Unpacking the U.S. Dollar’s Complicated Role As the Reserve Currency to Stabilize Markets
By MICHAEL PATON
The value of a nation’s currency (in this case the U.S. dollar) is determined simply by supply and demand for the currency. Supply and demand are influenced by a number of factors, including interest rates, inflation, capital flow and money supply. The most common method to value currency is through exchange rates traded globally. The 2022 Triennial Central Bank Survey from the Bank for International Settlements indicated that the U.S. dollar was bought or sold in about 88% of global currency transactions in April 2022. This share has remained stable over the past 20 years.
The value of the U.S. dollar has risen sharply in the second half of 2023, compared to currencies of many other countries, including the British pound, the Japanese yen and the euro. A stronger dollar sounds positive, like seeing results from all those hours you may have spent in the gym. However, currency markets are not weightlifting—and being strong may not be without negative consequences if you’re the dollar. In fact, it may be possible for the dollar to become too strong for its own good.
According to Fidelity Research, to understand why the dollar’s strength may not be an unquestionably good thing, it helps to understand how currencies are valued. The amount of a country’s currency that can be bought with a specific amount of another country’s currency always varies. Even countries with close economic and geographic ties such as Canada and the U.S. can see wide swings over time in how much a U.S. dollar buys in Toronto or what a Canadian dollar is worth in Key West, FL. Those fluctuating currency values reflect how much the governments, companies, banks and individual investors who buy and sell in global currency markets are willing to pay. Their views on the relative values of currencies mostly reflect where they believe they will get the best return on their investment.
Usually, if a country has relatively strong economic growth and low debt, its currency will be sought after in global markets which will cause its price to rise. On the other hand, countries whose growth is weak and debt is high may see less demand for their currencies and their value will lag those of countries with more robust economies. Growth alone doesn’t make a currency strong. Emerging-market countries, such as Brazil or India, may have good long-term growth prospects but their currencies are not so highly valued by global investors.
A positive feature of a stronger dollar is the lower cost of imported products from other countries. For example, if a car made in Germany is valued at 50,000 euros and then is imported to the U.S. when the dollar stands at $1.20 to one euro, the retail price of the car in the U.S. would (theoretically) be $60,000 (20% more than its European price to reflect the currency exchange rate). If the dollar were to appreciate to $0.90 to one euro, the car’s value in the U.S., using the same assumptions, would decline to $45,000—a significant savings for a U.S. consumer. However, a strong dollar can also detract from revenues generated by multinational companies based in the U.S. The net income earned from foreign sales will decrease once exchanged into dollars. A stronger dollar means U.S. companies that export products abroad will be less competitive because the price of the product translated into euros or another currency is higher, which can lead to lower sales as foreign buyers shift to lower-cost alternatives.
There are a variety of factors that cause the U.S. dollar to rise, but the primary factor boils down to demand for the dollar. If the demand for the dollar increases, then so does its value. Conversely, if the demand decreases, so does the value. The demand for the dollar increases when international parties, such as foreign citizens, foreign central banks, or foreign financial institutions demand more dollars. Demand for the dollar is usually high as it is the world’s reserve currency. Other factors that influence whether the dollar rises in value in comparison to another currency include inflation rates, trade deficits and political stability.
A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions to prepare for investments, transactions and international debt obligations, or to influence their domestic exchange rate. A large percentage of commodities such as gold and oil are priced in the reserve currency, causing other countries to hold this currency to pay for these goods. The dollar’s status as the world’s reserve currency is due primarily to the fact that countries accumulated so much of it and that it was still the most stable and liquid form of exchange. Backed by the safest of all paper assets, U.S. Treasuries, the dollar is still the most redeemable currency for facilitating world commerce. For this reason, it’s highly unlikely the U.S. dollar will experience a collapse any time soon.
About the author: Michael J. Paton is a portfolio manager at Tocqueville Asset Management L.P. He joined Tocqueville in 2004. He manages balanced portfolios and is a member of the fixed-income team. He can be reached at (212) 698-0800 or by email at [email protected].