By Tim Cole
Barwon MDA
Investment and finance industry articles often seem to be primarily produced by marketing departments or spin doctors. It is quite a challenge for most of us to sort out truth from fiction at the best of times, let alone when we are bombarded by the likes of Industry Super Fund advertising and similar marketing posing as education.
I mention this as Australia looks to Asia for its future growth, as historically Australia has been focused on all things USD, JPY or GBP. I remind the reader that the premise of the GFIN Barwon MDA investment models is based on capital flow into and out of the US Dollar (USD). Despite impending free trading agreements (FTA) our financial markets are inextricably linked to the USD.
The USA has huge budget and current account deficits, but the world remains highly US dollar centric. Many international currencies are linked to it, and even when people question the AUD strength it is relative to the USD. Of 1,785 active commodities futures contracts, 1,133 are denominated in US dollars. Nearly 90% of the more than $5.3 trillion a day in foreign exchange transactions involve the USD, the same as 25 years ago. More than 80% of trade finance is done in USD, and 60% of foreign currency reserves of the world’s central banks are in USD.
Summarising, there are three good reasons the USD is not about to lose its status as the world’s reserve currency:
1. The greenback is the world’s safe haven. The U.S. government has a long history of honouring its obligations. Rightly or wrongly USA Treasury securities are regarded as the world’s safest investment, and the Federal Reserve is the world’s primary central bank.
2. The size of the market for USD denominated debt securities is unparalleled. No country’s bond markets offer comparable depth and transparency. Therefore, finance markets have thin bid/ask spreads, and large numbers of instruments to hedge USD exchange rate risk.
3. There are no realistic alternatives. What would replace the USD as the reserve currency? Certainly not the Euro, a political experiment between prosperous large countries and profligate smaller ones that still threaten to come apart at the seams. Not the Japanese Yen, the currency of a country that has fought a debilitating two decade fight with deflation and whose budget deficit as a percentage of GDP is more than twice as large as the USA. The Chinese Yuan is not easily tradable and is still government controlled. Switzerland with its Franc is an example of fiscal responsibility but its economy is too small.
Historically, global investors have flocked to the USD in times of crisis, and it’s easy to understand why. The United States is the world’s richest country and is the world’s largest economy and its share of global GDP is growing. Despite forecasts of growth in China and India economies no nation as yet seriously challenges the USA dominance.
During the market turmoil of 2008 the effects of this USD dominance was playing out before our eyes. Call it “risk on/risk off” or “flight to fantasy”, when things are rocky the USD is at the centre of the game.