USD to come under further pressure but unlikely to lose reserve currency status - Capital Economics

FXStreet reports that strategists at Capital Economics think the US dollar will weaken a bit further this year but suggestions that its role as the world’s primary reserve currency is in jeopardy are wide of the mark.

“Concerns that the coronavirus pandemic has put the dollar at risk of losing its status as the world’s main reserve currency tend to focus on the rapid increase of US government debt, the expansion of the Fed’s balance sheet, and the risk of runaway inflation. Dollar bears can also point to the fall in the dollar’s share of global FX reserves over the past couple of years, which has come despite a generally strong dollar. But, while it is too early to say what the long-run effects of the coronavirus pandemic will be, we don’t think that concerns about the dollar’s reserve status have played a significant part in its recent decline.”

“The dollar’s fall since March can be readily explained by factors other than concerns about its reserve status. These include the continued, if fitful, recovery of risky assets, the fall in US interest rates relative to those elsewhere, and the fact that European policymakers have taken major steps towards shoring up their currency union. The shift in sentiment towards the euro is remarkable: net speculative positioning in favour of the common currency is now the highest level on record. The euro’s recent surge probably reflects relief that an existential threat (in this case disagreement about how to tackle the fallout from the pandemic) has been averted, more than a judgement about the dollar.”

“If anything, the coronavirus crisis has reinforced the dollar’s role as the world’s key currency. In March, the dollar surged as safe-haven demand jumped and short-term dollar funding dried up. As a result, the Fed ended up backstopping not only its own financial institutions but also, through its swap lines with other major central banks, those of the rest of the world. It is hard to imagine the ECB or the PBoC taking on a similar role in a crisis.”

“Even if the current dollar-dominated reserve currency equilibrium is in some sense sub-optimal, that doesn’t mean a shift will happen any time soon. Sterling remained the world’s main reserve currency well after the British economy had been surpassed in size by the economies of both the US and Germany. And, perhaps more importantly, there is no obvious alternative to the dollar. The next two largest economies, the euro-zone and China, are both smaller than the US, and the euro (due to its still-fragile political underpinnings) and the renminbi (due to China’s capital controls and unique political system) have significant shortcomings as reserve currencies.”