Andrew Harris
In a crisis, people tend to flee to the US dollar, as it is considered the least risky currency. This reputation as a safe haven underpins the dollar’s unofficial status as the world’s ‘reserve currency’. But just as the British pound lost its reserve currency status to the dollar, there are now signs that the dollar’s status could be under threat.
Indeed, debate around the US reaching its debt ceiling has sparked some economic and financial market uncertainty. Were the US to default on its debt, this could threaten the dollar’s risk-free status.
- The US dollar is widely regarded as the world’s ‘reserve currency’, but debate over the debt ceiling caused political and economic uncertainty this year, and is likely to do so again in future
- Were the US to default on its debt, this could lead to damaging consequences for the US dollar’s status as the reserve currency
- This topic is explored in greater detail in Fathom’s research note ‘Is the dollar’s status as a reserve currency at risk?’
The US dollar is often referred to as the world’s ‘reserve currency’ — a status usually given to the currency that makes up the largest share of economic transactions and official reserves globally. At present no rival appears close to stealing the dollar’s crown, but that is not to say there are no risks to the dollar’s status. One domestic factor that has sparked economic uncertainty is the US reaching its debt ceiling — the legislative limit on the amount of debt the US government can accumulate. An agreement in principle to raise the ceiling was reached on Sunday but debates around raising that limit are likely to recur in subsequent years. This blog will explain why the US defaulting on its debt could threaten the dollar’s status.
The US has reached its debt limit of US$31.4 trillion. This is not a new event, and negotiations usually end with the debt ceiling being raised. A deal was reached on Sunday and is now making its way through Congress. This greatly reduces the likelihood of default but, until everything is signed off, there remains a risk that the US may default.
Chart 1: US debt ceiling and public debt
*Debt limit series goes to zero during where the debt ceiling was suspended
A US default would have enormous implications for financial markets and the real economy, damaging trust in the very concept of a ‘risk-free rate’, as this research note commissioned by Refinitiv explains.
The spreads of short-dated credit default swaps (CDS), which reflect the likelihood of the US government defaulting, widened significantly and surpassed the previous debt-ceiling-related high, reflecting investors’ worries about increased risks — although the probability of default remained low. The debt ceiling now seems likely to be raised (and CDS spreads have fallen somewhat) but the prolonged wrangling over the ceiling which appears to have become a more regular occurrence could slowly decrease trust in the dollar.
Chart 2: US and UK sovereign one-year CDS spreads
Source: Refinitiv Datastream / Fathom Consulting
If the dollar were to lose its status as the reserve currency, this would damage the US economically — as Fathom’s longer report on this topic explains, reserve currency status has given the US an “exorbitant privilege” (a phrase coined by Valéry Giscard d’Estaing, when serving as French finance minister in the 1960s), allowing the country to finance its borrowing from the rest of the world cheaply.
Strong demand for US assets drives their price up and causes the yields, or interest rates, required to secure loans to be correspondingly lower. Indeed, overseas investors earn a lower average yield on their investments in the US than that earned by US investors abroad.
High demand for US assets is one of the reasons why the US can consistently finance a wide trade deficit. As Chart 3 shows, that deficit was worth almost 6% of US GDP in the late 2000s, largely funded by inflows of portfolio investment. Were the dollar to lose its status as the reserve currency, the US economy would lose this massive boost.
Chart 3: US financing of current + capital accounts
Source: Refinitiv Datastream / Fathom Consulting
Furthermore, the US would have less economic leverage over other countries. Most economies are exposed to both the US dollar and dollar-denominated assets, increasing the US’s power to impose economic sanctions. It is noticeable that before the invasion of Ukraine, Russia decreased its holdings of US Treasuries, and thus its exposure to potential sanctions. China — the second-largest holder of US Treasuries and the USA’s main geopolitical rival — is doing the same.
As the longer report on this topic explores in detail, for the US dollar to lose its status as the world’s reserve currency, another currency would have to be ready to take its place — but do either the euro or the renminbi, the dollar’s closest rivals, currently fulfil the criteria necessary to challenge the dollar?
For more on this story, Refinitiv customers can read the full research note ‘Is the dollar’s status as a reserve currency at risk?’ here.
Fathom Consulting is a world-leading consultancy specialising in the global economy, geopolitics and financial markets. For more information, please visit www.fathom-consulting.com.
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