INSIGHTS

The US dollar has been the world’s reserve currency for close to 80 years. It started to displace the British pound in the 1920s, and secured the undisputed mantle after World War II.

A reserve currency is one that is held by central banks and financial institutions as part of their foreign exchange reserves, and widely accepted in global trade circles.

The dominance of the greenback is entrenched in the sheer size of the US economy. It is the world’s largest, accounting for more than 25 per cent of global gross domestic product.

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It also has a stable political backdrop, deep capital markets and a strong rule of law, as well as a powerful military.

All these things ensure a high degree of confidence in the US dollar, making it a common medium of exchange and a reliable store of value.

Many commodities - including oil, gold and dairy products - are also priced and traded in US dollars. This creates additional demand and strengthens its position.

Even so, the US dollar’s dominance has declined in recent decades.

International Monetary Fund figures suggest the US dollar share of global currency reserves fell to 58 per cent at the end of last year, the lowest in almost three decades and down from 72 per cent in 2001.

This has fuelled talk of de-dollarisation, which means a falling reliance on the mighty greenback as the world’s reserve currency.

The euro has been around for almost 25 years now, and it has become a valid substitute.

With a 20 per cent share of global foreign exchange reserves the euro is a clear number two, well ahead of the pound and the Japanese yen.

Longer-term, the Chinese renminbi is often cited as one of the most obvious alternatives to the US dollar.

This makes some sense, as China is an ambitious and motivated country, while its share of the global economic pie is steadily growing.

Then again, China’s reluctance to fully embrace structural economic or market reforms could prove a limiting factor.

For its currency to be a credible challenger to the US dollar, China would have to relax capital controls, bolster its rule of law and reduce regulatory risk.

There's even been talk of a new common currency being developed, to facilitate trade between the BRICS nations - Brazil, Russia, India, China and South Africa.

That’s difficult to see in the near-term.

These five countries have very different economic interests and strategic priorities.

While there’s an increasingly close relationship between Russia and China (which we need to monitor), the others in that group are somewhat removed.

Crypto followers will suggest it too has a role to play, but there are plenty of reasons why that’s not realistic.

Putting all those hurdles aside, if we did see a significant de-dollarisation the impact on financial markets would be wide ranging.

The US economy would face higher interest rates, and its sharemarket would struggle to maintain the valuation premium it currently enjoys.

US assets would fall in value (in absolute terms and also relative to others) and many investors would look elsewhere when putting their capital to work.

However, it’s hard to see the greenback being dethroned anytime soon.

When you consider the attributes needed to be a reserve currency, it simply has too many things on its side, including the fact there’s no obvious or credible alternative.

The US dollar could see its share of global currency reserves keep drifting lower, but its reserve currency status is unlikely to come under threat in foreseeable future.

Nonetheless, for investors looking to hedge their bets a sensible approach is to hold a range of international assets denominated in multiple currencies that include, but certainly aren’t limited to, the US dollar.