Safe haven currencies are the backstop assets of the financial system: where investors turn when all else is falling. They are the stores of value that have proven their ability to ride out political and economic storms, protecting capital when little else can.
In the living memory of today’s financial professionals, those currencies have remained the same. But at a significant juncture in global markets, as the dollar’s reign comes into serious question, the role and future of safe havens is also coming under the microscope. What might a de-dollarizing world mean for safe havens? What can the history of these currencies tell us about their possible future? And will tomorrow’s safe havens look very different from those of today?
A Golden Dawn
When turmoil hits financial markets, investors must look for a place to hide, seeking to preserve their capital as asset prices are falling. These are the safe havens: a select group of assets that are typically defined by their ability to act as stores of value, to act contrary to most other assets during financial storms (inverse correlation), and to demonstrate sufficient liquidity to be easily redeemed. Another definition of a safe haven asset is that it exhibits a negative risk premium: the same characteristics that mean it will likely underperform the risk-free bank rate in the long term make it attractive during a crisis.
The idea of the safe haven has been a perennial through financial history. Gold and precious metals are the classic examples of assets trusted to retain their worth in all financial weathers, especially when the economy slows. In the period covering 1978-2009, gold delivered a real return of 7.1% per annum during recessions, compared to -9.0% for equities.
For much of history precious metals and currencies were one and the same, leading to widespread adulteration and counterfeiting of coinage. In the city states of Renaissance Italy the bill of exchange started to become widely used in trade, and by the late 17th century the economist Charles Davenant could write that: ‘all great Dealings were transacted by Tallies, Bank-Bills and Gold-Smiths Notes… For Tallies and Bank-Bills did to many uses serve as well, and to some better than Gold and Silver.’
As economies, financial markets and banking systems matured, increasingly the currency itself and its derivative instruments has become the store of value. That has especially been the case among a select few examples with a proven track record of performing strongly during times of financial crisis: the safe haven currencies, safety valves of global finance. In the highly concentrated currency market, where 83% of foreign exchange trades utilize just seven currencies, they are the most select group of all.
Since the mid-20th century, the currencies earning this designation have been the US dollar (USD), Swiss Franc (CHF) and Japanese Yen (JPY). Their status as safe havens can primarily be explained by a combination of historically low interest rates, positive current account balances, large and liquid financial markets capable of handling high volumes of trading, and political stability. It is further reinforced by the dynamics of the ‘carry trade’ popular among currency investors, who in stable markets will borrow in a low-interest rate currency to invest in one with a higher rate and profit from the spread. When volatility hits, the unwinding of this trade serves to strengthen the safe haven (low rate) currency which is being bought back, further bolstering its ability to hold or increase its value while other assets are falling.
That can result in dramatic moves for normally low-volatility assets during political or economic shocks: the Swiss Franc went up by 3% in the two hours after the first plane hit the World Trade Center on 9/11, while following the Brexit vote in 2016 the yen immediately strengthened by over 7% against the dollar.
Safe Havens vs. Reserve Currencies
Of today’s three safe haven currencies, the dollar is the outlier: since the early 1970s, interest rates in the USA have been substantially higher than in either Japan or Switzerland, while since 1980 it has run a current account deficit averaging 2.5% per annum, compared to regular surpluses among its safe haven peers. Moreover, the dollar has been an inconsistent performer during times of financial strife, strengthening during some recessions, including the aftermath of the global financial crisis in 2009, but suffering in others.
The USD has earned its safe haven credentials via a different route: as the global reserve currency for much of the last century. No other currency comes close to the greenback’s dominant position in global finance: it represents over 60% of worldwide FX reserves and over 40% of cross-border loans and international debt securities, while around half of all global trade is invoiced in dollars. Overwhelmingly, commodities are priced, payments made, reserves held and transactions facilitated by the dollar as the world’s most liquid, trusted and recognized currency.
USD is the latest in a long line of reserve currencies through history, stretching back to the drachma that was the unit of exchange for the Athenian Empire, and the silver denarius that underpinned the financial dominance of Ancient Rome. For much of recorded financial history there has been a single currency relied upon for trade and exchange above all others, typically issued by the dominant political and trading power: a chain culminating in the USA’s rise to dominance in the wake of both world wars, as it became a major creditor to devastated European economies while its own industrial production was rapidly expanding.
Reserve currencies and safe havens will often overlap, but the two are not synonymous. USD is a safe haven just as the pound sterling was at the height of the British Empire in the 19th century, but the dollar’s closest competitor as a reserve currency, the Euro, is not a true safe haven: although it fulfils some criteria, such as a typically strong current account balance, and has at times behaved as one would expect a safe haven to, the fundamental structure of the Eurozone mitigates against it. As a monetary but not fiscal union, it cannot guarantee stable policy making across the bloc, while debt levels and financial stability vary considerably across member nations. The sovereign debt crisis of 2010, and the fears it might be the undoing of the Eurozone, exposed vulnerabilities inherent in its currency union that remain fresh in the memory.
Just as a reserve currency need not be a safe haven, the opposite is also true. The Swiss Franc, generally regarded as the most dependable store of value, generally accounts for less than 0.5% of global FX reserves to the Euro’s 20%. The distinction is important: while reserve currencies have often functioned as de-facto safe havens, they are not the same thing. One is the prevalent unit of global exchange; the other, more limited in scope, a place for investors to retreat in times of strife.
At a time when de-dollarization is on the table, and attention is turning to what the reserve currency or currencies of the future may look like, it must be remembered that safe havens have their own particular characteristics and distinctive purpose. The fact that some reserve currencies have acted as safe havens does not mean they always will.
History’s Hard Lesson
While the history of currencies may be an imperfect guide to their future, some of its lessons are universal. One is that every reserve currency ultimately loses its pre-eminence, through some combination of economic pressure, financial mismanagement or external shock events. And in parallel with the demise of the currency comes the fall of the political power that underpinned it.
The decline of the Roman Empire has often been illustrated through the debasement of its coinage, with the denarius featuring progressively smaller proportions of silver as attempts were made to meet growing military costs, leading to a financial spiral of rising inflation, taxes and trade deficits. With declining financial and monetary stability, the global trade networks that had undermined Roman prosperity were eroded, and political and financial decline became inescapable.
It was the first, and by no means last, example of a reserve currency being destroyed by a cycle of debasement and inflation. As Prof Avinash Persaud has argued: ‘One of the things you notice when you look back at reserve currencies in the past is that their end is always associated with inflation… the country is losing its reserve currency status, all this local currency debt is coming back, all these checks are coming back to be cashed. Dealing with this debt, the country tries to inflate its way out of the problem.’
The Spanish Empire that rose in the late 15th century would follow a similar pattern. At its peak it was the world’s pre-eminent political and trading power and its silver dollar, the Spanish real, functioned as the global reserve currency. Yet the arrival of an apparent windfall, the influx of gold and silver from its colonies in the New World that began in the late 1510s, was to cause a significant distortion in its economy, with higher circulation of precious metals fueling inflation and, in one analysis, ‘the illusion of prosperity’. Spanish rulers overreached themselves financially and militarily, leading to what was effectively the first sovereign debt crisis in 1575. Eventually they became caught in a bind similar to the Romans before them: unaffordable military costs, rising trade deficits and the pain of currency debasements. Spain, which had been one of the world’s richest countries in the 15th and 16th centuries, would decline into one of western Europe’s poorest. It took until the 1820s to recover the level of per capita income it had first attained in
1590.
By then the British Empire had become the anchor of global trade, taking in at least 30% of global exports by 1860. Sterling was the world’s primary trading and reserve currency: an estimated 60% of global trade was invoiced and settled in sterling between 1860 and 1914, while at the turn of the 20th century, GBP’s share of foreign exchange reserves was more than twice that of the franc and mark, its nearest rivals. The dollar, which within decades would be top dog, barely featured in the conversation.
The economic devastation of war and the decline of British Imperial power would reverse those trends and set the stage for the rise of the dollar. National debt, which had been a quarter of GDP in 1913, mushroomed to 130% by 1920. The heavily trade-reliant British economy suffered in a new era of protectionism, with exports slumping to three-quarters of their pre-war level by the mid 1920s. Gradually then suddenly, sterling’s status as a reserve currency and safe haven was eroded, a process made complete by the century’s second world war. Britain had become the latest empire to experience the mutually-reinforcing decline of economic and political power.
In parallel the US was laying the groundwork for its future status as the successor financial power: the establishment of the Federal Reserve in 1914 helped to enshrine New York as a financial market with deep liquidity and, as war devastated Europe’s economies, America became a major creditor as well as the predominant industrial economy left standing. After 1945 the dollar’s status as the global reserve was unquestioned, persisting ever since.
While reserve currencies rise and fall as analogues of geo-political power, safe havens follow their own trajectory. While states and political unions may actively work to try and establish their currency as a reserve, as has been the case with the Euro since its inception and more recently with the yuan, safe haven status is more a reflection of an economic reputation earned than a political goal achieved. ‘There is no such thing as a playbook for a currency to attain safe-haven status’, one analyst recently commented.
History shows that such status is conferred on economies that, through distinctive combinations of political and economic circumstances, can demonstrate the much-sought stability of low rates, financial stability and positive current account balances. For Japan, these were the product of its ‘economic miracle’: the recovery from the devastation of wartime bombing that saw its economy grow at twice the rate of Western Europe’s and two-and-a-half times that of the US from 1950-73, doubling in size during the 1960s alone. Japan’s manufacturing sector became the envy of the world, helping to deliver an annual trade surplus in 75% of years between 1970 and 2021.
While in Switzerland, economic stability, political neutrality, accommodative monetary policy and its unique banking system have helped to underpin historically low interest rates, consistent since 1930, and including a period of negative rates from 2014-22. For Switzerland, safe haven status has been partly self-fulfilling: a strong currency makes imports cheaper, keeping a tight rein on inflation (which reached a 29-year high at just 3.5% in 2022, compared to 10.6% across the Eurozone) and reinforcing its global reputation for stability.
This reflects the primacy of perception when it comes to safe havens. ‘Safety is endogenous, and when investors believe an asset will be safe, their actions can make that asset safe,’ economists from the National Bureau of Economic Research have suggested. The herd mentality that sees investors flock to the same small pool of assets during financial crises is one of the best guarantees of those assets continuing to be seen as safe havens: akin to a bank run operating in reverse.
As its history shows, safe haven status is highly distinctive and earned only through a long track record that may rest on highly specific local factors. The designation is hard to achieve and, thanks to its tendency to be self-reinforcing, may be even harder to lose.
What Now? What Next?
What, then, is the likely future for safe havens as we enter a world in which the global reserve currency is once again under threat? If the dollar falls from primacy, will its fellow safe haven currencies go with it?
In considering these questions, it should first be acknowledged that the current debate around de-dollarization is nothing new. From the inflation shocks of the 1970s to attempts to internationalize the yen in the 1980s and the financial crisis of 2007-8, USD’s status as the global reserve currency has repeatedly been questioned. Even if ongoing attempts to depart from the dollar are successful, its demise as the basis of global exchange is likely to be a slow process.
The yuan, its most touted alternative in the emerging era of Chinese geo-political power, has obvious limitations as a reserve currency candidate: not just its minimal share of existing FX reserves, a barrier that could conceivably be overcome, but its currency controls and lack of a sophisticated derivatives market. Both detract from the ease of access and liquidity that have been fundamental pillars of reserve currencies through history. As the economist Robert Aliber once described, GBP and USD ‘became international currencies neither by Act of Congress (Parliament) nor by Act of God, but rather because they met various needs of foreign official institutions and foreign private parties more effectively than other financial assets could.’ In its current form, it is inconceivable that the yuan could effectively meet those needs.
Another version of the future is one in which the dollar goes into irreversible decline and is never replaced. A de-globalizing, de-dollarizing global economy is one that will likely tend towards smaller blocs of trade and economic co-operation, without the need or want for an omnipotent currency with political power to match.
Such a world could see the historic norm of a dominant reserve currency become an artefact. But even in this scenario, the importance of safe haven currencies will not diminish, nor necessarily will their identity change. The fact will remain that investors must have somewhere to retreat during periods of turmoil, and the bar for a currency to achieve this status will continue to be high. It is easier to conceive of the yuan becoming a de-facto reserve currency for countries in China’s political orbit, or the Brazilian real serving a similar purpose in South America, than to imagine either qualifying as a safe haven. Power and political will alone do not a safe haven make.
That does not mean no currency will again rise to the status of safe haven. It is not impossible for a once volatile currency to change its spots and earn a reputation for reliability: for much of the mid-19th century, Switzerland had a higher interest rate than the Netherlands or UK, only establishing its outlier low-rate status from the 1930s on. The countries and currencies that emerge as winners of the de-dollarizing world will have the chance to prove their credentials as potential safe havens. But it is a long road, and a high bar.
By contrast, while prospective safe havens face a difficult job to prove their credentials, their established peers are likely to be granted a degree of latitude precisely because they have a track record. As the yen hit its lowest level against the dollar in over three decades last year, and Japan tallied its highest ever trade deficit, analysts have begun to question whether it can maintain its safe haven status. But the case is as yet unproven and the fact remains that, when investors must have somewhere to turn, they are likely to favor the havens that have proven resilient in the past in the absence of compelling alternatives.
Regardless of what happens to the dollar and the composition of foreign exchange reserves, the world will continue to need safe haven currencies: a club that will continue to be as difficult to join as it is to leave, and which is destined to remain highly exclusive whatever the future may bring.
_________________________________________________________________________________
Sources: Ranaldo and Soderlind, ‘Safe Haven Currencies’, Swiss National Bank Working Papers, 2007.
Coudert and Raymond, ‘Gold and financial assets: are there any safe havens in bear markets?’, CEPII, 2010.
Gorton, ‘The History and Economics of Safe Assets’, Annual Review of Economics, May 2017.
Randalo and Soderlind, ‘Safe Haven Currencies’, Review of Finance, 2009; Cho and Han, ‘The tail behavior of safe haven currencies: A cross-quantilogram analysis’, Journal of International Financial Markets, Institutions and Money, January 2021.
Maharaj, Kelly-Scholte, Aguirre, ‘Rethinking safe haven assets’, JP Morgan Asset Management, 2019.
Bertaut, von Beschwitz, Curcuru, ‘The International Role of the U.S. Dollar’, FEDS Notes, October 2021.
Butcher, ‘Debasement and the decline of Rome’, Studies in ancient coinage in honour of Andrew Burnett, 2015.
Persaud, ‘When currency empires fall’, Gresham College, December 2004.
Charotti, Palma, Pereira dos Santos, ‘American Treasure and the Decline of Spain’, University of Manchester, January 2022; Miller, ‘Spain’s Lesson in Hubris: Tracing Spain’s Financial Collapse to the Beginning of its New World Empire’, The Classic Journal, May 2020.
Alvarez-Nogal and De La Escoura, ‘The rise and fall of Spain (1270-1850)’, The Economic History Review, February 2013.
Karlstorem, ‘How Did They Become Reserve Currencies?’, IMF, 1967; Jones, ‘Does sterling’s slide into obscurity foreshadow the US dollar’s fate?’, Financial Times, 7th April 2022.
Crafts, ‘Walking wounded: The British economy in the aftermath of World War I’, CEPR, August 2014.
Ernst, ‘Safe-haven currencies amid turmoil’, Credit Suisse, 31st March 2023.
Macro Trends, ‘Japan Trade Balance 1970-2023’, via Japan Trade Balance 1970-2023 | MacroTrends
Baltensperger and Kugler, ‘The historical origins of the safe haven status of the Swiss franc’, Aussenwirtschaft, 2016; Gilchrist, ‘The small European nation of Switzerland beat sky-high inflation. Here’s how’, CNBC, 27th February 2023.
He, Krishnamurthy, Milbradt, ‘What Makes US Government Bonds Safe Assets?’, National Bureau of Economic Research, February 2016.
Karlstroem, 1967.