Moving away from reserve currency domination

This article appeared originally in Gulf News: link to original article

The International Monetary Fund recently lowered its growth projections for the global economy, exacerbating the uncertainty that has haunted the economic and financial world since the 2008 financial crisis and continues to do so today. The 2008 crisis witnessed the introduction of low and negative interest rates by a few central banks, encouraging investors to look for higher yields wherever and whenever those could be found.

This led to three interesting developments in global economic and financial markets, specifically in relation with emerging versus established currencies. The first is the shift by investors from debt issued in US dollars and euros to debt issued in emerging markets in pursuit of higher returns, regardless of risks involved.

In a 2018 report issued by the Bank for International Settlements, domestic debt, or debt issued in local currencies, has been on the rise since the 1990s. On the contrary, international issued debt has staggered behind with a gap of $40 trillion. This shift to issuance of domestic debt versus foreign debt has been brewing over the past 20 years or so, with 2008 being the turning point that widened the gap between interest in emerging market debt and all other debt.

Debt issued by emerging markets included those in local currencies as well as in foreign currencies, such as the dollar and the euro, or in foreign markets to appeal for international investors.

Levels playing field

While low and negative interest rates fuelled interest in higher yield generating emerging market debt, the shift to emerging market debt, and more specifically that issued in local currencies, is encouraging a shift away from the usual issuance currencies to others. In due time, this will lower the prominence of reserve currencies and heighten the importance of emerging currencies, creating a multi-centric world of global currencies where no single large economy has the final say in the world’s global financial and economic system.

The above mentioned connection between interest rates and forex is an indirect one. There is, however, a direct connection that affects the shift to — or away from — certain currencies.

When looking at interest rates and their connection to currencies, one must take into account that the discussion gyrates mainly around short-term rates that central banks use. The alteration in those rates, or the lack thereof, can manipulate currencies’ values and either encourage or discourage investments into them and their associated debt instruments.

That is, a dilution in a currency’s value discourages investments into it and vice versa. Furthermore, the introduction of Quantitative Easing (QE) post 2008 further diluted currencies’ values, turning the world’s reserve currencies into safe havens even with unpromising or negative yields.

Safe haven mindset

Most recently, yields on long-term US bonds have dipped below those of short-term bonds. For many analysts, this sounded the alarm on economic growth prospects for the world’s largest economy, especially since such a drop is usually correlated with an upcoming recession. This assumption has been true throughout US history with one exception.

The ensuing result of the drop was also behind the decision by US Federal Reserve (Fed) to reverse its decision on hiking interest rates and announcing rate cuts in its recent meetings. Hypothetically, this should lead to investments heading away from US markets rather than towards it.

In a similar fashion, the European Central Bank (ECB) has announced a rate cut and a continuation of its QE programme. Though the decisions by the two major central banks are not necessarily unrelated, they both would add to the shift away from their markets as explained earlier.

Centennial offers

The second development post 2008 financial crisis has been the issuance of not long-term, but centennial bonds by countries like Argentina and Austria, which in effect took advantage of the ultra-low interest rates and sold debt at the most convenient time. In Argentina’s case, which is an emerging market, interest in the bond by investors highlights a long-term keenness in the country and its currency despite its economic woes.

Whether other countries are going to follow suit or not is not clear as central banks enact monetary policies that are most appropriate for their own domestic economics, with minimal attention given to regional and global context. Given the dip in its long-term bond yields, the US is likewise best positioned to sell similar centennial bonds.

The third and final development is that the 2008 financial crisis has left major central banks such as the Fed or the ECB with very little option should another financial crisis hit the global economy. Meanwhile, central banks in emerging markets with their relatively high interests are better positioned to deal with any upcoming financial crisis or a down cycle, possibly in the early to mid 2020s, ceteris paribus.

This does not necessarily eliminate the possibility that such a crisis or a down cycle takes place in one or multiple emerging markets, though the ramifications, unlike what happened in 2008, will depend on how integrated those are in today’s global financial system.

In conclusion, the interplay between short-term and long-term interest rates and the desire to find higher yields in emerging markets have contributed to the shaping of a new, multi-centric universe of currencies. The result is the move away from currencies that were once considered the world’s reserve currencies.

Moving forward, currencies’ centrality will become more regional than global, and countries will be more focused on further elevating the prominence of those currencies. The forecast of the largest economies in 2050 could provide a sense of that.

The last thought that I want to leave you with: Which currency will be the most dominant in the Middle East moving forward?