So, it’s official. The global rating agency S&P has determined that the Russian government has defaulted on part of its international debt. In itself, this is not as big a deal as it may sound. Nonetheless, the circumstances have revived concerns about the future of the US dollar as the reserve asset of choice for central banks around the world.
Russia is now judged to be in ‘selective default’ because it has attempted to repay holders of two US dollar-denominated bonds with Russian roubles. At the very least, this is a technical breach of the terms of the debt. It will also probably lead to some material losses for bondholders, even though the Russian currency has partially recovered from its initial collapse following the invasion of Ukraine.
This default does not really matter, for three main reasons. First, it is no surprise. The financial markets had seen it coming and already priced it in. Second, financial institutions have been reducing their exposure to Russia for a long time, especially after the invasion and illegal annexation of the Crimean Peninsula in 2014. Third, Russia is not a big player in international bond markets anyway. Years of huge energy surpluses mean that Russian foreign debt is relatively small and well covered by large reserves of foreign currency – if Russia can access them.
But this is where the wider angle comes in. The fact that western sanctions have made it harder for Russia to service its debts has led some to question whether other countries might go off the US dollar as a reserve asset.
Predictions of the dollar’s imminent demise as the world’s reserve currency have of course been around for decades – and they have consistently been proved wrong. For most of the 1970s, 1980s and 1990s, about 65 to 70 per cent of official reserves were held in US assets. This figure has since steadily declined but was still just under 60 per cent at the end of last year. What’s more, this is despite the relatively rapid growth of competing economies, notably China, and even the creation of a rival currency, namely the euro.
However, the fundamentals that made the US the reserve asset of choice have not really changed. The best way to think about this is to compare the dollar to the alternatives. For example, the US has a strong institutional framework, operating under the rule of law and with many constitutional checks and balances. It is therefore a much more predictable and safe place to invest than, say, China.
The US financial markets, including government bonds, are also relatively large and liquid. The same might be said of the euro, but it has never really taken off as a reserve asset. The share of the euro in global reserves is still only around 20 per cent, similar to where it was when the single currency was launched in 1999.That might change if the EU morphed into a successful fiscal, banking and political union (obviously, a big if). In the meantime, most investors do not see the euro as more than the sum of its parts, including the old deutschmark. China also falls down on the pool of available assets too. There is an awful long way to go before the Chinese government bond market could rival the US.
In the meantime, the share of global reserves held in renminbi (2.8 per cent in the final quarter of 2021) is still smaller than either the Japanese yen (5.6 per cent) or, wait for it, the mighty British pound (4.8 per cent). Indeed, many countries around the world still try to keep their own currencies stable against the US dollar, either with explicit pegs or some sort of managed arrangement. The ‘dollar zone’ is therefore much bigger than the US economy itself. You do not have to hold reserves in US dollars in order to defend a dollar peg. But the fact that so many economies are tied to the US dollar in some way reinforces its status as a reserve asset.
Finally, it is not obvious why the fallout from Russian sanctions should change this. It is possible that some dodgy regimes (perhaps China or in the Middle East) might be less comfortable holding money in US assets. But then, what is the alternative? The major developed countries are increasingly coordinating their policies, so moving reserves from the US to, say, the euro or sterling is unlikely to escape sanctions. Switching to renminbi assets might just swap one set of political risks for another, perhaps greater, and of course this is not an option for China itself.
In the long run, it does seem likely that the dollar’s share in global reserves will continue its gradual decline, with the euro and (increasingly) the renminbi as the main beneficiaries. However, this will happen at a glacial pace. In the meantime, whether the actual market value of the dollar is higher or lower in five or ten years time against currencies like the pound will continue to depend on the usual drivers, including relative economic growth, inflation and interest rates. Even during global crises, the US dollar remains a safe haven. Predictions of the imminent demise of the dollar’s dominance are therefore, as before, still somewhat premature.