A new report from Vontobel and Eurasia Group suggests that there could be an erosion of the US dollar’s reserve currency status as geopolitical tensions between America and China continue.
The paper, titled The Next Digital Superpower: Scenarios for the US-China conflict and implications for the global economy, argues that the current US-China trade war is actually symptomatic of a broader struggle for digital supremacy between the two countries, and that this could have implications for the currency markets.
Although one of the more positive scenarios outlined by the report envisages a new trade agreement between the US and China, with the latter subsequently becoming more integrated into the global economy, given that the trade war itself is the result of a wider conflict between the two countries, it is deemed to be one of the less likely outcomes that might occur.
More probable, according to the report, is that even if the tariff escalation is halted then this conflict will simply move elsewhere – for example, Chinese companies might no longer be given access to technology in the US. One scenario outlined in the report could see the US rally a number of countries around it and force them to boycott products from China and the development of two separate 5G networks in the world, one used by the US and its allies and the other used by China and its allies.
“From a macro perspective, this scenario is not good for productivity globally and could lead to higher inflation. So lower equity and bond returns would probably be the very top-down results of this political scenario,” Sven Schubert, investment strategist director at Vontobel Asset Management, and one of the authors of the report, tells Profit & Loss.
He adds: “Productivity is important for currencies because if you have higher productivity growth, then you can afford currency appreciation because you can simply produce more goods with the same input costs.”
But in any of the scenarios outlined in the report, the importance of the renminbi (RMB) is set to increase, according to Schubert.
“In the positive scenarios as China becomes more integrated into the global financial markets, there is a high likelihood that the importance of its currency will increase. In the negative scenarios, we see the potential for growing importance of the renminbi in the Asia-Pacific region, particularly amongst allies of China or countries involved in the Belt and Road initiative,” he explains.
Amidst the growing importance of the RMB, the report also suggests that the US dollar might lose ground as the reserve currency of choice, although it explicitly notes that the former is not likely to replace the latter.
“While we are not arguing that the renminbi is likely to become the world’s leading currency, it is important to point out the likely effect that a shift from a hegemonic to a more bipolar order would have on currency markets. At the very least, there is likely to be some deterioration of US dollar market share of the denomination of trade contracts and debt market,” it says in the report.
The report backs up this claim by pointing to another example of where a shift away from a hegemonic world order leads to protectionist measures and a significant shift in the currency markets – during the demise of the British Empire.
Data highlighted in the report shows that the pound sterling–denominated share of global public debt dropped from 90% before World War I to below 40% in the 1940s, and that by the 1920s, the US dollar had already exceeded the share of sterling on a permanent basis.
“What you can see is that in the past, the shift towards a more bipolar world has triggered the falling importance of the major currency in the world,” says Schubert.
Again, Schubert says that although he expects the global use of RMB to continue growing, he doesn’t expect it to displace USD as the global reserve currency. Interestingly, he notes that the euro could grow in importance given that the strategic value of Europe could grow if the ongoing geopolitical struggle between the US and China continues.
“We see a scenario where both China and the US has an interest in getting Europe on their side. That puts Europe in quite an interesting position, and it could be similar to how Switzerland benefited during the Cold War from its policy of remaining neutral. So that’s something that we highlight in the paper, that if Europe plays its cards right they might benefit from this situation,” adds Schubert.
Of course, if the erosion of USD as the global reserve currency doesn’t happen because it’s being supplanted by RMB, this obviously begs the question of what will replace it. According to the report, the answer is that the USD’s lost market share is “likely to be supplanted by baskets of currency similar to the IMF’s Special Drawing Rights (SDR)”.