US Public Finance Vulnerabilities: Is the Dollar’s Reserve Currency Status Really Enough?

The creditworthiness of the US and the dollar’s status as the top reserve currency have long mutually reinforced each other. But is this relationship indefinite? Scope Ratings questions the extent to which deteriorating US fundamentals can be ignored.

The dependence of the US on the dollar’s standing is captured in Scope Ratings’ latest rating action affirming the country’s AA/Stable rating. Central to Scope’s assessment is that the US would potentially be rated lower, were it not for the advantages derived from the dollar’s unparalleled reserve currency status: The country can run fiscal and current-account deficits with only marginal debt sustainability concerns.

Scope acknowledges that the dollar’s status as the leading reserve currency is assured for the foreseeable future, also due to the Federal Reserve’s credible monetary policy. Based on the IMF’s COFER database, about 62% of the world’s total foreign exchange reserves are allocated in dollars as of Q2 2018, followed by the euro (20%), yen (5%) and pound sterling (4%), with currently only 2% of allocated reserves being denominated in Chinese renminbi. Even so, there is growing international use of the yuan, partly through developments like Shanghai’s renminbi-denominated oil futures exchange. In addition, President Trump’s ‘America First’ agenda could become a driver for de-dollarisation, evidenced, for instance, in Russia’s offer to switch to euros in trade with the EU.

“Our concerns about the relationship between US sovereign creditworthiness and the dollar are a call on trajectory, not timing, as some changes will transpire over a very long-term window,” says Alvise Lennkh, analyst at Scope. “Reality is dynamic, so when it comes to the US rating, investors should not ignore the underlying economic fundamentals simply by referring to the dollar’s dominance, undisputed though it is for the foreseeable future,” says Lennkh.

Specifically, the threats to the sustainability of US debt are fourfold:

Potential GDP growth has slowed significantly to around 1.6% for the 2011-2020 decade and is expected to rise only minimally to 1.9% for the 2020-2028 period, the lowest since the 1950s, according to Congressional Budget Office data.

Accumulated fiscal deficits in the past 10 years have led to a sharp increase in general government gross debt, rising from 65% of GDP in 2007 to around 108% in 2017. The fiscal cost of the Trump administration’s tax cuts and spending increases is substantial, likely to push the federal government deficit to exceed 5% this year and stay above that level over the coming years, according to the IMF, raising the debt-to-GDP ratio to around 117% by 2023.

Contingent liabilities constitute a potentially significant burden to the federal government. According to the IMF, adding the net present value of accrued deficits from pension and health-care related programmes to the debt level results in a debt-to-GDP ratio of around 260%, second only to Japan (277%) among advanced economies and significantly above that of the UK (160%) and France (110%).

The polarisation of US politics has led to a less deliberative legislative process, political brinkmanship and policy uncertainty. The Trump administration’s fiscal and trade policies have the potential to add to global imbalances, further increasing the range and size of future risks and uncertainties confronting the US and the world economy.

“We believe it is unlikely that a new spirit of bipartisanship will emerge post-congressional elections in November to address the country’s underlying structural challenges and reduce the heightened policy uncertainty,” says Lennkh. “In this context, investors should be even more wary about simply assuming the dollar’s reserve-currency status will remain unrivalled forever. It doesn’t feel right.”