Investors' Outlook June 2018

Investor Outlooks , Multi Asset 6/1/2018 by Christophe Bernard
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The dollar remains America’s “exorbitant privilege”

It was Valéry Giscard d'Estaing, finance minister of France, that supposedly coined the term in 1964. At that time, President Charles De Gaulle outlined the meaning of this expression at a press conference in February 1965: "The fact that many countries, as a matter of principle, accept U.S. dollars just as they would accept gold for the settlement of the differences that exist to their profit in the U.S. balance of payment, pushes the Americans toward borrowing, and borrowing for free, from foreigners. Because what they owe them, they pay – or at least parts of it – with dollars they can print at will."

Soon after that, de Gaulle instructed the Banque de France to convert U.S. dollars gained from the bilateral trade surplus into gold. Germany followed suit and eventually, as the financing needs of America rose – not least due to the Vietnam war efforts – the U.S. administration unilaterally abandoned the convertibility of the U.S. dollar in August 1971, for fear of seeing a depletion of the U.S. central bank's gold reserves. Since then, there has been no independent anchor to monetary creation, and it is no surprise that indebtedness has structurally surged everywhere, at a growth rate well in excess of economic growth.

So why is the U.S. dollar still dominant in global trade (64 percent market share) and central bank reserves (62 percent share of reserves)?

Clearly, the United States is the paragon of the liberal world order, has stable and strong institutions and disposes of the prime military might. Taken together, these attributes usually ensure a currency's pre-eminence. Moreover, a deep, liquid financial market supports the greenback's global dominance. The "dollar privilege" helps eliminate foreign-exchange risk for U.S. economic agents and allows for cheap financing. The latter point is a significant advantage as the U.S. exhibits a structural current-account deficit.

Over the past two decades, another "privilege" has been the extension of U.S. law beyond America's borders. If a company uses U.S. dollars for business or clearing purposes (basically any multinational company), it automatically becomes a potential target of the American justice system. As the U.S. market is the largest and access to dollar liquidity is often a matter of life or death, companies usually follow U.S. rules or sanctions. The fines collected from companies in breach have brought the U.S. Treasury tens of billions of U.S. dollars over the past ten years. A great "privilege" indeed for America – but also a rising source of frustration for both friend and foe.

However, the behavior of the Trump administration is undermining two key pillars of dollar dominance: on the one hand, it destabilizes the global trade order that took decades to build. On the other hand, America's military assistance to allies under the NATO framework is being questioned. Finally, the aggressive use of the U.S. dollar to project U.S. interests on a global scale (as the Russian aluminum producer Rusal and the Chinese telecommunication provider ZTE, for instance, have realized) is likely to sow the seeds of its own demise, as the rest of the world indeed considers this privilege "exorbitant".

At the same time, the U.S. administration is cutting taxes and ramping up spending to levels which will lead to a budget deficit in excess of 5 percent of GDP for years to come. With the current account remaining in deficit to the tune of 3 percent of GDP, the so called twin-deficit put the dollar in the vicinity of countries whose currencies are weak, or very weak (see chart 1).

Price of gold and the U.S. dollar after breakdown of Bretton Woods, 1971–1981

Source: Thomson Reuters Datastream, Vontobel

In conclusion we strongly believe that a major crisis of confidence in the U.S. dollar will unfold at some stage. Although we overweight the U.S. dollar at the moment, on record interest rate differential to the euro, an economic soft patch in the euro zone and a full-blown political crisis in Italy, we will be closely watching the markets for this potential watershed event that would have far-reaching consequences for portfolio construction. It goes without saying that gold will most probably provide effective diversification if a dollar crisis unfolds (see chart 2).

Expansion of the budget deficit brings the USA close to emerging countries such as India or Turkey

Source: IMF, Vontobel


Investors' Outlook