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Commentary: U.S. isolationism casts cloud over dollar's reserve currency dominance

LONDON (Reuters) - The share of central banks’ FX reserves held in dollars has fallen since Donald Trump was elected U.S. president, in large part due to exchange rate valuation changes. But U.S. isolationism on the global stage could hasten that decline.

U.S. President Donald Trump speaks at a Make America Great Again rally at the Civic Center in Charleston, West Virginia, August 21, 2018

As the Trump administration doubles down on its “America First” stance with its trade wars, currency wars, and deepening geopolitical rifts that could threaten actual wars, foreign central banks may be encouraged to reduce their dollar exposure.

Some countries, like Iran, Russia and Turkey, are already looking at ways of reducing their dependence on dollars, in part to avoid punitive U.S. sanctions via restrictions on their use of the global reserve currency.

Bluntly put, some countries fear the United States is using the dollar’s reserve currency status as a stick to beat them with.

Global reserve currency status requires four things: size, stability, security, and liquidity. No other currency comes close to ticking all four boxes like the dollar, and it has been the world’s reserve currency of choice for over 50 years.

It is on one side of 88 percent of all foreign exchange trades, according to the Bank for International Settlements, and is the currency in which internationally-traded commodities like oil, metals and gold are typically denominated. Analysts estimate over 80 pct of traded oil is priced in dollars.

But its omnipotence is not permanent.

Barry Eichengreen, professor of economics at the University of California, Berkeley, and a recognised authority on central banks and international reserves, outlines a scenario where the dollar’s long-heralded decline gathers momentum.

He suggests the catalyst could be fraying diplomatic and military ties between the United States and its allies. Eichengreen estimates that the loss of the dollar’s “security premium” could result in a 30 percentage point reduction in its share of reserves held by U.S.-dependent states.

That’s a lot of dollar-deniominated assets, potentially $750 billion or more, up for sale if the United States continues down its isolationist path. And that’s just from Washington’s allies, never mind countries with more natural antipathy towards the United States.


International Monetary Fund data show that global reserves rose 8 pct to $11.59 trillion at the end of March from $10.71 trillion at the end of December 2016, just weeks after Trump was elected. Reserves are now approaching the record $11.98 trillion reached in 2014.

But the share of global FX reserves held in dollars fell to 62.48 pct in Q1 this year, the lowest in over four years and down from 65.34 pct in Q4 2016. Currency analysts estimate that much of that was down to the dollar’s 12 pct decline over the period.

U.S. Treasury figures last week showed that Japan, the world’s second largest holder of Treasuries, cut the amount of U.S. government debt it is holding to $1.03 trillion in June, the lowest level since 2011.

Japan, of course, is not an enemy of the United States - at least not yet - although the prospect of a trade war between Washington and any of its allies can now no longer be dismissed.

There’s no shortage of countries with far more fractious political and economic ties with Washington that won’t need much encouragement to reduce their dollar exposure.

Think Iran, a long-standing U.S. adversary which has been invoicing part of its oil exports in currencies other than the dollar for years; Russia, which is subject to heavy U.S. sanctions, and China, which is facing tariffs on an increasing share of its U.S.-bound exports as high as 25 pct.

Turkey too. Its economy is sure to suffer from the recent currency collapse, a crisis exacerbated by Washington slapping duties on U.S.-bound metal shipments. Relations between presidents Trump and Erdogan are deteriorating rapidly.

The pushback against the greenback may be gathering momentum. China, the United States’ largest creditor, in January launched yuan crude oil futures which could eventually become a global price benchmark alongside Brent and WTI crude.

That said, a pre-requisite would be liberalising China’s capital account to allow the free movement of money. Gulf oil producers peg their currencies to the dollar and would face exchange rate risks by invoicing sales in other currencies.

So big changes to central banks’ FX reserve holdings won’t happen quickly. In the world of reserve management, they never do. But there’s reason to believe that the dollar’s long reign as global FX reserve king may be more vulnerable now than it has for decades.

-- The opinions expressed here are those of the author, a columnist for Reuters --

Reporting by Jamie McGeever; Editing by Kirsten Donovan