It wasn’t the least unexpected thing that ever happened. Barcelona’s winning the football Champion’s League was probably more of a foregone conclusion. So was Andy Murray’s crashing out of Wimbledon in the semi-finals. Still, the decision by the ratings agency Standard & Poor’s (S&P) to strip the United States of its triple-A rating can hardly have come as a great surprise to anyone.
The US had been looking less and less creditworthy for years. Japan lost its triple-A rating years earlier. There was no real reason why the debt-addicted US should hold onto the top investment grade much longer. The real issue was when it would get downgraded, not if it would. So the short-term panic around the move can be safely ignored. The market responded in its usual bonkers way, hammering the price of equities, and moving instead into US Treasury bills. In fact, anyone thinking straight would have been moving in precisely the other direction. The message of the downgrade was that the debts of cash-strapped governments looked a lot less attractive, while cash-rich corporations looked a better bet. But in the middle of a panic, markets rarely move rationally. It is the medium term that matters. And the medium-term message of S&P’s decision is that the dollar cannot survive much longer as the world’s reserve currency. But after the dollar, what comes next precisely?
The dollar has, of course, been in decline for a long time. When it became the world’s reserve currency, the US was overwhelmingly the dominant economic power. That is no longer true. A decade ago, the dollar accounted for 72% of global currency reserves. That is now down to 60%. Once it gets below 50%, the dollar’s reign as a reserve currency can officially be declared over. Indeed, a recent UBS survey of asset managers found that a majority, for the first time, no longer think the American currency will have a dominant role in a quarter of a century. It is unlikely they will have to wait that long. It’s what will replace it that matters. The dollar’s central place in the financial system meant the US could borrow more cheaply than it otherwise could. Everyone had to hold some proportion of their assets in the reserve currency, both to facilitate trade, and to preserve wealth. The dollar, and by extension all American assets, were more valuable than they otherwise would have been for the last 50 years simply because of the currency’s reserve status. So it follows that whatever replaces it will steadily appreciate in price. But what take its place?
We can safely discount the euro, even though one of the objectives of its founders was to challenge the dollar’s role. The single currency is besieged on all sides. The Iraqi dinar has more chance of replacing the dollar than the euro does right now. In fact, the euro is heading for a break-up.
How about the IMF’s special drawing right (SDR)? In the view of the asset managers surveyed by UBS, the majority view is now that the SDR will take up the dollar’s role. But it is a complete non-starter. The SDR is made up of four currencies – dollar, euro, pound and yen – all of which look like rubbish, rather than just one currency that looks like rubbish. It is hardly an improvement. The IMF isn’t even a government, and the French political establishment – not exactly a group of people known for their fiscal rectitude – appear to have a permanent lock on its management. So it’s no better than the dollar – and probably even worse.
Gold has a much better claim, which is why it has been soaring in price for most of the last decade. But the gold standard had all sorts of problems. It was prone to constant revaluations as countries struggled to stay within its disciplines. It rarely survived a major war. It may well have fuelled booms and busts – although the dollar standard of the last 40 years can hardly be claimed to have done a better job of calming those. Still, it is hard to believe a system that only just worked in the far simpler economy of the 19th century is going to work in the more complex one of the 21st.
What about the yuan? There is a good case to be made. Historically, the currency of the world’s biggest economy has been the reserve currency – that was true of the pound and then the dollar. China runs a big trade surplus and its savers increasingly finance the world already. The trouble is, the yuan is not even fully convertible, and China is hardly politically stable. The dollar ticked both those boxes when it took over from the pound. The yuan doesn’t tick either – although it may by 2015.
Perhaps the most interesting possibility is a new type of currency unit made up of a basket of commodities – say oil, gold, iron ore and rice. A basket of the most basic commodities would provide a much more reliable store of long-term value than a paper currency backed only by the rather shaky promises of the US government. And it would be a lot more broadly based than a system depending only on gold. A basket of commodities would certainly make more sense than a basket of paper currencies, such as the SDR.
So which will win? The most plausible candidates are the yuan and a commodity-based currency. So investors should be increasing their exposure to both China and basic raw materials. China’s economy could easily turn down, and commodity prices will come under pressure if global growth slows. But if either becomes a reserve currency, they will beat other assets over the medium term.
• This article was originally published in MoneyWeek magazine issue number 550 on 12 August 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.