The Diluting Dominance of US Dollar
Twilight of the greenback
Ever since the Bretton Woods Agreement in 1944, most governments and central banks around the world have relied on US dollar to back up the value of their own currencies. However, dollar’s share of global reserve currencies has been in steady decline over the past 20 years as central banks turn to nontraditional currencies, including China’s renminbi, to diversify their holdings. The US sanctions on Russian in the wake of latter’s invasion of Ukraine have further expedited this fall as identified by Gita Gopinath, IMF’s First Deputy Managing Director, who recently warned that financial sanctions imposed on Russia threaten to gradually dilute the dominance of the US dollar and could result in a more fragmented international monetary system.
The US dollar, needless to say, is a dominant international medium of exchange in trade and commerce. Its ascent continued and, after World War II, it became the most powerful global currency and was officially termed as the reserve currency or vehicle currency. After sealing its position in the early 1970s as a dominant currency in oil trade with a deal with the oil-rich Kingdom of Saudi Arabia to conduct global energy trade in dollars, the US dollar still continues to reign. The status of the dollar was enhanced by the collapse of the Bretton Woods system, which essentially eliminated other developed market currencies from competing with the USD.
Today, most of the world’s trade is conducted in US dollars and it now enjoys the status of a “de facto” global reserve currency for trading between most nations. However, the tide is turning now. The ground, dominance and confidence in the US dollar are significantly diminishing and the Russia-Ukraine war, and the ensuing US sanctions on Russia, as well as the rise of Chinese yuan, may prove to be the last nail in the coffin of US dollar. This assertion is corroborated from the findings of a new paper issued by the International Monetary Fund titled: “The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies” which says that reserve managers have moved out of dollars in two directions, with one quarter headed into the renminbi and three quarters into currencies of smaller countries that have traditionally played a limited role as reserve assets. Co-authored by Serkan Arslanalp, Barry Eichengreen and Chima Simpson-Bell, the paper points out that a characterization of the “evolution of the international reserve system in the last 20 years is thus a gradual movement away from the dollar, a recent if still modest rise in the role of the renminbi, and changes in market liquidity, relative returns and reserve management enhancing the attractions of nontraditional reserve currencies … These observations provide hints of how the international system may evolve going forward.”
Why currencies collapse?
The root of any collapse stems from a lack of faith in the stability or usefulness of money to serve as an effective store of value or medium of exchange. As soon as users stop believing that a currency is useful, that currency is in trouble. This can be brought about through improper valuations or pegging, chronic low growth or inflation.
It is to be noted here that many global currencies in the past dried and many of them even died due to a shortfall of political and economic relevance to the world. For instance, in 1900, US dollar was 0% whereas pound sterling stood as 62% in the total redeemable reserve of the global currencies – Central banks have to hold reserve currency for meeting liquidity demand, exchanging their own currency for international transactions, and diversifying portfolios to avert gloomy economic times. Comparing to other currencies, the dollar reserve stands close to 60% now in the central banks of countries around the world.
How dollar’s rise started
The dawn of American monetary supremacy coincided with the last World War, while the sun was setting not just over the British empire but over the dominance of the British pound.
Guests from around the world were welcomed to Bretton Woods, New Hampshire, in 1944 with a statement from US President Franklin Roosevelt, who later described the goal of that conference: avoiding a repeat of the international economic warfare of the 1930s that culminated in the bloodiest conflict in human history.
Central to that effort was creating the two bodies, a new International Monetary Fund to stabilize currencies and a World Bank to lead development and reconstruction.
They would be located in the US capital, and the IMF would base its exchange rates on the US dollar, which itself was pegged to the price of gold (until 1971).
Britain resented its loss of status and wanted to remain the epicentre of the financial world — but its massive war debts and damage left the US as the uncontested superpower of the capitalist world.
The US dollar is, to this day, involved in nearly 90 percent of all international currency exchanges, is used in half of cross-border goods purchases, and represents about 60 percent of central bank reserves held in cash and bonds.
That centrality makes US sanctions an especially powerful tool.
Why is it collapsing now
Many reasons can be enumerated for the decline of US dollar; Covid-19, China’s rise, war or military expense and the Russia-Ukraine (the US & West-backed) war could expose the blunt deficiency of US dollar in day light. Leading geopolitical adversaries of the United States — Russia and China — have already started the process of de-dollarisation. Other smaller powers are also joining the ranks. Here we take a look at some major causes.
a. Russia’s de-dollarization drive
Russia had started its three-pronged efforts towards de-dollarisation in 2014 when sanctions were imposed on it for the annexation of Crimea. First, Russia reduced its share of dollar-denominated assets to about 16 percent in 2021. It had already announced that it would be cutting the USD from its $186 billion National Wealth Fund. Second, it reduced its share of trade conducted in US dollar by prioritising national currencies in bilateral trade. The use of dollar in Russia’s exports to BRICS crashed from about 95 percent in 2013 to less than 10 percent in 2020. Third, Russia also developed a national electronic payments system called “Mir” in 2015 after several payment processing firms denied services to Russian banks.
b. China’s rise
China aims to use trading platforms and its digital currency to promote de-dollarisation. China has established RMB trading centres in Hong Kong, Singapore and Europe. In 2021, the People’s Bank of China submitted a “Global Sovereign Digital Currency Governance” proposal at the Bank for International Settlements to influence global financial rules via its digital currency, the e-Yuan. The IMF has already added Yuan to its SDR (Special Drawing Rights) basket in 2016. In 2017, the European Central Bank exchanged EUR 500 million worth of its forex reserves into Yuan-denominated securities. However, the lack of full RMB convertibility will hinder China’s de-dollarisation ambition.
c. Rise of other currencies
The US dollar, which is the world’s reserve currency, can see a steady fall in the current context as leading central banks may look to diversify their reserves away from it to other assets or currencies like the euro, renminbi or gold. Moreover, the most interesting alternative to the dollar’s primacy may not be other national currencies but digital currencies. Central banks are actively exploring the use of these electronic means of payment. If a system of payments for international transactions emerges that is seen as safe, stable and not dependent on any one country, then the dollar’s central role may be replaced by a different form of money altogether.
d. Geopolitical risks
The weaponisation of trade, the imposition of sanctions and the hanging sword of Damocles in the form of an ever-present threat of exclusion from SWIFT by the US could trigger a faster de-dollarisation as countries displaying diplomatic and economic autonomy will be wary of using US-dominated global banking systems. This can also trigger a shift in the overall global forex market framework as potential foreign policy coercion or sudden disruptions will not go down kindly with countries, which will start exploring how to build bulwarks.
The “de-dollarisation” by several central banks is imminent, driven by the desire to insulate them from geopolitical risks, where the status of the US dollar as a reserve currency can be used as an offensive weapon. Thus, the war in Ukraine and the subsequent economic sanctions will trigger central banks to go back to their drawing boards to reassess their dependency on the greenback. Efforts are already underway for the possible introduction of a new Russia-China payment system, bypassing SWIFT and combining the Russian SPFS (System for Transfer of Financial Messages) with the Chinese CIPS (Cross-Border Interbank Payment System). The notion of de-dollarisation sits well in the thought experiment of a multipolar world where each country will look to enjoy economic autonomy in the sphere of monetary policy.
e. US sanctions on Russia
The sanctions, from restrictions on Russian banks to measures targeting its economy, imposed by Western nations, could cause a more fragmented international monetary system.
In a recent interview, Gita Gopinath, IMF’s First Deputy Managing Director, categorically warned of a gradual decrease of the dominance of the US dollar in the world financial systems after the unprecedented financial sanctions imposed on Russia after its incursion in Ukraine. She said the war will also spur the adoption of digital finance, from cryptocurrencies to stablecoins and central bank digital currencies, and the greater use of other currencies in global trade would lead to further diversification of the reserve assets held by national central banks.
Moreover, Goldman Sachs has warned that the US dollar faces risks that could erode its global dominance, saying it is dealing with some of the same challenges that the British pound faced in the early 1900s. The bank’s analysts, including economist Cristina Tessari, said the dollar faces a number of challenges similar to those faced by the British pound before it declined. The pound was once the world’s reserve currency, but was supplanted by the dollar in the middle of the 20th century. Those challenges include the fact that the US has a relatively small share of global trade compared to the dominance of the dollar in global payments. The country has a deteriorating “net foreign asset position,” with rising foreign debts. And that it faces geopolitical problems, such as Russia’s war in Ukraine. Moreover, the move by the US and its allies to freeze Russia’s central bank out of much of its foreign currency reserves has raised concerns that countries could start moving away from using the dollar, due to worries about the power the currency grants the US.
Goldman argued that the status of the dollar is largely in the US’ hands. “Policies that allow unsustainable current account deficits to persist, lead to the accumulation of large external debts, and/or result in high US inflation, could contribute to substitution into other reserve currencies,” the bank’s analysts said.
Is the collapse imminent?
Despite triggers to the move away from it, de-dollarization will be a protracted process. Apart from the euro and gold, most other foreign currencies have some inherent risks associated with them. The historically “neutral” Switzerland joining the EU in imposing sanctions on Russia, eliminates the Swiss Franc from being an asset that can work as a hedge against economic sanctions. Central banks are left with very few choices to diversify.
Having said that, a drop in the dollar’s stature is inevitable as major economic powers like China rise. The Western hegemony of the financial system was challenged when the 2008 global financial crisis exposed underlying cracks within the US economy. Moreover, demographic factors will continue to challenge Europe’s growth prospects. The rise of Asia as an economic powerhouse will raise the importance of currencies like the yuan. But, while the frequent use of the US dollar as a potential weapon for achieving foreign policy objectives will no doubt accelerate the process of de-dollarisation, there is still a long road ahead.
The dollar’s global hegemony is fading, but in the place of mutually beneficial financial and global trading arrangements, regional currency blocs are forming, each guarded by a jealous and suspicious hegemon: the dollar, the euro and the renminbi. As each hegemon jostles for position in a crowded world, conflicts between them are all but guaranteed.
The writer is a member of staff.
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