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U.S. Retreat From Trade Deals Poses a New Threat to Dollar

Trade friction is emerging as the latest threat to the U.S. dollar’s position at the heart of the global financial system.

A Mexican family inspecting a BMW at a Mexico City dealership. Mexico has struck major trade deals in recent months with the European Union and Pacific nations.

Trade friction is emerging as the latest threat to the U.S. dollar’s position at the heart of the global financial system.

For decades, central banks have held the bulk of their foreign-exchange reserves in the dollar, reflecting the dominant role the U.S. and its currency have played in global trade. As the U.S. pulls back from partnerships while countries like Mexico and Japan strike their own trade deals, the dollar’s dominance could be undermined, investors and analysts said. That dominance has been referred to as an “exorbitant privilege,” allowing the U.S. to borrow cheaply and run persistent deficits.

Though a less U.S.-centric trade system would take years to fully evolve, it would have significant implications for global central bankers charged with allocating some $11 trillion in reserves. Many are now ramping up investment in such currencies as the euro and Chinese yuan, reflecting the effects of such moves as the U.S. retreat from the North American Free Trade Agreement and Trans-Pacific Partnership.

Trade Blocks

As the U.S.’s trade rhetoric has intensified, other countries have worked to build alternative trade relationships.

Trans-Pacific Partnership

EU-Canada Comprehenesive Economic and Trade Agreement

Size of economies

$9.9 trillion

Signed March 2018

Canada

Size of economies

$18.5 trillion

EU-Japan Economic

Partnership Agreement

Provisionally in force September 2017

Size of economies

Japan

$21.9 trillion

Negotiations finalized December 2017

Vietnam

Brunei

Malaysia

Singapore

United

States

European

Union*

New

Zealand

Australia

GDP, 2018

$10 trillion

EU-Mexico Global Agreement

5

Size of economies

$17.9 trillion

Mexico

Agreement in principle April 2018

1

Peru

Chile

Trans-Pacific Partnership

EU-Canada Comprehenesive Economic and Trade Agreement

Size of economies

$9.9 trillion

Canada

Signed March 2018

Size of economies

$18.5 trillion

EU-Japan Economic

Partnership Agreement

Provisionally in force September 2017

Size of economies

Japan

$21.9 trillion

Negotiations finalized December 2017

Vietnam

Brunei

Malaysia

Singapore

United

States

European

Union*

New

Zealand

Australia

GDP, 2018

$10 trillion

EU-Mexico Global Agreement

5

Size of economies

Mexico

$17.9 trillion

1

Agreement in principle April 2018

Chile

Peru

Trans-Pacific Partnership

EU-Canada Comprehenesive Economic and Trade Agreement

Size of economies

$9.9 trillion

Signed March 2018

Canada

Size of economies

EU-Japan Economic

Partnership Agreement

$18.5 trillion

Provisionally in force September 2017

Size of economies

Japan

$21.9 trillion

Negotiations finalized December 2017

Vietnam

Brunei

Singapore

Malaysia

European

Union*

United

States

New

Zealand

Australia

GDP, 2018

$10 trillion

EU-Mexico Global Agreement

5

Size of economies

Mexico

$17.9 trillion

Agreement in principle April 2018

1

Chile

Peru

GDP, 2018

$10 trillion

United

States

5

1

EU-Canada Comprehenesive Economic and Trade Agreement

Size of economies:

$18.5 trillion

Provisionally in force September 2017

European

Union*

Canada

EU-Japan Economic Partnership Agreement

Size of economies:

$21.9 trillion

Negotiations finalized December 2017

European

Union*

Japan

EU-Mexico Global Agreement

$17.9 trillion

Size of economies:

Agreement in principle April 2018

European

Union*

Mexico

Trans-Pacific Partnership

Size of economies:

$9.9 trillion

Signed March 2018

Brunei

Vietnam

Japan

Canada

Malaysia

Mexico

Singapore

New

Zealand

Chile

Australia

Peru

*Excludes the U.K.

Sources: IMF (GDP); staff reports

While the U.S. and Mexico remain in negotiations over Nafta, which could come to a head in the coming days as House Speaker Paul Ryan has set a Thursday deadline to receive paperwork, Mexico has struck major trade deals in recent months with the European Union and the group of Pacific Rim nations that make up the TPP.

Alejandro Díaz de León, governor of Mexico’s central bank, said that while the U.S. remains Mexico’s most important trade partner, he expects the euro to play a bigger role in the country’s foreign-exchange holdings in coming years as the balance of the nation’s bilateral trade shifts in that direction.

"It is Mexico’s conviction to be a very open economy, open to trade and financial flows,” Mr. Díaz de León said. Trade deals with Europe “will definitely at the margin continue to diversify our external accounts and increase the relevance of the euro.”

Jens Nordvig, chief executive of analytics firm Exante Data, estimates global central banks could shift $200 billion to $300 billion in reserves into the yuan, euro and a handful of other foreign currencies this year as a result of trade changes. His estimate is based on central banks’ increased buying of Chinese bonds in the first few months this year.

While he cautions that central bankers tend to adjust reserves slowly, “the flows that potentially come out of this are really big.”

Few are calling for an immediate end to the dollar’s reign as the world’s primary reserve currency.

Central banks held about 63% of their reserves in U.S. dollars at the end of last year, the lowest level in four years, according to data from the International Monetary Fund. Meanwhile, allocations to the euro rose to 20% and reserves held in the Japanese yen rose to 4.9%.

“What’s sure is that over the long term, if trade relations change, it will have an implication on the currency makeup of the reserves,” said Christian Deseglise, global head of central banks for HSBC . “As trade becomes more denominated in euros [and yuan], they’ll need to have currencies to match.”

Central banks have long been encouraged to hold enough foreign currency in reserve to cover a few months of imports, and often debt obligations, in case money stopped flowing into the country. Changes to the currencies those imports are denominated in would encourage reserve managers to reshuffle their allocations, while analysts say a recent uptick in debt issued in currencies such as the euro could amplify the need for more diversified reserves.

That comes as investors worry that the global economy has become too closely tied to the U.S. economy and its currency. Roughly 40% of all global trade is invoiced in dollars, according to a 2015 paper from Harvard University economist Gita Gopinath, and many countries have borrowed heavily in the currency in recent years.

The risks of the dollar’s dominance have come into focus in recent weeks as a modest dollar rally raised concerns about the ability of some emerging-market nations to service their dollar debt and pay for imports. Argentina, whose currency has fallen to record lows against the dollar, is seeking a credit line from the International Monetary Fund to help stabilize its economy.

While the dollar’s biggest competitors remain plagued by economic and structural questions—including the long-term viability of the euro system and the economic risks of China’s debt-fueled growth and aging society—analysts believe both the euro and yuan could benefit from recent shifts in global trade.

Daniel Mminele, deputy governor at the South African Reserve Bank, said the central bank still has most of its reserves in dollars but has been adding currencies such as the Japanese yen and yuan to its basket of reserves in recent years.

“There is diversification due to the fact that the global economy is less and less U.S.-centric,” said Jean-Jacques Barberis, who helps manage currency reserves for more than two dozen central banks at European asset manager Amundi. “At the same time, the U.S. remains a major driver of the global economy and that’s why the evolution is very slow.”

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