Capital Rules Everything Around Me: The Making of a Reserve Currency
Capital Rules Everything Around Me
Part One: The Making of a Reserve Currency
There can be a lot of misunderstandings about what qualifies a particular currency—in this case, the US dollar—as a global reserve currency. In the last few years, financial and mainstream news media have kicked this subject around with the supposed rise of the BRICS trading bloc and rumoured decline in the petrodollar system.
I contend that this discourse misses the mark. Global reserve status is all about capital, and the US dollar (USD) sits at the centre of global capital markets.
Forget Trade – Capital Rules. Everything. Around. Me.
US President Donald Trump has identified international trade imbalances as the central issue for the global economy. Arguably, though, that the US imports more than it exports is an immaterial component of the cross-border capital flows that support the USD, and secondarily, the US treasury market.
Source: BIS Quarterly Review, December 2022, by Mathias Drehmann and Vladyslav Sushko
The reality is that trade flows are small relative to daily foreign exchange turnover which is now over $7.5 trillion, with less than 2% directly tied to trade.
The rest? It’s capital: cross-border investment, funding, and speculation.
Dollars & Debt
Like the British pound before it, the US dollar’s preeminence is secured by its role in global capital markets and the emergence of an offshore market of debt, with deposits denominated in USD – the eurodollar system. While this came in fits and starts, with the pound dominating again in the 1920s and 1930s, the US dollar has been domininant since 1944 and post WWII.
As noted in the BIS Quarterly Review: December 05, 2022, and illustrated in the chart below “The USD was involved in nearly 90% of global FX transactions, making it the single most traded currency in the FX market.”
Source: BIS Quarterly Review: December 05 2022: Revisiting the international role of the US dollar by Bafundi Maronoti
Structurally, most cross-border investment flows are denominated in dollars. The perceived reliability of American institutions and courts make foreigners more likely to transact in dollar-denominated financial assets or issue credit in dollars.
The depth of the US treasury market and federal debt facilitated this as global actors can easily recycle and store their cross-border receipts and investments in US government debt markets, with low transaction costs and low risks. In essence, US government fiscal deficits played a key role in cementing the USD as a global reserve currency.
This led to broader network effects as debt issuance, a growing financial market, and the attendant growth in debt and liquidity of the US financial markets led to the emergence of an offshore debt and deposit market in which the USD was the central financing currency.
In 2012, the ECB published a research paper on the displacement of the GBP by the USD as the global reserve currency in the inter- and post-war period. Here are some of their findings:
"Our empirical results point to the development of US financial markets as the main factor that helped the US dollar overcome sterling’s incumbency advantage.
“...We find that financial deepening was indeed the most important contributor to the increase in the share of the US dollar in global foreign public debt between 1918 and 1932. In the case of the UK, economic stagnation (i.e. declining relative economic size) was the most important factor accounting for sterling’s declining share over the period.”
I believe that the latter point is important because we live in an era where confidence in the USD system is eroding as some U.S. politicians seek to reverse policies that arguably helped make it the most powerful, prosperous and economically advanced economy. Those policies are being challenged by an effort to recapture low-skill manufacturing jobs that have been lost for decades through a combination of outsourcing and automation.
It’s not just currency – it’s credit.
In sum, the U.S. dollar is not the world’s dominant currency just because of trade, oil, or history. It is central because the global financial system is built on dollar-denominated credit. U.S. Treasuries are the foundation of global portfolios. Portfolio flows, not trade flows, are, this author submits, more important shapers of currency demand. And in times of both economic boom and bust, the world has tended to turn to the dollar—not because it wants to, but because it has to.
TINA – There Is No Alternative
For now, this dominance will continue until another nation or bloc can offer the world a capital market as deep, liquid, and trustworthy as the U.S.—complete with the legal, regulatory, and institutional support that underpins it.
The United States’ chief economic rival, China, doesn’t (yet) have a fully convertible currency or an open capital account that would allow the development of an offshore Yuan- denominated credit market that would attract and act as a store of value for global capital flows.
The only two realistic alternatives to the USD are the Japanese Yen and Euro. Counterintuitively, the recent choice of EU politicians to let go of their death grip on austerity, a policy that has choked economic growth, actually increases the attractiveness of the euro as a global reserve currency.
The accounting is simple: one person’s debt is another one’s asset. If you want a global reserve currency, investors need to be able to fund, invest, trade and save in your currency.
For now, the US dollar is still the only global currency they can easily do that in.
Read the previous article in the series: Momentum and Behavioural Finance
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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