It’s been a privilege – RBC Wealth Management

“An exorbitant privilege” is how former French President Valéry Giscard
d’Estaing once referred to the U.S. government’s ability to issue the
global reserve currency.

And there’s no question—in our minds—that the dollar’s role as the world’s
savings vehicle contributed to U.S. economic success in the last 75 years.
But currency leadership has less helpful consequences as well, including
fiscal and trade imbalances. With the dollar’s role in the global economy
evolving—and in our view likely declining—we think this is an opportune
moment for investors to consider what comes next and how changing currency
appetites are likely to impact the global economy.

Contrary to popular wisdom, we believe there’s a strong case to be made
that the exorbitant privilege of reserve status is now a net liability for
the U.S. and that a shift to a more balanced global currency reserve
basket is likely a more stable framework for global economic activity. At
the same time, a potential declining role for the dollar represents the
weakening of another global unifying force, with likely negative
implications for U.S. leadership and possibly global political stability.

The good

Currency reserves are simply an economist’s way of describing how a nation
chooses to store its savings. Countries save for many reasons, but their
primary goal is to secure access to food, fuel, and other critical inputs
in the event of a domestic economic crisis. Countries could choose to save
these materials directly—like the U.S. does with its strategic petroleum
reserve—but that requires significant storage and defense costs. Most
countries instead hold a basket of foreign currencies, relying on their
ability to trade those holdings for needed goods and services. Since World
War II, the majority of world savings has been held in U.S. dollars; the
greenback’s current share of global saving is roughly 60 percent.

This reliance on the U.S. currency for savings has two main implications.

First, countries that hold dollars want to make sure that trade continues
to be denominated in dollars. They’ve bought into the ecosystem, and if
trade starts shifting over to rubles or euros or yuan, then their dollar
savings may not be helpful in a crisis. A country could try to switch to a
different currency, but that’s an expensive—and risky—move: make the wrong
choice or move too soon and your country could be locked out of vital
markets. It’s much easier to perpetuate the current system and support the
dollar as the trade vehicle.

For the U.S., having the dominant currency involved in global trade
matters. The theoretical benefit is that it eliminates the risk that the
U.S. cannot buy needed inputs. That’s nice, but given the size of the U.S.
economy, not a lot of folks were losing sleep over that risk. The real
benefit of the dollar’s role in trade, in our view, is that small and
midsize U.S. companies have a much easier time expanding into export
markets. Hedging currency risk is complicated and often involves a
tradeoff between protecting margin and satisfying customers. A U.S.-based
exporter selling in dollars avoids those costs and headaches, making it
easier for firms to begin exporting earlier in their corporate
development.

The other main benefit to having the reserve currency is that it helps
keep government borrowing costs down. Once foreigners have acquired
dollars, they need a low-risk, easily accessible way to hold them, and
that tends to mean owning U.S. Treasury bonds. This demand for government
securities has helped reduce long-term borrowing costs, giving a financial
boost to the U.S.

Not all sunshine

But not all the consequences of being the source of the world’s reserve
currency are positive.

To begin with, there’s the basic issue of how foreigners can acquire
dollars. There are only three ways:

• They can be given them, through financial aid;
• They can borrow them, typically by having central banks exchange blocks
  of their respective currency in a so-called “currency swap” arrangement;
• Or they can earn dollars through a trade surplus.

Since countries tend to grow their reserves over time, the U.S.
effectively needs to run a persistent trade deficit if it wants the dollar
to retain its share of reserves. The only alternative means of providing
dollars to foreign savers is through large amounts of financial aid,
potentially to strategic rivals, or by having the U.S. Federal Reserve run
an extremely complicated and potentially risky book of multicurrency swap
lines globally. Both alternatives are political and economic nonstarters,
in our view, so the U.S. can choose between a trade deficit or a
diminishing percentage of global reserves in the long run. It’s not a
coincidence that the U.S. has run trade deficits for decades.

Once foreigners have acquired dollars, they need a place to store them,
and that usually means Treasury bonds. The flipside of being the reserve
currency and borrowing cheaply is that a country must issue enough debt to
keep up with reserve holder demand. A key reason why countries have shied
away from euro reserves, in our view, is the lack of truly eurozone-wide
debt and the insufficiency of German and other perceived low-risk
sovereign bonds. The recent push by Germany to expand issuance to fund
defense spending could help increase the attractiveness of the euro as a
reserve currency, in our view.

Certainly, U.S. fiscal deficits go well beyond what is required for
foreign reserve growth, but even if the U.S. federal government shifted
toward a more balanced budget, a persistent budget surplus is problematic
for a reserve currency issuer.

Too expensive?

When the U.S. began running persistent fiscal deficits in the 1980s, the
stock of federal debt outstanding was around 30 percent of GDP. Today,
existing debt is closer to 120 percent of GDP. The numbers for trade are
directionally similar, although to a lesser degree.

Separating out the impact of currency reserve status on debt accumulation
and trade levels is beyond art versus science. There are simply too many
variables moving simultaneously to reach robust conclusions.

We think it’s fair to say, however, that a reasonable person could
conclude that the marginal cost of additional debt accumulation is higher
at 120 percent of GDP than 30 percent of GDP, and that expanding U.S.
trade deficits from their current levels will likely exacerbate domestic
economic and political concerns. In short, the longer the U.S. runs these
imbalances, the greater the costs become.

The benefits of reserve currency status, arguably, have not kept pace.

What comes next?

So far, we’ve been discussing the dollar’s reserve currency role and its
implications for the U.S., but the issue is, of course, global in nature.
For nations accumulating reserves, we see a real possibility that tariffs
and their impact on international trade prove to be the driver for
rethinking reserve strategy.

As we’ve discussed elsewhere, we think the Trump administration’s tariff
policies are designed to exploit foreign nations’ reliance on American
consumption. It’s an incredibly powerful lever, in our view, for the U.S.,
and by extension it’s a key strategic liability for both allies and
rivals. While the Trump tariffs are the most immediate and explicit
reminder of other countries’ economic dependence on the U.S., there’s a
long history of Washington using unilateral economic sanctions and
freezing dollar assets. This has generated significant international
pushback and resentment, primarily from organizations like the BRICS, a
multilateral group founded by Brazil, Russia, India, China, and South
Africa.

Given the U.S.’s increasing willingness to flex its economic might, we
would be surprised if countries did not seek to better balance their own
internal supply and demand, reducing reliance on the U.S. consumer. The
shift away from international trade is likely to lead to slower global
growth as the efficiencies from trade are lost. This is a dynamic that has
been going on for years, as we’ve previously discussed in our “Worlds apart” series, but we believe tariff threats are likely to accelerate the
shift.

Countries tend to base their reserve balances on the value of their
imports, so if countries shift away from trade and toward more of a
balanced domestic economy, they will likely find themselves with excess
reserves.

Our expectation is that most countries would maintain current reserve
levels. This would essentially allow them to “grow into” their current
stock of savings versus aggressively drawing down reserve totals to match
a reduced import bill. The reason for our view is simple—drawing down
reserves is a risky move, and central bankers by their nature tend to be
risk averse.

Emerging currencies fill the space created by the U.S. dollar’s declining
role in global reserves

Share of global currency reserves

The chart shows the percentage of global reserves held in various
currencies: the U.S. dollar; the euro; other traditional reserve
currencies (Japanese yen, British pound, Swiss franc); and major
non-traditional reserve currencies (Chinese renminbi, Canadian dollar,
Australian dollar). The percentage of reserves held in U.S. dollars
fell to roughly 58% in 2023 from roughly 71% in 2000. Approximately
half of the dollar’s decline was offset by increases in the major
non-traditional reserve currencies, which were not significant before
the early 2010s and now account for roughly seven percent of global
reserves.

• Other

• Major non-traditional (CAD, AUD, RMB)

• Other traditional (JPY, GBP, CHF)

Source – RBC Wealth Management, International Monetary Fund

Once nations re-enter a phase of reserve accumulation, we would expect
them to add to their savings with a focus on non-dollar currencies. This
is exactly the behavior we’ve seen since the turn of the century.

The risk that a country would move to immediately shift its currency
composition—essentially sell Treasuries and dollars and buy euros or
yen—is mainly theoretical. No other currency offers sufficient high
quality, stable value, liquid investment alternatives to act as a dollar
replacement. Unless or until that changes, the practical choice, in our
view, is dollar savings or lower savings.

If this interpretation proves correct, the short-term outcome is nearly
ideal for the U.S. Investing nations would continue to roll over their
Treasury holdings and dollar-based international trade would remain the
norm. Some degree of regional trade would likely migrate to a different
currency, but if most countries continue to hold Treasuries, the incentive
to trade in U.S. dollars remains.

Longer term, the U.S. would no longer enjoy its exorbitant privileges, but
it would also not face the inherent need to provide both dollars and debt
to the world. Less helpfully, a world that is less dependent on the U.S.
consumer is also less invested in the health of the U.S. economy.
Historically, foreign nations have not had much reason to push hard during
economic negotiations with the U.S.; after all, for most of the world a
healthy U.S. economy was key for their domestic economies’ production and
profits. From our vantage point, if and when countries shift toward
regional trade partners and their own domestic buyers, all sorts of
bilateral discussions look less cooperative and more like a zero-sum game.

Bretton Woods, Bancor, and beyond

The idea that the existence of a single reserve currency can create global
imbalances is nothing new. John Maynard Keynes is perhaps best known for
his statement that “in the long run, we’re all dead,” but he also was one
of the first to identify the inherent instability of a single currency
acting as the global reserve. He made a push at the Bretton Woods
Conference in the 1940s to base international trade on a global unit of
account called the Bancor, rather than the U.S. dollar.

The idea was to have all trade settled in Bancors and run through an
international clearing union. Countries that ran either a Bancor surplus
or a deficit would be charged a penalty rate on the imbalance. This would
provide incentives for trade to remain largely balanced. The idea has been
refloated on occasion, most notably following the global financial crisis,
but it has failed to be adopted largely because, in our view, countries
have been unwilling to cede that degree of control to an international
body. While we think the idea of a global unit of account has significant
merit, we see the geopolitical barriers as nearly insurmountable.

Instead of a radical transformation, we believe currency reserves are
likely to go through an evolutionary process. Falling trade will lead to
slower global growth and declining reserve needs, but the reduction will
likely be done passively. Some countries may choose to rebalance part of
their holdings away from the dollar, but the lack of “safe” investment
options for non-dollar currencies will act as a constraint, in our
opinion.

While any shift away from dollar reserves is likely to be presented as a
negative for the U.S. economy, we are not convinced the facts support that
interpretation. Instead, we think we’ve reached the point Keynes foresaw,
where the fiscal and trade implications of issuing the reserve currency
outweigh the rather limited benefits of reserve status.

In other words, we believe that in the long run Keynes may be dead, but
he’s still got a point.