If you follow the financial media closely (not recommended!), you’ve probably heard at least one pundit declare that the United States is about to lose its “reserve currency” status at any moment. And once it’s gone, the warning continues, a long parade of horribles will soon follow. Taken to an extreme, the endgame is the full “de-dollarization” of the global economy and a collapse in the value of the U.S. dollar. How real is this threat? And how might this impact your portfolio?
It is true that the U.S. dollar is currently the world’s dominant reserve currency, a status we have enjoyed since the end of World War II. This means that most international trade is conducted using dollars, and that U.S. dollars make up the majority of foreign currency reserves held by large entities, such as foreign central banks. This status is thought to be advantageous to the United States because it creates a natural, ongoing demand for dollars, some of which are recycled back into U.S. Treasury bonds, reducing interest rates, and enabling lower borrowing costs than might be the case otherwise.
It is also true that historically, “reserve status” does not last forever, and the prevailing world reserve currency has evolved over time, from the Dutch Guilder in the 1700s, to the British Pound in the 1800s, and eventually the U.S. dollar beginning in the mid 1900s. It would not be surprising, therefore, that someday another currency will dominate international markets. However, that day does not appear close if one looks at the composition of foreign currency reserves over the last few decades. While the percentage has declined gradually over the past quarter century, no other currency comes close to the level of foreign exchange reserves represented by the US dollar:
The foreign exchange value of the dollar also shows no sign of collapse; on the contrary, the dollar has been generally strengthening relative to other currencies for the past 15 years and relatively stable for the past 30 years:
Although there are no signs in the data of a significant decline in the use or value of the dollar, nor of anything resembling “de-dollarization,” we can still run a thought experiment for investors who remain concerned and would like to prepare their portfolios for this potential risk. Let’s start by looking at what happened to the last currency to lose its world reserve status, which was the British Pound in the late 1940s.
In the aftermath of World War II, an international agreement (“Bretton Woods”) fixed the exchange rates of major world currencies; the value of the British Pound was initially pegged at 2.8 dollars per pound. Exchange rates were not allowed to float freely until 1971. Since then, the value of the pound has declined by about 1% annually relative to the U.S. dollar. Compounded over 52 years, this represents a fairly significant decline of about 50%. However, we don’t know for sure if the change in reserve status was the main cause; there may have been several other factors at play.
Returning now to the question facing today’s investors — could the U.S. dollar face a similar fate over the next 50 years? Again, no one knows for sure, but there’s a pretty effective hedge for this possibility. In fact, if you are an evidence-based investor, you are probably already more prepared than you might think – as long as you own a diversified basket of global equities and accept the currency risk.
For US-based investors, a weaker dollar acts as a tailwind for returns on foreign investments. For example, if Japanese stocks rise by 5% in a year, and the Yen strengthens by 2%, your U.S. dollar return is boosted by the stronger yen (weaker dollar) to +7.1%. Similarly, if the Chinese Yuan, Indian Rupee, or Brazilian Real strengthen relative to the dollar, you can expect your emerging market stock returns to be enhanced through exchange rate effects. (These examples highlight the potential benefits of currency diversification, which can complement other forms of diversification in a portfolio.)
The eventual loss of U.S. currency reserve status is just a hypothetical scenario today, without much evidence to point to. But thought experiments like this one do remind us that the main goal of an effective portfolio is to maintain and grow your purchasing power, which includes protecting against the possibility of high inflation or a weaker domestic currency. Currency diversification offers globally diversified equity investors a good deal of protection in this regard.