The U.S. dollar has occupied a very privileged position since World War II—it has effectively become the world’s reserve currency. This privilege was earned by having a robust economy and a stable political system. Other countries, when they wanted to hold cash, often opted for dollars because they were safe and readily exchangeable.
A huge benefit of being the owner of the world’s reserve currency is that the U.S. has always been able to float government and corporate debt on very favorable terms because there has been such a strong demand for dollars outside the U.S. If other countries want to do government spending, it is much more expensive because they have to entice buyers outside their domestic market (with higher interest rates) to hold their currency. The U.S. has gained a significant economic advantage by being able to borrow money more cheaply than everyone else.
While the U.S. still has the largest economy in the world, it is not growing right now. Emerging economies like China, India, and Brazil have much higher growth rates than the U.S., and they are beginning to assert their economic clout. Fueled by decades of deficit spending, and perhaps egged on by its low borrowing costs, the U.S. government has now borrowed so much money that other countries are beginning to complain. The Chinese central bank, in particular, would like to replace the dollar with Special Drawing Rights (SDRs) as the de-facto reserve currency. SDRs are currently composed of a basket of four currencies: the dollar, the yen, the euro, and the pound. China would like to add the yuan to the basket as a fifth currency, so that they too could become a preferential borrower.
It’s unclear how the politics of the reserve currency will play out this time around, but with continuing massive deficit spending, enormous amounts of U.S. debt outstanding, and so much of it owned abroad, it’s clear that this will not be the last challenge to the special status of the dollar. Domestic investors are going to need to think globally and allocate globally to have investment success in the future.
