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Canada And Australia Dollars To Be Reserve Currencies

Stephen D. Simpson, CFA

There's always a difference in the markets between "de facto" ("in practice") and "de jure" ("in law"), and recent announcements regarding international reserve currencies would seem to reflect that difference. Word came out in mid-November that the IMF is likely to reclassify the Australian dollar and Canadian dollar as "official" reserve currencies. While this is indeed a significant development, it seems more a reflection of reality than a major prospective change.

Where the Reserves Are
Foreign exchange reserves are held by most governments as a means of facilitating trade and better managing (and maintaining) credit. Roughly $10.5 trillion of various currencies are held by the world's central banks, with nearly 62% of that in U.S. dollars (the lowest level in about 15 years). The euro is the second-most commonly-held reserve currency, making up about one-quarter of global reserves.

After these two Snow Whites, though, there are many dwarfs. The British pound and Japanese yen both account for just under 4% of reserves (each), while the Swiss franc makes up a tiny portion. The remainder, roughly 5%, is classified as "other" currencies. While a lack of complete candor from global central banks precludes a detailed rundown, it is widely believed that the Canadian dollar and Australian dollar make up the largest components of "other", though currencies like the Chinese yuan, South Korean won, Singapore dollar and Swedish krona are also held in some countries' reserves.

Recognizing Reality
As I suggested in the open, there's very much an element of recognizing what has already taken place, in the IMF's contemplation of upgrading the Canadian and Australian dollars. The Australian dollar is already held as a reserve currency by more than 20 nations (to the tune of approximately $60 billion), and nations like Russia and Switzerland have adopted the loonie as well (close to 2% of Russia's foreign currency reserves are Canadian dollars).

Why Are Australia and Canada Getting Upgraded?
As a quick look at those prior stats would suggest, a large percentage of the world's currency reserves are tied to economies that are not necessarily in the best of fiscal health. The eurozone has been a mess for a while now, due to the ongoing legacy of the sovereign debt crisis, with growing worries that Germany will slip into recession in 2013. Likewise, the U.S. economy is facing down a potentially serious fiscal cliff and saw its credit rating downgraded from AAA in August of 2011.

In contrast, both Australia and Canada sport AAA ratings today, with low deficits relative to GDP. Both countries have also built a reputation for being relatively conservative with their fiscal and monetary policies, reputations that were burnished as these countries fared considerably better through the global credit crunch and recession that followed the implosion of the U.S. housing market.

In recent years, both Australia and Canada have seen their currencies become a growing part of international reserves, more than doubling over the past decade. Some of this is due to their strong economies, as well as their wealth of natural resources (and the two are very much linked). Some of it, though, can also be tied to a vocal desire on the part of countries like China to deprioritize the U.S. dollar (and to a lesser extent the euro) as international reserve currencies.

Good News and Bad News
There's certainly an element of pride attached to having a nation's currency designated as a global reserve currency. At a minimum, it is a recognition that that country's economy is large, stable and in generally good health. It is also a vote of confidence insofar as countries are not going to eagerly build reserves of a currency that they believe is likely to depreciate significantly (part of the point of reserves is to create a store of value).

This designation does give an element of "safe harbor" status to both currencies. It can also significantly enhance a company's access to credit and can defray some of the impact of inflation (the United States has, in some cases, been able to "export" its inflation to large U.S. dollar holders like China).

There are downsides and risks to reserve currency status, however. For starters, buying up a currency is going to make that currency appreciate, and a higher currency value is potentially problematic for the export-driven sectors of the Canadian and Australian economies (particularly natural resources). Some of this appreciation has already taken place over the past decade, as countries have been building up their holdings, but there is nevertheless the risk of further appreciation if their reserve status grows.

Reserve currency status is also potentially destabilizing. For the Canadian or Australian dollars to become bigger components of the global currency reserve system, there are going to need to be quite a bit more of both currencies. That could force these countries to produce more money than their own economies need (by a large margin). That's arguably not a problem in the good times, but it creates the risk that any serious economic issues in either country could rattle investors and global bankers and create large destabilizing outflows. As the U.S. has realized in recent years, the larger the role of a currency in the global reserve system, the more overlap there is between national monetary policy and global monetary policy.

The Bottom Line
Hearing talk from the IMF of upgrading the Canadian and Australian dollars to "official" reserve currency status is really more of a recognition of reality over the past decade than a new era in global trade and finance. The bigger question is what happens going forward. Australia doesn't have much of an export sector to worry about outside of commodities, but Canada does, and it will be interesting to see how a higher value on the loonie impacts it. At a minimum, though, it is a good reminder that sensible and conservative internal economic policy has its rewards, and that global currency and economic policies are always a fluid situation.

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