The USD is poised to depreciate
The key determinants of currency valuations point to the weakening of the USD in the near future.
First, economic growth differentials will be less supportive of the USD.
The American economy is no longer expected to deliver exceptional economic performance compared to its peers, such as Europe or Japan. It may still grow faster than these rivals, but the differential in growth is unlikely to be as stark as in the past 20 years. In fact, the International Monetary Fund estimates that the biggest hit to economic growth from President Donald Trump’s tariff policies will be to the US itself and less so to Europe or Japan.
Beyond just the impact of the tariffs, the reason is that many of the factors that supported its superior performance are reversing: The immigration-fuelled expansion of the labour supply that generated growth is ending following President Trump’s crackdown on immigration. Moreover, the massive fiscal stimulus of the Biden years is also fading. Even accounting for the effect of planned tax cuts, the fiscal impulse will be neutral to contractionary. Business uncertainty has also soared as tariffs have been announced and then scaled back, confusing businesses. As Biden-era subsidies for green energy and new factories are cut back, the recent boom in factory construction will also fizzle out. While Trump’s promise of deregulation might encourage business spending, there is little clarity on that score yet.
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Second, the same can be said of interest rate differentials. Although the US central bank is currently reluctant to cut rates, the economic outlook points to at least two or three 25-basis point (bp) policy rate cuts by the year’s end. While other major economies, such as the Eurozone, will also ease monetary policy, the rate cuts in the US are likely to be greater and so diminish capital flows into the USD.
Furthermore, big changes in long-term rates could decisively affect the USD. For example, as Japanese inflation returns to normal levels after 30 years, long-term bond yields there have spiked recently — the 20-year yield is at its highest since 2000 and the 30-year yield is at a record level, making them more attractive to investors than before. As Japanese institutions such as life insurers hold trillions of dollars of US bonds, a small shift in their asset allocation will suffice to spur large-scale selling of USD assets and a weaker USD. This is possible, especially given the longer-term concerns about the USD described below.
The USD’s global reserve currency position is at risk
Ultimately, the USD’s ability to preserve its global reserve currency role hinges on trust: holders of USD assets need to feel confident in the legal, political, financial and institutional underpinnings of the USD. Some of these prerequisites have been slowly eroding for a while, but the actions of the current American administration appear to have significantly accelerated that erosion.
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A foundational element of trust is the country’s quality of governance, including its commitment to honour agreements it has signed, the strength of its institutions and its rule of law. The Trump Administration’s controversial actions have raised questions about how trustworthy the US is — just look at recent actions such as the blatant violation of trade agreements, the casual debasement of decades-old security alliances, the walking away from major global institutions, the assault on long-respected legal niceties concerning the treatment of vulnerable people such as illegal migrants, and the questionable closures of important agencies and institutions without Congressional sanction, among others.
Additionally, successive American administrations have aggressively exploited the USD’s dominance in international financial settlements to impose sanctions on other countries. Even its European allies were disturbed by the way a previous US administration weaponised the USD to sanction Iran. The sanctions against Russia amplified this uneasiness over American overreach. So, rivals and US allies are considering alternatives to the USD to avoid being at the mercy of the US.
The upshot is that we are now in a period where every country, whether small or big, whether a friend or rival of the US, is seeking to de-risk from the US. That is negative for the role of the USD.
Another critical prerequisite for a reserve currency is the country’s fiscal condition: Can it comfortably repay the debt that it issues? Recent political developments suggest that the American political class lacks the will to preserve fiscal probity. The budget that the US Congress will soon pass will probably produce US fiscal deficits averaging more than 6% of GDP over the coming decade — a dangerously high figure for a country not in a national emergency such as a war. Total public debt will expand by US$3.3 trillion ($4.24 trillion) or more over the next 10 years, bringing the US net public debt to GDP ratio closer to the levels of Italy and other nations with weak fiscal positions. Moody’s downgrade of the US sovereign rating, aligning it with previous downgrades from S&P and Fitch, means that the US is no longer a top-rated credit.
Moreover, the USD may be the loser from a fundamental shift in the global asset pricing regime.
The four-decade-long era of rising asset prices generated by declining inflation, falling bond yields, efficiency gains from globalisation, China’s gargantuan transformation and large-scale talent migration is over. These megatrends favoured USD assets over others because American companies and financial markets were better positioned to take advantage of these trends than their Japanese and European rivals, given their greater scale, innovation capacity and ability to restructure ruthlessly when challenged.
The projected shift in the trajectory of other countries’ surpluses could also prove a challenge. The USD was bolstered by these surpluses that had to be recycled into safe assets with decent returns, something which the US could provide better than others for the reasons given above. For example, after the Asian Financial Crisis, East Asians and India built up large foreign exchange reserves. Oil-exporting countries also accumulated massive surpluses. Now, the build-up of foreign reserves in Asia has flattened, while oil exporters are keen to deploy their savings more productively as they diversify their economies.
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Finally, the reserve currency role is usually played by the currency of the hegemon of the day. The global hegemon was Great Britain in the past, which helped elevate the British pound to its global role. Since the late 1940s, the US has taken over that hegemonic role, and not coincidentally, the USD took over from the pound as the dominant reserve currency.
What happens now that the US has a rival? China is not yet a peer superpower but has closed the gap with the US faster than most anticipated. China has shown it can match the US in key areas of technology, military projection and diplomatic outreach. Chinese companies are rapidly gaining scale, entrepreneurial verve and technological capacity, which, combined with government support, make them much more attractive to global investors.
But it does not look as if another currency can soon supplant the USD
So, the USD’s reserve currency status does not look as secure as before. However, it is not apparent that an alternative currency has emerged that can readily replace the USD.
The lesson from history is that considerable inertia helps preserve an existing reserve currency even when its fundamentals weaken. For example, the British pound maintained a significant role among global currencies even though two world wars had left it exhausted and economically weakened. It only finally lost that role after 1968, when a further devaluation of the pound and Britain’s decision to downsize its military capacity laid bare the decline of Britain as an economic and military power.
Also, the USD enjoys strong network effects — the usage of its currency grew on the back of a positive feedback loop, where increased usage drove further usage and left little room for competitor currencies.
In addition, the USD is also helped by the fact that any replacement of the USD as the dominant global currency would need to meet several conditions:
Its economy should have a substantial share of global GDP and be reasonably dynamic. China and the Eurozone come close but are not there yet.
It must offer deep, broad and highly liquid financial markets that can innovate considerably and change the range of financial securities to satisfy the varying needs of global savers. The US Treasury, commercial bond and equity markets have an unparalleled capacity in these areas, which no other market can yet equal.
The Eurozone offers the prerequisites to establish trust in its euro — the rule of law and a stable political system supported by robust institutions such as a central bank, financial regulators and independent courts with a long track record of credibility.
What should we expect then?
The USD will slowly cede its position in some of the functions of a global reserve currency, allowing the euro and yuan to play a wider role.
The change will first be apparent in the USD’s role as a medium of exchange, whereby the USD facilitates trade by offering a common currency for other countries. Much of China’s trade is already in yuan, which has largely displaced the USD. Other countries are gradually finding ways to limit their dependence on the USD.
However, it is difficult to see the USD replaced in its second role as a store of value, a currency in which global savings can be deployed. It will take many more years before either Europe or China can offer global savers anything close to what the US financial system provides. Europe needs to allow greater financial integration, which is politically difficult. China would have to liberalise its capital account and allow the yuan to be convertible — neither of which will be easy to pull off.
The third function of a global reserve currency is that it is a unit of account, whereby the USD is used to denominate international contracts and agreements. Here, it is possible to see other currencies replace the USD over time.
In the meantime, investors should also anticipate some possible changes:
Funds searching for non-USD safe havens are flooding into a narrow range of assets with limited scale and liquidity. This is why Singapore’s domestic interest rates have fallen recently. But many countries will resist this, fearing the consequences of overly strong currencies and/or too low interest rates.
The resulting lack of safe assets could thus accelerate the search for innovative alternative assets, perhaps allowing blockchain-related assets to prosper.
Whatever it is, investors and businesses need to be prepared for significant changes on the USD front.
Manu Bhaskaran is CEO of Centennial Asia Advisors
