Will the Dollar remain the central global currency?

26 Mar 2024 , 03:16 PM

The exorbitant privilege of the dollar

In his landmark book “Exorbitant Privilege – The Rise and Fall of the Dollar,” Barry Eichengreen had argued that the dollar had an exorbitant privilege for too long. However, he also right added that while the shift out of the dollar had to happen, it would be gradual and dollar dominance would last for much longer than anticipated. There has never been a dearth of dollar bashers in the world. Experts predicted the fall of dollar dominance during the Arab embargo crisis in 1973, then again during the high interest regime of the early 1980s and later during the IT sell-off as well as during the global financial crisis of 2007. 

More recently, experts had also predicted that the COVID crisis would finally lead to the powershift out of the US dollar. Nothing of that kind happened, or even appears to be happening. The dollar has enjoyed an exorbitant privilege because majority of the world trade is denominated in dollars, investment returns are measured in dollars, and foreign exchange reserves are also kept in dollars. This is not going away in a hurry. That is where the recent speech by Governor Chris Waller of the US Fed at the University of Bahamas assumes significance. He not only spoke about the challenges to the dollar, but also went on to underline why the dollar dominance could last for much longer.

What role does the dollar play in the global system?

The dollar has played a central role in the global financial system almost since the end of the Second World War in 1945. Here are 3 reasons the dollar has dominated the global financial system over the years. 

1. The first role of the dollar in the international financial system is as a store of value. The ‘store of value’ relates to the ability to save in a given currency and retrieve the savings in the future without a significant loss of purchasing power. A classic example is the share of the dollar in international forex reserves of various countries. Today, the US has about 60% share of international currency preference, followed by the Euro at 20%. The Chinese Renminbi is just around 2%, so it is still too small. The falling share of global central banks in US treasuries is more because forex reserves have not kept pace with the growth in US treasuries.

    

2. Let us now turn to the role of the dollar as a medium of exchange. This is best referenced by the share of the dollar in trade invoicing. Today 75% of all world trade continues to be denominated in US dollars (ex-Europe) and in the Americas, the share of the dollar is 96%. Even in Europe’s trade with the non-EU world, the share of Euro as the invoicing currency is just 50%. The other big role that the dollar plays is its dominant role in international banking and debt issuance. Globally, about 60% of all banking loans and deposits are denominated in US dollars, while 70% of the non-US debt is issued in dollars. These shares have hardly changed over the last 20 years, even during the crises of 2007 and 2020.
    
3. Thirdly, we look at the US dollar as a unit of account. This is what is referred to as the anchor currency used by other countries. Why are some of the most important commodities like crude oil and gold still denominated in dollars. That is because it is possible to get liquid exchange rates for every currency with the dollar. Interestingly, the use of dollar as an anchor currency has only increased in the last 20 years. The share of non-US economies anchored to the dollar, while the next best is the Euro at 5%. 

However, experts continue to be sceptical about the central role of the US dollar in the global financial system. Let us look at some of the concerns and the relevant ground realities in the global market today. 

Will decentralized finance reduce the importance of the dollar?

Decentralized Finance (DeFi) started to play a prominent role in the post GFC period. The global financial crisis (GFC) underlined the risks of fiat currencies which continue to operate without the checks and balances on the amount of currency that could be created. The key was to reduce the supply of currency creation and that led to the first major non-fiat currency, the Bitcoin. Cryptocurrencies are still operating in a legal grey area, but it is certain that their importance and appeal is growing. The logic behind the rise of cryptos is the limited supply and the difficulty in raising the money supply. However, the value of Bitcoin will always be volatile and that takes away its appeal as a currency. The most important point to remember here is that most digital currency trade using stable coins, which link their value one-for-one to the U.S. dollar. Ironically, 99% of the stablecoin market cap is linked to the US dollar. That means; expansion of crypto trading would only make the dollar more central to the global financial system. Impact on the dollar could be marginal.

Does the Euro have the potential to replace the Dollar?

Ever since the Euro emerged as the consensus currency of Europe in 1999, its appeal and importance has been gradually increasing. In the past, during conflicts in the Middle East, many Middle East and even Asian countries had shifted their reserves out of the dollar and into Euros. But is that really a significant trend? The Euro certainly remains a potent challenge to the dollar but the missing link today could be the fact that the Europe still has a relatively shallow and illiquid debt market compared to the US. With the UK out of the European Union, this problem only gets all the more compounded. On reason could be the quantum of outstanding treasury securities issued by the EU is still no match to the massive portfolio of $24 Trillion worth of treasury securities that the US has outstanding.

Will the Chinese Yuan challenge the dollar dominance?

Chinese yuan as a central currency to global trade or as a global currency store of value is just about 2-3%. In recent years, China has taken steps to free the currency, broaden and widen the debt markets and to reduce the regulation of the Yuan. The inclusion of the Chinese Yuan in the dollar index (DXY) has also been a boost. But, Chinese Yuan may still have a long way to go. For starters, the Chinese Yuan It is not freely convertible, at least on the capital account. Secondly, in the aftermath of the COVID pandemic and the supply chain constraints created by the prolonged Chinese shutdown, the level of investor confidence in Chinese institutions is relatively low. Some of the large countries like Brazil, Russia and Saudi Arabia are already having deals with China to settle their bilateral trade in the Chinese Yuan rather than in US dollars. However, that is still a very small part of the global trade. Many central banks have been sceptical about using the Chinese Yuan as an invoicing currency or as a reserve currency due to the ongoing geopolitical conflicts that China has with Japan, Taiwan, and India. For now, the role of the of China in the global financial system is likely to remain very focused in a few pockets only. 

With the de-globalization move impact the US dollar?

One big trend in the recent months has been the shift from a globalized system of trade and commerce to a more fragmented and bloc-based approach to trade and commerce. These fragmentation trends got a boost after the US and its allies imposed sanctions on Russia following the invasion of Ukraine. The fear was that countries could become defensive about the dollar if such arbitrary embargos were to be placed. However, even if we assume that there is a shift, the question what do countries shift to. The UK, Europe and Japan are all allies of the US in these sanctions and that is unlikely to make any of the countries prefer these hard currencies over the US dollar. Hence, that may not pose a major risk.

However, that is not to detract from the fact that fragmentation is happening and the preference is once again for smaller trade blocks than for the good old globalization that had made the US central to world trade and commerce. That is now being popularly referred to as geoeconomic fragmentation, wherein trade and financial flows realign and become restricted within a bloc of nations. However, at this stage it would be naïve to even expect any such block to seriously come up that could challenge the US as a trade and investment bloc. One must not forget that the Chinese economy is one of the largest exporters to the US and runs its biggest trade surplus with the US. Hence, any immediate change to the global dollar dominance situation looks unlikely at this point. In fact, there is little impact on US-China trade since tariffs were imposed on China by the US. The only shift that has happened is that the US imports of tariff-affected goods from China have plunged, but the imports of goods not subject to tariffs have continued to grow rapidly.

Moral of the story; where is the safe haven?

A final consideration regarding the international use of the dollar relates to financial stability concerns. In times of global financial stress, most investors and governments seek a safe haven currency and asset that can protect the value of their assets and stabilize their own financial markets. If one looks back at some of the recent crisis like the GFC of 2007, the EU crisis of 2011 and the COVID pandemic of 2020, the first global reaction was the “flight towards the dollar”. In a sense, that is a sort of vindication that in terms of crisis or in terms of uncertainty, the dollar is still the currency that investors prefer to be parked in. In times of crisis, it is more likely that global investors will rush towards the dollar, rather than rush away from it. Till that perception of dollar safety and stability remains, the dollar is likely to remain the central nodal currency for the global financial system.

The sum and substance of the entire argument, as articulated by Governor Christopher Waller is that the dollar is here to stay for a long time as the central currency. Just take a leaf out of history, the US had crossed the UK in terms of GDP and size by the start of the 20th century. However, it is only after the Second World War that the US dollar emerged as the central currency globally. In the current context, it may take another 20 years for China to get past the US GDP. Any talks of the end of dollar dominance, at this juncture, is quite premature.