD's dominance on its own.
Much to the US's chagrin, China is well equipped to win the tech war. Even if it is still behind the US in several important technology sectors, China possesses an army of scientists, a supportive government with vast financing resources, a competitive tech business sector and, most importantly, the ability to get access to and make use of big data. Data protection is the reason why the US Committee on Foreign Investment in the United States (CFIUS) ruled that TikTok is a risk for domestic security, forcing a fire sale of TikTok's US business. The US thinks – and probably rightly so – that the Chinese government could get easy access to the personal data of US citizens via TikTok.
In a similar vein, the US threat to ban Tencent and WeChat is a setback for China's strife for technological supremacy, even though these actions are detrimental to the investment climate in the US. Furthermore, while China might already be head-to-head or even ahead of the US in quantum computing and artificial intelligence, the US still has an edge in key intermediate goods, like semiconductors. China has failed so far, despite huge investments, to reach the same product quality. As the example of Huawei shows, the US tries to disconnect China from US technology and slow its progress by forcing it to switch to lower quality producers.
The dispute about the 5G rollout is just another stage of the tech war. For now, it seems like the US could succeed in rallying its European allies behind them in their efforts to prevent the rollout of the technology in Europe. The UK made a U-turn and decided to stop a Huawei-led 5G rollout. Meanwhile, the EU’s decision is still pending. Should EU policymakers decide in favor of the US in the fall, this would be another setback for China in the battle between the two superpowers.
Aside from the tech war, the lack of credible currency alternatives makes the demise of the US dollar a low probability event over the next ten years. For now, there seem to be only two eligible candidates that could garner enough strength over the coming decades to represent a viable alternative to the US dollar as a world currency: the yuan and the euro. However, today, neither the Eurozone nor China are serious competitors for the US in terms of the key economic figures that are necessary for assuming the role of a global reserve currency. The depth of US financial markets is unrivalled, central banks still prefer to hold a majority of their reserves in US dollar, the key commodities in the world are traded in US dollar and most global trade contracts are quoted in US dollar and euro. In fact, currently about 50% of global trade contracts are quoted in US dollar even though the US only accounts for approximately 12% of global trade which showcases US dollar dominance.1 Moreover, the biggest companies (unicorns) are still coming from the US. In fact, for decades, economists have called every now and again for the US dollar's demise in their 10-year forecasts, but the currency has proven the saying that “the condemned live longer”.
The US dollar might not be dethroned in the foreseeable future but it is likely to decline in importance over time and could find a serious rival in the yuan. Measured in terms of economic importance, the Chinese currency is currently underrepresented. Thanks to China's belt and road initiative, its influence in the Eurasian region and Africa is rising as it ties many countries to its economic system, which paves the way for the yuan to find its way more and more into global trade contracts. This has further been facilitated by China and Russia partnering up to reduce their dependence on the US dollar, which has resulted in the US dollar's share in trade settlements falling from 90% to 46% over the last five years. Latest data show that in the first quarter of 2020, the US dollar's share of trade between China and Russia fell below the 50%-mark for the first time. Moreover, the Chinese sales market has become increasingly important for global operating companies. 30% of US tech company sales, for example, are going to China and Asia in general. Finally, China is opening up for foreign investors, although at a slower rate than the US administration would like.
All of these factors should increase demand for the yuan. It seems that only if other key Asian countries (Japan, Australia, Korea, Philippines, Malaysia) were to successfully contain China's assertive foreign policy, could the yuan fall behind. Even though China's territorial desires have recently increased tensions within the region, other Asian economies have only limited sway over China because these countries tend to be more dependent on China than the other way around. Therefore, an escalation in which China is forced to abandon its geopolitical expansion designs seems unlikely.
The possibility of the euro taking away market share from the US dollar is more difficult to predict as this is tied to the slow process of deeper European integration. As long as the Eurozone lacks a fully integrated Eurobond market, the euro is likely to fall short of the requirements of becoming the world's reserve currency. If, however, the EU is able to continue the positive steps that it has taken during the pandemic, such as launching a rescue package and an EU budget to stabilize the Eurozone economies, the euro's attractiveness could increase.