The concept of a world reserve currency has been around for centuries, some of the more recent countries holding the crown are Portugal (1450-1580), Spain (1530-1640), Netherlands (1640-1720), France (1720-1815), and Great Britain (1815-1944). In 1944, near the end of World War II, the Bretton Woods Agreement established the US Dollar as the world’s reserve currency and it was backed by gold.
In the post-World War II era, the strength of the US economy and military enabled the US dollar to dominate the global financial system. Other currencies were linked to the value of the dollar and international transactions were settled in dollars. This allowed the US to fund its global economic and military aspirations by issuing more dollars than it had in gold reserves.
However, the Bretton Woods system began to unravel in the 1960s when the US persisted with trade deficits while also printing more dollars than they could back with gold. This resulted in lost faith in the dollar and ultimately led to the collapse of the Bretton Woods system in 1971. In the end, US President Richard Nixon announced that the US would no longer exchange dollars for gold at a fixed rate.
Since then, the US dollar has remained the dominant global reserve currency, however that dominance is declining. The volatile US economic environment, political instability, soaring debt levels, low interest rates and weaponization of the currency have led other countries to think of alternatives to the US dollar. But what could replace it?
At this point, it really boils down to 5 choices:
#1 – The Euro. The euro has emerged as a major global currency and has gained importance as a reserve currency. However, it is unlikely to replace the US dollar as the world’s reserve currency in the near term for several reasons:
- Political fragmentation: The European Union (EU) is a political and economic union of 27 member states, each with its own national interests and priorities. This fragmentation makes it difficult for the EU to speak with a unified voice on global economic issues.
- Economic instability: The Eurozone has experienced significant economic instability in recent years, with high levels of debt and unemployment in many countries. This has led to concerns about the long-term stability of the euro as a currency.
- Lack of a unified fiscal policy: While the EU has a single monetary policy under the European Central Bank (ECB), fiscal policy remains the responsibility of individual member states. This lack of a unified fiscal policy makes it difficult for the EU to respond to economic challenges in a coordinated and effective manner.
- Geopolitical concerns: The EU faces geopolitical challenges, including tensions with Russia and uncertainty about the UK’s relationship with the EU following Brexit. These challenges could make it difficult for the euro to gain global acceptance as a reserve currency.
#2 – British Pound: The British pound has a long history as a global reserve currency, but it is unlikely to become the world’s reserve currency in the future for the following reasons:
- The size of the British economy: While the UK is a major global economy, it is smaller than some of the other major economies, such as the US and China. As a result, the pound may not have the same level of global influence as these larger economies.
- Political uncertainty: The UK has experienced significant political uncertainty in recent years, including the Brexit process and the pandemic.
- Limited diversification: While the UK has a well-developed financial sector and a range of financial instruments, its economy is heavily focused on services, particularly financial services. This lack of diversification could make the pound vulnerable to economic shocks.
#3 – Chinese Yuan: The Chinese yuan has gained in importance as a global currency and is increasingly being used in international trade and finance. However, several factors will most likely hinder its path to global acceptance as a reserve currency:
- Limited convertibility: China maintains strict controls on the convertibility of its currency, which limits the yuan’s use in international transactions and makes it less attractive as a reserve currency.
- Lack of transparency: China’s financial system is less transparent than those of many other major economies, which could make investors and central banks hesitant to hold large amounts of yuan.
- Political concerns: The Chinese government’s control over the economy and its actions on issues such as human rights and trade have raised concerns among some countries.
- Limited global financial integration: China’s financial markets are still relatively closed to foreign investment, which limits the yuan’s use in international transactions and makes it less attractive.
#4 – Bitcoin: Bitcoin has gained a lot of attention and popularity as a decentralized digital currency which removes government control and manipulation. Unfortunately, it will most likely not become the currency for several reasons:
- Lack of control: Governments thrive because of their ability to print money and manipulate the money supply. This cannot be done with Bitcoin. There is a fixed supply and creation of bitcoin over time.
- Volatility: Bitcoin is highly volatile and can experience significant price swings in a short period of time. This volatility makes it difficult for investors and central banks to use Bitcoin as a stable store of value.
- Limited adoption: While Bitcoin has gained popularity in certain circles, it is still not widely accepted as a means of payment or a store of value.
- Lack of regulation: Bitcoin is largely unregulated, which could make it vulnerable to fraud, money laundering, and other illicit activities. This lack of regulation could limit its acceptance by central banks and governments.
#5 – A basket of securities: We could see several large economies come together and use their collective currencies as the world reserve currency, eliminating single country risk or dominance. This is the most likely alternative at this point, but there are still some factors to consider:
- Political fragmentation: Will the countries which make up this basket of currencies share the same political agenda? Will they be fighting amongst themselves?
- Economic instability: How stable are the respective economies of each country? What is the probability of one or more countries suffering an economic collapse?
- Lack of trust: Do the other countries around the world trust the government, intentions, economy, and transparency of each country represented in the basket?
Imagine a school playground with 195 children playing. One of those kids, named Sam (Uncle Sam), is the bully and dominates all the other kids, beating them up if they don’t do what he says. That is the current situation with the US dollar. Now, what if 5 of those kids band together and challenge Sam? The power struggle changes and potentially overthrows Sam.
Currently, there are 195 countries in the world, and several have banded together to form the BRICS. The BRICS countries include Brazil, Russia, India, China, South Africa. These 5 countries represent 41% of the global population, roughly 9 times more than the United States. While this seems like the current path, and most likely option, there are a lot of headwinds. Suffice it to say that these 5 countries don’t really like nor trust each other, and the global community appears to have trust issues with Russia and China.
For now, these are the 5 most logical choices for a replacement of the US dollar as the reserve currency of the world – however, none of them are a clear-cut winner. Even though we have seen Saudi Arabia accept Yuan for oil payments and other markets accept non-dollar payments, there isn’t a solid alternative overall. If there is a transition to a new reserve currency, it will take time and will likely be a gradual transition over decades.
This deterioration of the US dollar dominance will bring increased volatility to the currency markets – music to the ears of forex traders around the world!