The Rise and Fall of the Dollar’s Reserve Status
When the euro arrived on the scene, it took over around 32% of global foreign exchange reserves from the USD, with the tacit approval of the U.S. This dropped the USD’s percentage of global reserves from 95% to around 63%. Since then  its percentage of reserves dropped from 63% to 53% and now has risen back to 56%.
Arrival of the Euro
When the Euro arrived on the scene, gold continued to be held –with the exception of the amounts sold under the Washington Agreement and the Central Bank Gold Agreements—alongside the Yen, Sterling and the Swiss Franc.
The monetary system from the end of the World War has been firmly under the control of the U.S., with all other nations and their currencies dependent on the dollar’s proper functioning as the monetary system’s global foundation. The system functioned properly so long as the USD was managed as money measuring values across the world. Yes, the world had to accept the “exorbitant privilege” of the constant Trade Deficit, which worked well so long as the world’s economies, on balance, continued to grow, but the USD provided global liquidity and facilitated a globalization of world trade.
Unfortunately, the dollar and the Fed were beset by a major conflict of interests. On the one hand, the dollar had to be the stable base for the world’s monetary system; on the other hand, it had the task of coping with a U.S. economy and assist in maintaining stable prices and do all possible to assist in U.S. growth and low unemployment. These two tasks have become incompatible.
As this became clearer from the credit crunch in 2007 until now, confidence in the USD has declined.
Relationship of Currencies to the USD
The loss of confidence in the dollar is palpable, but as each attempt to find alternative currencies to the dollar was made, so the central banks of those currencies balked at the damage the ‘safe-haven’ treatment of their currencies caused to the int’l competitiveness. One by one, the exchange rates of ‘safe haven’ currencies was undermined by their central banks. First the Japanese Yen, then the Swiss Franc, were undermined as fleeing wealth sent their exchange rates through the roof. The net result was that other currencies showed themselves to be no more than branches on the ‘dollar tree’.
The net result has been that the entire currency system now shares in the loss of confidence in the dollar and carefully follows the course of cheapening the value of currencies alongside the dollar. This has left the dollar the sole global reserve currency once again, despite its increasingly threatening structural faults.
Loss of Confidence in the USD, Then Other Currencies
The fall in the percentages of the USD held as reserve assets from 63% in 1999 to 53% in 2012 precisely measured the loss of confidence in the dollar, as a currency, as attempts were made to flee to currency alternatives.
Short-term flights to other currencies still happen and will still happen as interest rate differentials remain tempting sources of profits. But the concept of ‘safe-haven’ currencies has gone. Once U.S. interest rates start to rise, we may well see a decimation of the liquidity levels. Nations with other currencies will suffer; nations with current account deficits will be the first victims of interest rate rises.
So why did the percentage of reserve portfolios move back to 56% in the second quarter of 2013?
This was an important change in the global monetary system.
Looking around after this change, it became clear that all currencies would follow the same course as the ‘Swissy’ and the Yen who are continually weakened by their central banks. With the bulk of the globe’s trade still transacted in the USD, no nation can afford to undermine its exports by allowing their currency to strengthen too much.
The same holds true of the Chinese Yuan at the moment and will do so until it can assist in carrying the mantle now being carried by the U.S. as the sole global reserve currency. The Yuan is close to becoming an alternative global reserve currency, a destination that the U.S. cannot change.
Confidence in the USD-based on Oil
Only oil producers whose balance of payments rests entirely on oil revenues, or nations who are self-sufficient in oil, can afford to allow their currencies to strengthen. This is because confidence in the dollar relies on being the currency in which oil is sold. If oil were prices in the globe’s main currencies, the exchange rate of the dollar would reflect it Balance of Payments. This would lead to a persistently declining exchange rate.
But even where an economy relies heavily on oil exports, if they have an export sector outside oil, they will force their exchange rates down or held steady against the dollar to protect those exports.
This emphasizes that the fundamental purpose of a currency is to assist in the int’l promotion of a nation. This implies that a currency is no longer a real store or measurer of value either locally of internationally.
So the dollar has returned, at the moment, to the foundation of currencies and the one that central banks will prefer to hold because it is the best of a bad bunch and the one on which the others rely.
Arrival of the Yuan
When we look forward we see the Yuan rising in importance as it becomes more and more convertible globally. Over time, expect more and more of China’s int’l transactions to be conducted in the Yuan and not via the dollar. This is a critical change as now the bulk of China’s transactions are done in the USD and then converted –by the People’s Bank of China—into Yuan. There is a date that only the gov’t of China knows, when it will make a change to that pattern.
There is a date somewhere in the near future, when China’s trade invoices are expressed in Yuan. This will necessitate the selling of local currencies directly for the Yuan to pay for imports. It is also likely that exporting countries to China are paid in Yuan and no longer in dollars. Expect the change will come about not precipitously but gradually so as to cause the least disruption to world trade. Once started, this process will not stop. The investor’s skill will be in knowing when that process impacts global trade overall.
To get this in perspective, China has well over $3 trillion in its reserves from trade as it grew steadily over the last 16 years. It’s now a vastly bigger economy and its int’l exposure on both the import and export fronts has grown alongside the expansion of reserves. If this need is changed into Yuan from the dollar, then the drop in the demand for the dollar globally will be precipitous! So it is not only the potential fall in the percentages of reserves in dollars, but the drop in the ongoing use of the dollar as a reserve currency. No nation will want a brutal change, and China will work with other nations to soften the blow much as it can.
Such a change is a pivotal change, particularly as there will be no interdependence between the Yuan and the dollar as we see between the euro and the dollar. China will not seek the interests of the U.S., and the U.S. has little concern for China’s interests.
You may think that at least China will continue to pay for its oil in dollars. Not so! Most of the oil deals China has organized can be switched into the Ruble or euro without strain, and some have already been agreed on that basis. Where there may be difficulty in doing so China will still have its vast $3+ trillion in dollars to use up so as to make the transition as smooth as possible. But eventually, China will have sufficient strength to dictate terms to all oil producers. They too may prefer to diversify out of the dollar then.
Not Gold vs. the USD, but Gold vs. all Currencies
We repeat that the overriding change that occurred since 2012 in asset allocation in reserves is that there has been a return to the dollar because that is the best of the worst among currencies, not because confidence has been restored back into the U.S. dollar. No currency is a safe-haven now.
How does that translate into an impact on gold?
What’s very clear is that if central banks feared for the prospects for the dollar up to 2012 they continue to do so now, because the situation has worsened for the dollar not improved. So where to go now?
Central banks and the entire banking system have disliked gold since the end of the Gold Standard because it prevented the devaluation of currencies without consequences. By removing gold from the monetary scene (except as a disjointed reserve asset) the consequences of devaluation have been removed, for a time. Eventually they will come back to haunt the monetary system, but so far, so good. Nevertheless, consequences are still on the way!
The first impact will hit when China forces a separation of U.S. fortunes from their own. The arrival of the Yuan as a reserve currency (almost on us) will mark the arrival of the first major consequence.
Once this happens, you will see the allocation of dollars in reserve portfolios drop again as the Yuan takes their place. The replacement of the dollar by the Yuan in reserve portfolios will go as fast as the use of the Yuan in global trade grows.
This makes sense of the World Gold Council’s statement we gave you last week,
“As more currencies are included in the reserve system, gold’s relationship with other currencies will likely evolve. It is likely that gold will retain its generally negative relationship with the US dollar, but it will also serve as a hedge against all fiat currencies. As the monetary system evolves to make room for alternative reserve currencies, gold will have a growing prominence as a balancing mechanism against the risks inherent in fiat currencies.”
The global banking system will continue to fight against gold because of the limits it places on them, but a day is coming when confidence in fiat currencies will have fallen so low that they will reach out to gold for their very survival. As efforts to retain confidence and credibility in the current currency system start to sag, so gold will return to the global monetary system to ensure ongoing liquidity and facilitate the functioning of the current monetary system.
We emphasize that gold will not be brought back as alternative money, but in support of current paper, national money. We may be closer than we think to that point!
At that point, do not expect to see gold measuring by currencies. Gold will measure currencies.
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