The term “de-dollarisation” has become a hot button in recent weeks as various countries have been looking to reduce their dependence on the US dollar. Russia and China have been receiving most of the headline attention for this due to various geopolitical tensions. However, other countries such as Argentina, Brazil, India, Saudi Arabia, and Malaysia have joined the conversation as well.
Why is this narrative gaining traction? There are a couple of main reasons.
- When the value of the dollar appreciates, it devalues the currencies of other countries. Since many countries use the dollar to buy commodities such as fuel, a stronger dollar can increase import expenses for countries overseas and make it more expensive to repay dollar-denominated debt. The dollar has been supported in recent years by global economic uncertainties and higher interest rates in the US relative to other countries.
- The US can use the dollar to impose sanctions against other countries. With the sanctions placed on Russia after the invasion of Ukraine, some countries have grown more concerned they could be next if there is a political misstep. Detaching from the dollar could lessen the severity of this for more politically risky countries.
With recession fears and market uncertainty swirling around, it’s understandable to wonder what impact this could have on the global economy. Would a fall of the dollar result in further turmoil or push us into a severe downturn? To understand the most likely outcome and potential impact, it’s important to first understand the history of the dollar as the world’s reserve currency.
The US dollar achieved reserve currency status following World War II with the signing of the Bretton Woods Agreement in 1944. This agreement essentially established the US dollar as the international reserve currency, which was backed by gold at a fixed rate (i.e. the gold standard). So the US dollar has been the dominant currency for nearly eight decades at this point.
While it seems unnerving to see headlines calling for a new global reserve currency, this isn’t the first time these predictions have been speculated. Questions about the dominance of the dollar have emerged throughout various moments in history, most notably:
- 1971 when the Bretton Woods Agreement was abandoned (eliminating the gold standard)
- 1999 when the European Union created the euro
- 2008 during the financial crisis and bank failures
Even breaking the gold standard in the 70’s didn’t lead to the demise of the dollar as many had worried. It seems obvious in hindsight, but looking at that event as it unfolded in real-time undoubtedly resulted in currency fears and uncertainties.
Because of recency bias, more accessible 24/7 news, and the current geopolitical climate, this time feels different, but it’s certainly not the first time the dominance of the dollar has come under fire. Though the number of headlines has been growing recently, it seems to be more noise than substance for now.
Here are some reasons to not worry about the dollar despite recent attention.
The US is by far ahead of other countries.
Approximately 60% of foreign exchange reserves maintained by the world’s central banks are held in US dollars. This is three times larger than the runner-up with the Euro only making up 20% of reserve funds.
Outside the Euro, the next most held currency in the world’s foreign exchange reserves is the Japanese yen at 5%. From there, the collective percentages from other countries are relatively insignificant.
Reserve currency status is highly correlated with the size of a country’s economy.
Similar to reserve currency, the US is the world’s largest economy with a 25% share of global GDP. China is second with an 18% share of GDP, and Japan is well behind in third with only a 4% share.
With this metric, China seems to be the biggest threat to dethrone the US. However, recent reports indicate China might never catch the US due to a shrinking population, lower productivity, and slowing exports, all of which have been weighing on growth. Furthermore, the yuan only makes up 2.5% of reserve funds, so even if China was able to reaccelerate economic growth, its currency is still well behind the US.
No other currencies are in a position to truly replace the dollar.
The most reasonable choice to replace the dollar would be the Euro. This doesn’t seem likely as despite any political uncertainty in the US, the Eurozone has seen its fair share of uncertainty in recent years as well (such as Brexit and country-wide strikes).
Other countries such as China, India, and Russia don’t have the same level of trust globally when compared to the US. To become a reserve currency, foreign nations need to have confidence in the laws and governance of a country to believe it will uphold fair transactions. Trust is an imperative piece for a currency to gain reserve status.
From an operational perspective, financial markets of a country also need to have the size and liquidity to facilitate transactions. The more liquid the market, the more efficiency there is, which results in lower costs. The US bond market is the largest and most liquid in the world, accounting for nearly 40% of all bonds globally (Japan is second with less than 19% and China is third with 10%). Too much currency fragmentation could result in inefficiencies and higher costs, which wouldn’t benefit anyone.
It’s not just the dollar these countries are trying to avoid.
The countries in question are trying to create more independence from all major developed nation currencies, including the euro. We’re just hearing more of the dollar narrative because of our physical location in the world. Ultimately, we are seeing a wave of politically riskier countries trying to find alternative currency options to protect themselves against possible sanctions from more developed nations in the future.
The end of the dollar has been about to happen ‘within the next 10 years’ for the last 50 years, but still hasn’t happened yet.
There is a New York Times article from June 10, 1975 titled OPEC WILL SEVER LINK WITH DOLLAR FOR PRICING OF OIL. The article starts “The oil‐producing nations agreed today to sever the link between oil prices and the dollar and to start quoting prices in Special Drawing Rights, the governor of the Iranian national bank, Mohammed Yeganeh, said.” There were numerous additional articles from 1975 projecting OPEC’s intention to delink from the dollar.
As might be apparent, this never came to fruition. That doesn’t mean there haven’t been any oil transactions outside the dollar. In 2012, Iran started accepting Chinese yuan for oil payments to circumvent international sanctions that were making it difficult to conduct transactions in US dollars. However, the US dollar has remained the dominant currency in global oil trade (among other areas) despite these developments and the matter of fact headlines.
Even if the dollar loses some influence, the US would still be ok.
The most likely outcome from all of this isn’t a total abandonment of the US dollar, causing a global economic depression. Realistically, some countries will begin doing more transactions in other currencies. We’ve already seen this start taking place in some instances. For example, China and Brazil recently reached a deal to settle trades in their own currencies, though it’s important to note that China surpassed the US as Brazil’s largest trading partner so this might have been inevitable anyways.
Even if there is a small shift in how countries do business outside the US, the dollar is expected to endure as the global reserve currency. It’s too far ahead of any other viable option right now, and the US remains the eminent economy.
Some experts believe the future could be more multilateral since there isn’t a frontrunner in line to overtake the dollar. If this comes to fruition (it could take decades to even get that far if it ever happens), the US may lose some of its power and ability to impose sanctions on other countries, but it doesn’t necessarily spell disaster for markets or the economy as the dollar would likely remain the preferred currency for most developed nations. This is far from the economic nightmare many are fearing from the recent media buzz.
The US dollar remains the dominant global currency, and it is likely to continue to play a significant role in international trade and finance for the foreseeable future.
– The Aspire Wealth Team
Weekly Wake-Up