The U.S. share of a leading index of global equities is now around 70 percent. That is significantly above the dollar’s share of global reserves, now around 58 percent.
The dollar share of the portfolio of Taiwan’s huge life insurance industry is thought to be north of 80 percent. That is significantly above the dollar’s share of China’s reserves. That last disclosed number, from 2018, was 55 percent—and my own tracking doesn’t suggest a significant change since then.*
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All these numbers call into question the incredibly widespread notion that the “bid” for dollars in recent years is somehow tied to the dollar’s status as the world’s leading reserve currency.***
The actual data—from both the main creditor countries and the U.S.—is quite consistent here: it shows that the flow into dollar assets in the last few years has largely come from private investors seeking yield, not state investors who are compelled to hold safe assets.
That’s true of Asia. Look at a chart of cumulative reserve flows from the balance of payments against the cumulative current account surplus of the largest East Asian surplus economies, setting aside the city-state financial centers.
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Reserves tracked the current account surplus almost perfectly until 2014, but have subsequently fallen well short. Portfolio outflows have made up the gap. Portfolio investors in principal are private, though in practice lines are blurred (China’s China Investment Corporation and the State Commercial Banks, Korea’s National Pension Service, Japan’s Government Pension Investment Fund and Post Bank). But most portfolio investors aren’t compelled to only hold “safe” and liquid assets (that is assets with low risk of default).
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The outward flow from Japan has long included a significant flow from investors other than the Ministry of Finance, The shift in the composition of outflows away from reserves is thus especially pronounced if Japan is left out of the data
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And if the analysis is extended to Europe, the same conclusion holdings. Reserve related outflows never were the main counterpart to the euro area’s external surplus. The main outflow has long come from European institutional investors and banks looking for yield in fixed income markets abroad. That said, the fit between gross portfolio outflows and the current account is correlation as much as causation: the euro area at times has attracted portfolio inflows, so the net outflow isn’t the same as the gross outflow; and there are also import flows of foreign direct investment (heavily distorted by tax consideration though, alas; see Philip Lane)
Cumulative reserve flows into the U.S. have tailed off as the U.S. economy emerged from the great recession ahead of Europe and Japan.
Seeking Safety or Seeking “Exceptional” Returns?
The U.S. exceptionalism argument—namely that U.S. markets offer financial returns exceeding those of the returns on offer elsewhere, and thus a concentration in U.S. financial assets makes sense—sometimes gets rolled together with the argument that the dollar gets inflows because its of being the world’s top currency. But they are conceptually distinct claims. The “reserve currency flow” is, in theory, not a function of returns; the U.S. exceptionalism argument is directly tied to financial returns.
They also illuminate what I consider to be an important debate. Namely, how to measure the impact of the dollar’s global role on U.S. financial markets, and implicitly, how to think about the channels through which the flows tied to the dollar’s broad global use (public and private) impact U.S. financial markets.
One approach, which I don’t especially like, focuses on the dollar’s share of global reserves and, to a lesser degree, other measures of the dollar’s global use in private trade settlement and private financial transactions.
This approach suggests that foreign demand for safe dollar assets is not determined by the actual growth in dollar reserves—and thus the dollar’s “reserve” status is tied to current flows into the dollar, even in the absence of significant dollar reserve growth.
This approach is incidentally very commonly used, including by sophisticated actors. It is, among other things, embedded in the model the IMF uses for its “external balance assessment.”***
The second approach focuses on the actual scale of dollar reserve accumulation (it could be extended to include a measure of private demand for safe dollar assets).
Dollar reserve growth needs to be estimated historically, as the currency composition of a significant share of the global reserve portfolio wasn’t disclosed before 2015. But there is not strong evidence that extending the dollar’s share of total reserves across the entire reserve stock generates a misleading result (it slightly underestimates dollar reserves from 2005 to 2010, back when China’s dollar reserve share was higher, but when I tried doing this formally, the juice wasn’t worth the squeeze).
The nice thing about the two approaches is that they yield different predictions about the impact of the dollar’s reserve role on current demand for financial assets.
Dollar reserve share
The first view says, more or less, that “dollar dominance” of global reserves continues. The dollar’s reserve share hasn’t changed much over the last ten years. China’s big diversification occurred between 2005 and 2014 (so before it entered into the IMF data set), and thus the dollar’s role as the leading reserve currency helps explain both continued dollar strength and ongoing foreign demand for U.S. bonds.
Flows from dollar reserve accumulation
The second view, by contrast, says that reserve-related inflows and the associated yield-insensitive bid for safe dollar assets only really has an impact during periods of rapid reserve accumulation. And since there hasn’t been much recent reserve accumulation, it attributes the current financing of the U.S. current account deficit less to the dollar’s reserve role and more to private investors belief in U.S. exceptionalism.
One component of that is the view that well, U.S. tech stocks only go up—and that successful investors should never bet against the U.S. digital gains and thus should investors basically be bullish the dollar even as elevated valuations.****
The other is the view that the dollar offers better returns than other fixed income markets, and that “U.S. exceptionalism” makes it safe to hold dollar bonds unhedged for the yield pickup even as conventional measures of exchange rate risk are elevated (one thing most market FX analysts agree on is that the dollar ain’t cheap; European visitors to the U.S. generally have the same view).
It is worth remembering that the United States funding costs aren’t currently low compared to the other reserve currencies, which calls into question large and time insensitive estimates of the impact of “dollar dominance” on U.S. yields. 10-year U.S. Treasury rates are close to 4.5 percent; 10-year German bund rates are 2.5 percent; 10-year Chinese government bonds yield less than 2 percent and 10-year JGB rates are around 1.5 percent.*** Dollar deposits pay around 4 percent, more than euro, yen, or yuan deposits.
A related argument is that the dollar itself offsets a bit of insurance against really bad investment outcomes, as the dollar tends to appreciate in bad states of the world. U.S. assets thus offer, or so the argument goes, better returns in normal states of the world and better protection, because of the dollar’s unique role as a safe haven in times of stress, from bad states of the worlds. In other words, why hedge?
But in a world where the U.S, is pulling in funds from the surplus regions because dollar-denominated bonds offer superior returns to their domestic bond markets, the argument that the dollar’s reserve currency status lowers U.S. funding costs thus has to rest on more than a simple look at U.S. rates relative to the rates of other potential reserve currencies.
The U.S. Treasury does, of course, offer unparallel scale—there are just way more Treasury bonds than bunds or JGBs available in the private market or, for that matter, CGBs.
I do think that matters for some big investors—trillion-dollar reserve portfolios are much more easily accommodated in the Treasury market than in the bund market, or the CGB market. Of course at times it can risk cutting the other way: investors looking to sell out of their existing Treasury portfolio could compete with the Treasury and its need to sell new bonds to finance the United States’ large fiscal deficit.
And there are network effects; Treasuries are liquid because they are widely traded, and that makes them more attractive (at least until the U.S. saturates the market, widely traded assets that trend down aren’t that attractive). The arguments that there is a convenience premium built into the Treasury market make sense to me, though it may be a bit state-contingent and its size and persistence is debated.
A related argument focuses on the “flow” of dollar reserves relative to the available supply of safe assets. I am a big fan of thinking about reserve-related flows in this way.
But there are, of course, ambiguities on both sides of the ledger: one reason why reserve growth has slowed is that key players have accumulated foreign assets in other state accounts, and the supply of reserve assets is somewhat elastic simply by virtue of the fact that the definition of a safe asset is somewhat elastic (U.S. Agencies were quite widely held in reserve portfolios prior to the global financial crisis, and were considered quite safe; euro area government bond yields converged before the euro area crisis).
I think most estimates of the flow impact of reserve accumulation suggest a percentage point of foreign reserve demand for U.S. bonds reduces U.S. borrowing costs (either on the 5-year or the 10-year) by 15-30 basis points. That is, for reasons I don’t fully understand, a bit larger than the estimated impact of a central bank buying its own assets (most estimates of the flow impact of QE find an impact or more like 5 basis points for a percentage point of central bank purchases).****
Such models suggest that the dollar’s “reserve currency role” is currently having an unusually small impact on U.S. borrowing costs and U.S. financial markets as, well, reserve growth has been modest and bond inflows no longer correlate with reserve growth.
Another approach, which looks at total dollar reserve holdings versus stock of outstanding U.S. safe assets, actually suggests that the impact of dollar reserves on U.S. market is falling, as foreign holdings of dollar reserves are falling both as a share of U.S. GDP and as a share of the Treasury market.
Both approaches still point to certain risks if the dollar were to suddenly lose its appeal as a reserve asset.
If purchases matter, so do sales, and there is a difference between a passive fall in dollar reserve holdings as a share of the market and an active one.
Both 2008, when central bank sales of Agencies disrupted the Agency market, and 2020, when central bank sales of treasuries triggered a Treasury sell-off (and an unwind of a portion of the basis trade), highlight how large central bank sales can be disruptive at times.
But there is, in my view, a bit too much mythologizing about the dollar’s reserve currency role—and a bit too little attention paid to actual dynamics around dollar reserves.
I think Professor Krugman would largely agree, I certainly strongly agree with his January post.
All this matters of course for the debate over the right size of the U.S. fiscal deficit going forward; the U.S. shouldn’t count on large ongoing flows from reserve managers who basically are compelled to hold a large share of their total assets in dollars. China has gone to great lengths to avoid adding to its Treasury portfolio over the last fifteen years, and it now accounts for the lion’s share of the global current account surplus (correctly measured). And it matters for global markets: if the flow into the U.S. has been driven by a search for exceptional returns — or at least higher returns than available in the large savings glut economies of Asia — there is no particular reason to expect that the dollar will continue to offer exceptional protection in bad states of the world.*****
“Risk” assets don’t usually rally in bad states of the world. That may be relevant if July 9th turns into “judgement” day, and President Trump decides to unilaterally set new out a new tariff schedule for all the countries around the world that haven’t struck a new Trump II trade deal.
* The exact number depends on two unknowns—the share of the foreign assets of China’s banks that enters into the U.S. data, and the scale of China’s dollar holdings held in European custodians.
** This view is shared by senior U.S. bankers, many European investors and policy makers, most geopolitical strategists, President Trump (it seems) and conspiracy theorists on “X.”
*** The reserves variable that enters into the IMF model is the share of the dollar or the euro in global reserve holdings, it doesn’t interact with the scale of reserve growth, so it basically has served as a static upward adjustment in the U.S. current account norm for most of the last twenty years. It thus implicitly suggests that flows into the U.S. are tied to the dollar’s status (its reserve share), not to actual reserve-related flows
*** 10-year Korean rates are 2.8 percent, 10-year Taiwanese rates are 1.5 percent,
**** These all rely implicitly on portfolio balance models, and assume that financial markets aren’t perfectly frictionless, and that various investors have their natural habitats in different parts of the bond market and thus a strong bid for “safe” assets from reserve managers can push private investors out of the market and into riskier assets.
***** The dollar’s rally in 2008 is generally misunderstood. The dollar rallied for the same reasons the yen rallied, namely it was a “funding” currency for pre-global financial crisis carry trades. Foreign investors actually pulled money out of U.S. bond markets (though the crisis was characterized by a flight out of risky bonds to safe bonds, and at the time Treasuries were safe) — foreign investors actually reduced their U.S. exposure. The dollar rallied because U.S. funds that had been lent out to finance various carry trades came home amid a generalized reversal of capital flows. See this blog.
