There was a time not too long ago that the US Dollar was looked at as one of the most stable currencies in the world. In fact, foreign investors would flock to the US Dollar during times of instability in their own regions to have some semblance of safety.
Sadly, those days seem to be long gone. Nowadays, even US residents are actively looking for foreign currencies to diversify their holdings. We will look at why this is the case, how the US Dollar is different from when it was clearly the dominant world currency, and what’s next for the Dollar.
We will also explore the benefits and the risks of holding foreign currency as a US citizen and look at four currencies that could be a part of your portfolio if you do decide to go that route.
How the USD Became the Global Reserve Currency
After the first World War, the United States was arguably the strongest country in the world from a financial standpoint. As such, it began to lend money to nations that had been affected by the war. The borrowing only increased as time went on, maxing out during the second World War.
By 1944, the vast majority of the developed world owed large sums of money to the US. Although the nations had been using the Gold Standard until now, using it did not seem feasible anymore.
It was much easier to use a new economic system that would tether the currencies to the US Dollar, and the Dollar to gold. This is what was agreed upon at the Bretton Woods conference in 1944. This was also where the seeds for the IMF and World Bank were sown.
After this, the USD simply went from strength to strength. The US had by far the largest amount of gold in the world at that time and countries began to use it as a reserve currency as well as the main currency for world trade.
However, all of this began to change in the 1970s! With high inflation, countries began to demand gold back from the US so that they could stabilize their economy. President Nixon thought it better to take the US off the gold standard rather than deplete all their reserves.
Since then, the USD has been losing ground as the dominant world currency. While it still holds that title comfortably, Russia and China have begun making efforts to dethrone the USD as the global reserve currency by reducing their exposure, purchasing gold, and conducting trades in their own currencies rather than the Dollar.
|2016 Q1||2017 Q1||2018 Q1||2019 Q1||2020 Q1|
|Total Foreign Exchange Reserves||10,935,497.32||10,912,279.98||11,617,665.76||11,610,768.01||11,731,944.26|
|Shares of U.S. dollars||65.46%||64.69%||62.79%||61.73%||61.99%|
|Shares of euro||19.55%||19.28%||20.36%||20.27%||20.05%|
|Shares of Chinese renminbi||1.07%||1.40%||1.95%||2.02%|
|Shares of Japanese yen||3.68%||4.54%||4.59%||5.36%||5.70%|
|Shares of pounds sterling||4.63%||4.27%||4.67%||4.55%||4.43%|
|Shares of Australian dollars||1.72%||1.77%||1.70%||1.67%||1.55%|
|Shares of Canadian dollars||1.81%||1.90%||1.86%||1.91%||1.78%|
|Shares of Swiss francs||0.19%||0.17%||0.17%||0.14%||0.15%|
|Shares of other currencies||2.96%||2.32%||2.45%||2.42%||2.33%|
The share of the USD has been declining as a foreign reserve currency, whereas the Renminbi has been rising. Source: World Bank
What Makes a Currency Strong?
Before we dive into the specifics that may cause you to look at alternate currencies, let’s take a look at how the strength of a currency is determined.
Political and Economic Stability
This is something that should be quite self-explanatory. Countries with a stable economic and political environment usually end up becoming safe havens for investors whose own currency is riskier. Even in 2020, over 60% of the world’s reserves are in USD.
Not only that, but the US treasury securities are considered to be the safest investments in the entire world and are used as a benchmark against which the risk/return of other investments is compared.
Foreign Reserves and Trade
The amount of trading that a country does directly impacts the strength of its currency. For example, the vast majority of crude oil across the world is traded in USD. Because of this, countries need to maintain sufficient reserves of USD in order to be able to purchase crude oil when they require it.
The need to maintain reserves in a particular currency increases its demand, thereby increasing its price as well as strengthening it relative to other currencies. On top of this, it is in the interest of the countries that hold a particular currency as a reserve to prevent its value from plummeting.
As such, the vast majority of the world buys the USD during a crisis as upholding its value is as important for other countries as it is for the United States.
China, despite being in a trade war with the US, still has vested interests within the country. As such, even China would prefer to keep the USD strong, at least for a few more years.
Size of Economy
A currency is simply a representation of the economy of a particular country. Usually, the larger the economy, the stronger the currency. In 2017, the US had more than 24% of the entire world’s GDP. However, this number has been constantly decreasing as China and other countries catch up.
It is expected that the gap between the GDP of the US and China would reduce to less than $5 Trillion within the next 5 years. In fact, while the US has the strongest GDP in the world in nominal terms, China’s is actually much higher when you look at the GDP in terms of purchasing power parity. This is one of the reasons why investors are looking for alternatives to the USD.
Why is the USD Risky?
While we have already discussed some of the factors that make the USD risky heading into the future, let’s take a look at some of the other factors that are causing investors to worry about the Dollar’s role as a safe-haven investment.
- Since the Dollar is used as a reserve currency, the US often ends up bailing foreign institutions in order to protect its own interests. With the economy being fragile due to the pandemic, this could happen again very soon.
- The total government debt was almost $23 Trillion by 2019. The US is by far the most indebted nation on earth. This naturally leads to people being wary of the currency.
- The government further exacerbated this problem through its COVID-19 economic rescue package. The package will require the government to print trillions of dollars. With the government already deeply in debt, investors are skeptical as to the future of the Dollar.
- With other governments (especially in the Eastern hemisphere) moving away from the Dollar, alternative safe havens such as gold are beginning to seem much more attractive than ever before.
Benefits and Risks of Holding Foreign Currency
If you are an investor who plans to hold a significant portion of their wealth in cash, then you should definitely look at exploring foreign currency.
The biggest advantage is diversification. Chances are that you already own a lot of investments that are denominated in the Dollar. For example, you are already massively exposed to the Dollar if you own US stocks or treasury securities. If the dollar does end up going down, the value of all of these securities will go tumble downward with it.
There are a lot of currencies for you to choose from. However, the Chinese renminbi is probably not the safest option. For one, China is in a trade war with the USA. Despite the Dollar being riskier than ever before, it is still the strongest currency in the world, and the US government will probably retaliate with all their might to protect their interests.
There are a lot of other currencies that you can take a look at. These currencies will allow you to hedge against any political risks as well as any risks that may arise due to the triggering of a certain event. For example, COVID-19 hit the US much harder than the rest of the world. While the full impact of the pandemic on the Dollar is not apparent as of yet, investors who are properly hedged will obviously sleep better.
Let’s take a look at 4 currencies that are probably a good idea for investors looking to diversify their cash holdings.
1. Australian Dollar
The AUD is simultaneously similar and different to the USD. Australia, while not as strong economically as the US, is a developed country with an inherently stable political system. In fact, the AUD/USD pairing is one of the most common ones on forex platforms.
Obviously, we are not talking about forex trading here. Even as a safe haven, the Australian dollar has some clout. The AUD fell by quite a bit when the pandemic hit the world in full force. However, it has risen over 20% since its low point on 19th March.
The Australian government has a history of not intervening in the currency markets, stable but high-interest rates, and encouraging trade with its Asian neighbors. Being a country that is rich in natural resources including raw food produce, gold, and oil, Australia seems like a compelling investment. The higher interest rates should point to a higher return on capital, and the debt profile of the country is much better than that of the US!
Note: Australia currently has a record low interest-rate of 0.25%. However, we expect this to increase as life normalizes considering the stability of the country and the historical rates.
2. New Zealand Dollar
Institutions across the world are quick to dismiss New Zealand when it comes to investment opportunities due to its small size. The story for individual investors is quite different. Due to its small size and its efficient government, New Zealand is much better equipped to deal with a crisis. It is obvious from how efficiently it managed to defeat COVID-19.
Sadly, interest rates are at record lows in New Zealand right now so you should not expect a lot of returns. Traditionally, NZD has been thought of as a high-yield currency. Traders have used this currency a lot as a part of carry trades. This has led to the NZD being volatile during times of crisis.
This was more apparent than ever during the 2008 financial crisis. Volatility rose as global markets tumbled, causing the NZD to fall considerably more than similar currencies.
The New Zealand Dollar has always been volatile. It seems to perform especially worse during an economic crisis.
Throughout its history, the NZD has had a lot of ups and downs. As such, it is not an ideal currency for conservative investors. That said, it does hold its value quite well in the long run. Its strength usually relates to tourism and the price of milk (New Zealand is one of the largest exporters of milk worldwide). As such, the currency is a good idea for active investors looking for above-average returns.
3. Canadian Dollar
In many ways, the Canadian Dollar is the closest you can get to investing in the USD without actually investing in the US. Canada is another country with a currency that is considered stable. However, unlike the US whose stability seems to emerge from its currency being the global reserve, Canada’s stability seems to emerge from its stable economic policies.
Canada has been praised for its moderate approach to business, thus making it a favorable spot for companies looking to expand operations in the developed world. The currency has also been considered as a safe haven historically. When you couple this with the fact that it is the sixth most common reserve currency (increasing currently), you see why the CAD is a great currency to own.
However, do remember that the US economy also has a significant direct impact on the CAD. This is because the US and Canada are huge trading partners. Apart from this, the main way Canada makes money is through the export of commodities. As such, rising commodity prices usually lead to a stronger CAD and vice versa. Oil is perhaps the most important one, as we have seen it impact the currency not only in 2020 but also in 2015.
4. Swiss Franc
The last currency we are going to take a look at is the Swiss Franc. The CHF, along with Switzerland in general, is considered to be a safe haven by the entire world. This has been proven time and time again. We saw multiple European nations rush to Swiss banks to store their wealth in the form of Swiss Francs during the European Debt Crisis. Prior to that, we saw people forgo assets in the US and purchase Swiss ones during the financial crisis.
Swiss banks, institutions and companies are known for their secrecy as well as the deregulated nature in which they are run. On top of that, Switzerland has perhaps the most stable government in the entire world. A perfect example of this can be seen in the fact that they have stayed neutral for centuries, even through some of the largest conflicts in the world.
During the war, they have a strict policy of doing business with all the combatants, regardless of who they think is in the right. On top of this, Switzerland has one of the most formidable armies in the world, making sure that the invasion of the country to loot its wealth is not a possibility.
Its strong financial background makes the CHF and assets that are backed by the guarantee of the Swiss government as some of the safest in the world. If you are someone who is looking to preserve their wealth (or a portion of their wealth) in the event of a global economic crisis, then the Swiss Franc is definitely the way to go!
We just went through a few reasons why the USD may not be as safe as it once was. After that, we took a look at 4 alternative currencies that are similar to the Dollar in some regards but may allow you an appropriate amount of diversification.
If you are looking for a safe currency, then the Swiss Franc is obviously the best bet. The Australian and the Canadian Dollars are for people who want a currency which somewhat similar to the US Dollar, but they do not want exposure to the activities of the US government. The New Zealand Dollar, on the other hand, is probably best for activist investors looking to turn a significant profit through their cash holdings.