While the world changes at a rapid pace, the U.S. dollar is still used to settle a majority of global trade in 2012. In the 1960s, global leaders took to calling it our nation’s “exorbitant privilege,” and it most certainly is. Dollars can be used internationally to buy all the basic commodities that fuel economic activity.
Dollars don't come easy for other countries, however. Countries need developed economies that can produce exports to sell into foreign markets. By selling goods to countries that have dollars, an exporter can build up enough reserves to buy basic necessities, like oil from Saudi Arabia. If for some reason a country can't get dollars, they must pay much higher prices for imports, which could inflict significant damage on their economy.
The Asian Financial Crisis of the late 1990s saw a number of dynamic economies brought to their knees as they were drained of foreign exchange reserves. China adamantly wants to avoid that experience. They embarked on a decade long policy of expanding exports and earning money from the rest of the world. Today China holds a war chest of $1.7 trillion dollars in the form of Treasury securities. They are vulnerable if the dollar or Treasuries should fall, but even a depreciated dollar can still buy almost anything anywhere.
U.S. policymakers express concern over this dollar horde, fretting that China has too much leverage over the American economy. Any such fears underestimate the power inherent in the “exorbitant privilege.”
So enter The Society for Worldwide Interbank Financial Telecommunication (SWIFT). Most international transactions between financial institutions require a SWIFT code, otherwise the money can't go anywhere. With Iran, Western nations are showing that a large pot of foreign exchange reserves can be rendered useless. Not only did they remove Iran from the SWIFT system on March 15th of this year, but they also put out notice that any international bank doing business with Iran will also be removed from the system.
It is not too dramatic to call this open economic warfare with the Western banking system (and the U.S. dollar by extension) as the weapon of choice. China is right to be concerned that their dollar holdings no longer offer a protective economic buffer. There is one path that can mitigate risks of the dollar being used as a weapon against them: making their currency, the yuan, an internationally-traded currency. China does so much business with so many growing countries that a tradeable yuan is a foregone conclusion in all but the timing.
In September 2011, Chinese officials declared that in four years the yuan could be used to purchase international goods and services. The dollar now serves as a middleman between China and their trading partners. If that goal is met then cutting out the middleman will lower transaction costs for emerging markets and China. Sometime before then a shift to higher allocation in emerging market stocks will be worthwhile, though that could still be several years off. It will be important for prudent investors to stay alert to these global currency shifts.
As the dollar's role in international trade declines, the dollars sitting in accounts will gradually be worth less. It is not to say the dollar will go in a straight line down. But it does mean that times when the dollar is strengthening will be good for putting cash to work. Wealth preservation and income generation should be at the forefront for investors.
Broadly, the U.S. stock markets have outperformed international stock markets since the 2008 crash. Asset allocations favoring the U.S. have worked in investors’ favor. A part of this has been large foreign investors wanting to get into the U.S. market during uncertain times in the world. But the dollar as a flight to safety trade won’t last forever.
This massive shift of global economic forces is happening gradually, yet faster than anyone a few years ago would have imagined. The impact will be felt over time by American investors in ways that are barely noticeable on a day to day basis. Yet one can and should prepare for how the world will look years down the road when the Chinese yuan inevitably succeeds in becoming an internationally tradeable currency.
Emily Sanders is Chairman & CEO of Sanders Financial Management. She graduated magna cum laude from the University of Pennsylvania with a bachelor's of arts degree in international economics and from New York University with a master's of business administration in accounting. She is a Certified Public Accountant (CPA) and a Certified Cash Manager (CCM), as well as NASD Series 2 and 65 licensed. Ms. Sanders is the firm's chief investment officer.
Prior to founding Sanders Financial Management, Inc., Ms. Sanders served as assistant treasurer at BellSouth Corp. for nine years where she and her staff of 14 managed $1 billion in corporate and pension fixed income investments, as well as the international finance group handling foreign exchange, mergers and acquisitions and global banking.