The only viable alternative asset for official reserves is physical gold, as it alone has the requisite liquidity, correlation characteristics, and trust.
Now, a working paper from the IMF3 has gone one stage further, tentatively identifying the formation of a RMB currency bloc, in addition to the dominant dollar reserve currency bloc and the euro currency bloc.
Excluding the RMB, the dollar bloc is clearly dominant in terms of GDP and usage. In terms of purchasing power parity (PPP), the dollar bloc accounted for about 60% of global GDP between 2011 and 2015. The euro accounted for 26%, sterling accounted for 7%, and the yen accounted for 5%.
If the RMB is included as a separate bloc, however, the world becomes much more multipolar. The dollar would account for 40% of global GDP, with the RMB at 30%, the euro at 20%, the yen at 5% and sterling at 3%. These figures suggest that the international monetary system (IMS) is already shifting from a bipolar focus on the dollar and the euro to a true, multipolar system.
PPP measures may overstate the influence of the RMB but there is little doubt that China is fast becoming the dominant economic force in today’s world. This has significant implications for the IMS and reserve currencies.
There are already signs that US debt levels have undermined the dollar’s status as the dominant reserve currency. The US is running a net investment liability to the rest of the world of around 40% of US GDP, financed by exceptionally low interest rates. This is increasingly unstable, particularly given that the euro- and RMB-bloc are both running current account surpluses.
As we move to a multipolar reserve currency system, therefore, certain steps will need to be taken to ensure the IMS remains fit for purpose. And gold could play an important role in this environment.
Today, the IMS relies on the dominance of the US dollar and the US has to run a current account deficit to supply the world with dollars. As we move to a multipolar system, that need should diminish. Ironically, however, the increasing importance of surplus economies, such as Europe, China and other Asian nations, has reinforced the dollar’s strength without alternative channels for surplus savings.
Among central banks, standard reserves portfolio management strategy calls for GDP or payment-weighted holdings of foreign exchange reserves. As the dollar accounts for 88% of all foreign exchange transactions, these surplus economies end up holding more dollars in their reserves, thus concentrating their risks in the dollar, rather than diversifying their risks.
The approach may seem short-sighted but it is perhaps inevitable, as there is no global central bank and no global fiscal policy. As a result, central banks and governments are forced to try and balance three, often conflicting, demands: portfolio management strategy, national risk management strategy, and global systemic stability.
This explains why dollar holdings in official reserves have remained at roughly two-thirds of global total official reserves. Capital flows from emerging markets to developed countries have occurred because central banks and private investors have sought the liquidity and superior credit ratings only offered by the dominant reserve currency markets.
The inherent weakness of this ‘non-system’ is clear, however, which may explain why many emerging market central banks are increasing their allocation to gold. It is liquid and has neither credit nor default risk.
The former chairman of the US Federal Reserve, Alan Greenspan, has explicitly recognised this, publicly stating that gold is the ultimate insurance policy. The value of fiat currencies depends on their credit rating, fiscal health, and government or central bank policies. Gold requires no counterparty signature, does not depend on national fiscal or economic policy and is therefore the most effective hedge against geo-political risk.
If gold is to fulfil its potential, countries with large current account surpluses need to play their part, recognising gold as a systemic and significant diversifier of global risk.
Cyber currencies do not offer an appropriate alternative. Created by anonymous data miners, without counterparties or central registration, they are highly volatile and can expose investors to fraud, manipulation, and theft. Gold, by contrast, has a unique and diverse demand profile that makes it an ideal portfolio diversifier and a potential safe haven asset.
The inescapable conclusion is that the only viable alternative asset for official reserves is physical gold, as it alone has the requisite liquidity, correlation characteristics, and trust. Central banks seeking true risk diversification or insurance, therefore, should increase their gold holdings.