By David Ruff, Partner & Portfolio Manager
The presidents of Brazil and China reportedly signed 15 new trade agreements covering an extensive array of industries including agriculture, communications, and semiconductors to name a few. With China being Brazil’s number one destination for key commodities, bilateral trade between the countries may exceed $200 billion in 2023. From a US perspective, some contend the most alarming aspect of the deal is that all future trade will occur in each other’s currency. Like other recent announcements, the dollar will no longer be used to facilitate trade between these two economic behemoths. Dealing another blow to dollar hegemony, in December 2022, China and Saudi Arabia signed a new partnership agreement with future energy purchases paid in yuan. Although utilized less for both global trade as well as reserves, the dollar should remain the world’s primary currency, but its lowered usage adds importance to currency diversification in investment portfolios.
Petrodollars or dollar-based international energy transactions have dominated since the end of WW II. Based on trust in the US currency and military at the time, some characterize a 1945 deal between President Franklin Roosevelt and Saudi King Abdul Aziz Ibn Saud as one which bartered dollar-pegged oil for the US providing Middle East security. Hence, the foundation for the petrodollar formed. Ah, but times change and since 2018 we’ve seen the rise of the petroyuan. A credible source for the yuan’s proportion of international energy trade is not yet available, but it appears to be growing rapidly. Notably, Russia, Iran, and Venezuela trade in petroyuan and control 40% of the world’s crude reserves. Other examples of yuan usage include UAE sales of natural gas, and a yuan-denominated contract between French oil giant TotalEnergies and China National Offshore Oil Company. The ascension of the petroyuan seems assured.
Predictably, authoritarian regimes of Russia and Iran seek non-dollar denominated trade. They’ve learned US sanctions block country access to SWIFT or the Society for Worldwide Interbank Financial Telecommunication, a necessary system for dollar-based international trade and access to dollar reserves. Less expected, many countries, although condemning the Russian invasion, appear united in their opposition, or maybe better said, united in their half-hearted support of the West’s sanctions, judging by their transition to US dollar substitutes. For example, India pays Iran in rupees for crude and compensates Russia in rubles for crude and defense systems. Even Turkey, a country without a credible central bank and a regularly plunging lira, boldly announced they’re transacting with Russia in rubles.
It appears the anti-dollar contagion is spreading. In Africa, Kenya now demands the use of shilling for Persian Gulf oil. In Latin America, Brazil and Argentina clamor for a regional currency called the sur, and ASEAN introduced a new plan to reduce dependence on the major currencies, of which, the US dollar is most utilized. The Southeast Asia block plans to move to local currencies and renminbi for trade settlement. Of course, these moves are self-serving. The relatively high US inflation rate forcing the Federal Reserve’s 475 basis points in interest rate hikes to date almost universally strengthened the dollar versus other lower interest rate currencies. This made key imports prohibitively expensive for many countries. Moreover, although some suggest the US erratic monetary policy, worrisome debt growth, and financial system instability should be blamed, probably the more pressing reason for the dozens of countries abandoning the dollar is the scary prospect of being the next target for US economic warfare. Diversifying out of the dollar reduces vulnerability to sanctions or US actions designed to hurt an economy. In addition to less usage as the unit of global exchange, this fear partially explains the shrinkage of the proportion of central bank reserves denominated in US dollars. Estimated by the IMF to be 58%, this is the lowest level since 1994.
Despite these dollar-dumping occurrences, and the doomsday scenario prognosticated by some market pundits, don’t look for a crash and burn of the US dollar and US economy anytime soon. Importantly, the recent decline in the proportion of dollar-based central bank reserves is not unique. As shown in the chart below, a precipitous decline started in the late 70s, kicked off by another period of high US inflation. Notice the recent decline has not accelerated the trend since 1999, the time of the euro’s introduction.
Although controlling a smaller share of cross-border payments and central bank holdings, the US dollar will continue to be an important global currency for both exchange and reserves. Importantly, no other currency provides a viable alternative to rise to preeminence. Most currencies simply lack the scale. The world’s number two ranked currency for reserves, the euro at approximately 20%, may be the best positioned since it’s backed by a credible central bank, and represents a set of relatively stable economies accounting for a substantial portion of the world’s GDP. That said, it’s not likely the euro dominates. Disunity among the member states adds risk to holding the euro, and there are still relatively few euro-bonds representing the euro-wide economy. Most European bonds are issued by a European country whose fundamentals can differ significantly from the eurozone as a whole. This explains why the dollar’s falling proportion recently has not been taken up by the euro but other currencies like the Swedish krona, the South Korean won, and Australian dollar. Likewise, the yen suffers from the fact that most Japanese debt is held domestically. Realistically, not enough bonds are accessible internationally to serve the reserve function. The renminbi appeals with its broad reach as a trading instrument due to China’s economic heft and growing global influence, but mistrust of China’s policy maker’s commitment to free markets and extensive capital controls means the yuan is not freely tradeable. This is a necessary characteristic for a universally dominant reserve currency. Some make the case for digital currency such as bitcoin, claiming it’s the Switzerland of currencies with no government able to weaponize it for geopolitical gain, but major obstacles exist here as well. Pronounced price instability and the inability of governments to control their money supply after ubiquitous bitcoin adoption suggests a doubtful rise of crypto to a level rivaling the dollar.
Thus, given the dearth of qualified replacements, king dollar will not see its reign end anytime soon. Rather, we believe we’re entering a multi-polar world where money holdings and transactions will be less dominated by the dollar, replaced not by another single currency, but a plethora of currencies. Those favored will be from countries with the best fundamentals and these will change from time to time. Key variables include the rate of inflation, interest rate levels, fiscal deficits, trade balances, terms of trade, economic openness, and labor productivity. Given the dollar’s slipping dominance, we expect deterioration in these fundamentals will likely negatively impact the US dollar’s relative price against other currencies, especially those used for reserves, to a greater degree in the future.
Finally, we note dollar aversion induced many central banks to stock up on gold. Viewed as an effective inflation hedge, gold reserves are believed to have reached a three-decade high with the 2022 accumulation pace the fastest since 1967. Holders of our ADR and Global portfolios know we have a gold mining investment. We believe the well-run company should benefit with gold near an all-time high.
Similar to countries diversifying from the US dollar for risk purposes, investors should also pursue currency diversification. Equity investors, in particular, should diversify across companies transacting in other currencies vis-à-vis the US dollar for a meaningful portion of their portfolio. Accordingly, country and currency analysis should be emphasized in security selection. We highlight currency allocation accounted for a significant proportion of our ADR portfolio return advantage over the benchmark and S&P 500 for the 12-months ending March 31st. We believe the currency element will continue to be important in diagnosing future performance attribution.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.