Why BRICS Dropping the Dollar Isn’t a Threat to Its Supremacy

BRICS threat to us dollarThe BRICS countries (Brazil, Russia, India, China, and South Africa) are vying for an alternative to the U.S. dollar for financing and trade, upending the status quo and posing a threat to the American currency. But what exactly does this BRICS threat to the U.S. dollar mean for the reserve currency?

China is already the second-biggest economy globally, Brazil is in seventh place, and India is in tenth—the BRICS are the dominating countries of the developing world. And as many investors know, the strength of emerging economies coincides with currency strength. So, should the BRICS dropping the dollar have you bearish on the greenback?

Global Development Banks—the IMF and the AIIB—Square Off

Emerging economies are frustrated with static organizations like the International Monetary Fund (IMF), which is seen as solely promoting U.S. economic interests and the dollar. For example, the IMF executive board, which is responsible for critical decisions like lending to countries with debt imbalances, grants equivalent voting power to both Brazil, a $2.2-trillion economy, and Belgium, which has $500 million of gross domestic output. (Source: International Monetary Fund web site, last accessed April 14, 2015.)

Moreover, the U.S. holds 16.5% of the voting rights and can prevent any critical decision from passing, which requires an 85% majority. No wonder emerging economies like China are in the midst of establishing their own global economic organization aimed at servicing international trade and financing.

China’s Asian Infrastructure Investment Bank (AIIB), formally announced in October 2014, is a new development bank aimed at financing infrastructure projects across Asia. One of the impetuses for the AIIB was to support China’s New Silk Road, a trade network connecting the economic giant to rest of the world via routes through Europe, Russia, and the Middle East.

Another establishment dubbed the New Development Bank (NDB) is a joint effort between the BRICS to provide additional funding for infrastructure projects for the group of trading partners. The idea is to bridge the financing gaps of emerging market economies via the NDB’s participation in public and private projects through loans, guarantees, and equity stakes. The startup capital will total $50.0 billion, equally distributed among the founding member countries, growing to $100 billion.

U.S. dollar bears would point out that the U.S. is not a part of both development banks. In fact, according to some spectators, it’s vehemently opposed to them. Institutions like the IMF and World Bank, established in the post-WWII period, have been the traditional global economic watchdogs and lenders. Fast-forward to 2014 and China’s AIIB and the NDB, for BRICS member nations, are looking to circumvent the Bretton Woods agreement of 1944. But is the emergence of BRICS and international trade institutions really as much of a threat to the U.S. dollar as it’s made out be?

U.S. Dollar Borrowings on the Rise

Despite rising debt levels, fragile economics, and increasingly bipartisan institutions, the U.S. dollar continues to be the world’s reserve currency. The U.S. dollar, as a share of global foreign exchange holdings, is still above 60%, the same as it was in 2003. (Source: International Monetary Fund web site, last accessed April 14, 2015.) All the while, outstanding total U.S. public debt rose from $8.8 trillion in 2007 to $18.0 trillion in April of 2015. Buyers of the greenback clearly see no better alternatives.

A quick look around the globe reveals that much like the U.S., other nations are up to their eyeballs in debt as well. Debt-to-gross domestic product (GDP), as calculated by McKinsey & Company, stands at 400% for Japan, 382% for Singapore, 290% for Sweden, and 223% for the U.S. (Source: McKinsey & Company web site, last accessed April 14, 2015.)

So the world is borrowing and surely some of these countries have taken advantage of the stability of the U.S. dollar and rock bottom interest rates. In fact, they have. According to Bloomberg, sovereign and corporate borrowers outside the U.S. have amassed $9.0 trillion in dollar-denominated borrowings. (Source: Bloomberg, April 12, 2015.)

This accumulation of U.S. dollar-denominated debts will continue to serve as a boost to the demand for the greenback for the simple reason that debts have to be repaid in U.S. dollars. However, institutions and global central banks are also purchasing U.S. dollar-denominated securities, like Treasury securities, to hold as assets, further boosting the dollar.

Benefits of the U.S. Dollar

Dominance of the U.S. dollar as the reserve currency was not affected by the global financial crisis. For example, foreigners increased their holdings of U.S. financial assets from $1.0 trillion in 2000 to $5.6 trillion in 2013. (Source: International Monetary Fund web site, last accessed April 14, 2015.) So U.S. investments, and the resulting demand for U.S. dollars, have continued their uptrend. But why?

Clearly, there is a multitude of factors at play here. There’s more to it than just the cost of borrowing for debtors and the return on investment offered by U.S. Treasuries.

Perhaps post-financial crisis private sector securities, issued by multinationals, were seen as not safe—or at least not as safe as government bonds like U.S. Treasury securities.

Globalization could be part of the reason, as well.

Greater volatility in the flows of capital—money constantly crossing borders—could have increased the need for safe financial assets, ones that at least guarantee the return of the principal for investors. U.S. Treasuries have an added advantage of being highly liquid, easy to buy, and just as easy to sell.

Another argument, put forth by economists at the Bank of International Settlements (BIS), is that the economic output by countries whose domestic currency closely follows the dollar has risen. Think of China’s renminbi, which was pegged to the U.S. dollar until 2006, or the Canadian dollar, which closely follows its neighbor to the south.

For many nations, their domestic currency closely tracks the U.S. dollar. Therefore, the value of those nations’ output matches the level of domestic economic activity and the exchange rate. As a result, it makes sense for central banks to hold a large portion of their reserves in U.S. assets, whose value moves in lockstep with the domestic currency of most nations. (Source: International Monetary Fund web site, last accessed April 14, 2015.)

Another factor driving the demand for U.S. dollar-denominated assets is that alternative investment options are poor. And that is not about to change soon, as on Wednesday, April 8, the Swiss government announced a bond issuance with a negative yield—that is a negative return to its holders. This metric implies that the Swiss government is getting paid by investors to borrow. At least a five-year U.S. Treasury yields 1.3%. (Source: U.S. Department of the Treasury web site, last accessed April 14, 2015.)

BRICS Dumping the Dollar

Without doubt, there are major tailwinds powering the sails of the U.S. dollar, but isn’t the rise of the BRICS going to severely cut into that demand?

A currency, in its simplest economic sense, is a measure of a country’s economic vitality. Developing nations like China, Brazil, and India are sure to grow at higher rates than the developed world, resulting in the proportionate strengthening of their currencies.

The emergence of the BRICS will result in increased trade between those parties—trade and financing that will be transacted in currencies alternative to the dollar. However, this will not eliminate the strong demand for the U.S. dollar or its supremacy as the world’s top unit of exchange.

The reason, aside from the benefits of U.S. assets mentioned earlier, is that investments do not exist in a vacuum. Government bonds, for example U.S. Treasuries or Greece government bonds, are tied to the fortunes of that government and the institutions that underpin it. Foreign investors clearly have more faith in the Federal Reserve than, say, the Bank of Greece or the Central Bank of the Republic of China. Or maybe it’s just simpler, more liquid, and transparent to transact through U.S. dollars and invest in U.S. assets.

Reform and change on the international playing field is in full swing with the introduction of the AIIB and the NDB. However, don’t let this fool you into thinking that in the foreseeable future, the demand for and supremacy of the U.S. dollar will be significantly diminished.

If you are looking for a reason to be bearish on the U.S. dollar, the emergence of the BRICS nations and new institutions like the AIIB or the NDB aren’t the developments to be analyzed.