investors are predicting that the U.S. currency is on its last gasp.
Well, I hate to burst their bubble… The dollar is going to stay on top through the twenty-first century for two reasons: The weakness of competitors and the stable, flexible and open political institutions of America.
Both are important factors to observe after you look at the three basic characteristics of a durable reserve currency:
- Durable reserve currencies are strong, stable and provide ample liquidity – A reserve currency should demonstrate deep liquidity so investors can move in and out of it without sharp movements in price. It also needs to be widely recognized by global investors as a reserve currency.
- Reserve currencies require financial and political stability – The fiscal discipline and political stability of the country needs to be unquestioned. Countries with large fiscal deficits are unable to be dependable safe havens since the path of least resistance is to devalue the currency to make debt loads more manageable.
- Reserve currencies come from market-based, rules-driven, open economies –Investors and trading partners thrive best in a market-oriented economy where the rules are clear and transparent. Faith in the fairness of the judicial system and institutions is vitally important.
It’s All Relative
I know you’re looking at the above characteristics on my reserve currency report card, and thinking it really doesn’t look so great for the greenback.
But remember, while the United States needs significant reform and fiscal discipline, currencies are valued on a relative basis.
So let me ask the obvious question: What rival currencies do these pundits have in mind?
First, take a look at the euro.
Europe has been in a non-stop financial crisis for some time. Most of the continent’s banks are not only shaky but also downright scary. German, U.K. and French banks are just trying to keep the balls in the air. That’s not very reassuring.
The monetary union needs to be much more closely aligned with political and economic union. But that requires 26 states signing over their sovereignty. That’s not going to happen anytime soon.
Not the Yuan
The other reserve currency idea on many pundits’ lists is the Chinese yuan.
No offense, but this is simply ridiculous, and here’s why…
The first important issue is liquidity. The Chinese yuan isn’t even convertible. The government forces Chinese exporters who receive U.S. dollars to turn them over to the Central Bank. (This is how China built its $3 trillion in reserves). Citizens can’t take it out of the country. It isn’t accepted as legal tender anywhere outside of China.
The other problem with the yuan or Renminbi is that it’ll be a long, long time before China allows its currency to float freely. China built its entire system on tightly controlling their currency’s value. If the currency strengthened 10% against the U.S. dollar in six months, millions of exporters already on razor-thin margins would go bust.
In addition, China’s weaknesses as a global safe haven are glaringly obvious. Two examples should suffice: All of its strategic industries are firmly in state hands and its judicial system is anything but independent. That shouldn’t instill much global confidence.
Next, I can’t top how Fraser Howie, a managing director at CLSA Asia-Pacific Markets, co-author of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, sums up China’s financial shell games:
“There’s an awful lot of money just going round and round from one pocket to another, giving the appearance of strength when it’s really not there.”
Finally, there’s the basic question of political stability and durable transparent institutions. We may see our political process as gridlock, but others see it as stability. Institutions like our independent judiciary, free speech and free press. Likewise, the smooth and transparent transfer of power after each election is reassuring to global investors.
A new book, Why Nations Fail by Daron Acemoglu and James A. Robinson, based on 15 years of original research, does an excellent job of getting to the core of why China’s present system and course isn’t sustainable.
The authors contend that countries such as China that lack inclusive and open political economic institutions eventually face roadblocks. Economic growth can be achieved by “extracting” profits for some time, but eventually radical reform is necessary to achieve long-term success.
So go ahead and diversify your global portfolio with the Swiss franc, through the CurrencyShares Swiss Franc Trust (NYSEARCA:FXF), or the Australian dollar, through the CurrencyShares Australian Dollar Trust (NYSEARCA:FXA), but I would avoid the WisdomTree Dreyfus Chinese Yuan ETF (NYSEARCA:CYB).
Just don’t go overboard. You’ll likely get crushed by a snapback in the U.S. dollar.
Related: (NYSEARCA:GLD), (NYSEARCA:UUP)