Currency Update – Current Threats to the U.S. Dollar’s Global Role
/Last month, Brazilian President Luiz Inácio Lula da Silva urged developing countries around the world to start using alternatives to the U.S. dollar in international trade and investing. In conjunction with that, Brazil and Argentina began to explore the possibility of a common currency, partially to circumvent the need for U.S. dollars in many cross-border transactions between the two countries.
China and Brazil also announced a trade agreement by which they would settle trade transactions in Chinese yuan instead of the dollar. In the Middle East, Saudi Arabia has been in talks with China regarding replacing U.S. dollars with Chinese yuan (CNY) in oil trade deals. This follows similar arrangements between China and Iran, Pakistan and Russia as the Chinese government seeks to increase global trading in yuan.
What do actions such as these portend for the future of the U.S. dollar and its position as the primary currency of exchange in global trade and investment?
This trend towards currency diversification around the world has been going on for many years. It is only recently that questions and concerns about the ramifications from de-dollarization have been raised to the front-pages of the news.
Since the end of World War II, the ascendancy of the United States to the largest, economic force in the world, along with its strong financial system and the stability of its political system have helped to place the U.S. dollar on a pedestal amongst global currencies. Global trade and investment flows have predominantly been conducted in U.S. dollars, which has subsequently enabled the dollar to become the most widely held global reserve currency held by central and foreign institutions for several decades.
As you can see in this illustration, the U.S. dollar has been the currency of choice for reserve purposes around the globe.
Although the percentage of global currency reserves held in U.S. dollars has fallen since its high of over 80% in the late 1970’s, central banks currently hold about 60% of their foreign exchange reserves in U.S. dollars, and about half of international trade, loans and global debt securities are invoiced in U.S. dollars.
In foreign exchange markets where currencies are traded, U.S. dollar demand for transactional purposes has remained steady over the years. The dollar is still involved in nearly 90% of all financial market transactions. In 2022 for example, the average turnover per day with the dollar on one side of the transaction was $6.6 trillion, up 14% from $5.8 trillion in 2019 (Note: In this illustration, foreign exchange turnover adds up to 200% in the chart below because there is a currency on each side of a trade).
How has the United States and the U.S. economy benefited from the U.S. dollar’s position in the world?
The U.S. dollar's status as the global reserve currency has provided several benefits for the United States and the U.S. economy over the past few decades. Among those include:
1. Lower borrowing costs: With the U.S. dollar being the dominant global reserve currency, the U.S. government and U.S. businesses can borrow money at lower interest rates than they otherwise would be able. This is because foreign investors and central banks are willing to lend money to the U.S. at lower rates in order to hold U.S. dollars as a safe and stable reserve currency.
2. Greater access to global capital: The U.S. economy can access a larger pool of global capital as a result of the dollar's status as the global reserve currency. This allows U.S. businesses and financial institutions to access funding from a wider range of investors, which can help to support economic growth and investment.
3. A natural source of funding for the U.S. Government: U.S. dollar reserves are always held in highly liquid Treasury Bonds or agency bonds, debt securities that historically have performed well during times of heightened global economic risk. This makes these investments very attractive for central banks to hold. Foreign demand for these U.S. debt securities directly helps the U.S. government fund its spending costs.
4. Trade Advantages: Because the U.S. dollar is the dominant global reserve currency, many countries around the world hold large amounts of U.S. dollars in their foreign exchange reserves. This creates a natural demand for U.S. exports, as other countries need to use U.S. dollars in order to pay for goods and services from the U.S. Many international transactions, such as oil and other commodities, are priced in U.S. dollars, and this helps to maintain a steady demand for the currency.
5. Greater purchasing power for Americans: The global demand for dollars means that U.S. dollars can be used to buy around the globe and the dollar’s value can remain relatively stable against foreign currencies.
6. Increased influence in international affairs: The U.S. dollar's status as the global reserve currency gives the U.S. government and U.S. financial institutions significant influence in international economic and financial affairs. This provides the United States the ability to use financial tools such as sanctions to pressure other countries to comply with its policies.
It is this last point that has frustrated some foreign countries over the years. For example, heightened geopolitical tensions including the Ukraine-Russia war and stress with the U.S.-China trade relationship have prompted Russia and China to lock into a partnership where they have openly communicated an interest to undermine U.S. geopolitical dominance, including the dollar’s supremacy.
As mentioned earlier, one of the results of this Russian-Chinese alliance has been an increased level of transactions and trade taking place in currencies other than the U.S. dollar, in this case the Chinese yuan and Russian ruble. Such actions have also circumvented the current U.S. led-international sanctions on Russia, which included the freezing of more than $300 billion of Russia’s foreign currency reserves.
Despite local trading blocks around the world becoming more reliant on the use of non-U.S. currencies, replacing the U.S dollar on a global scale will be very difficult in the future.
Could the Chinese yuan or the Euro replace the U.S. dollar as the dominant global reserve currency soon?
While China’s role in the global economy continues to grow, there are major limitations for the yuan (or renminbi, RMB) as a global reserve currency. It faces serious obstacles from persistent currency controls and a closed capital account.
A reserve currency must serve the three basic functions of money on a global scale: providing a store of value, a unit of account, and as an accepted medium of exchange. A major aspect of an effective reserve currency is also its ability to act as a safe haven during moments of international economic and political stress.
The U.S. continues to be the world’s largest economy with the most robust and highly transparent financial markets system. Importantly, the U.S. dollar is also a free-floating currency and capital is allowed to freely flow into and out of the U.S.
Our current global system of trade is primarily based on floating exchange rates where a currency’s value is allowed to fluctuate freely in response to market demand and supply forces, rather than being manipulated by a central authority or government. This is not the case in China, for example, where strict capital controls allow the Chinese government to control investment flows and have tight controls on its currency. There are limits on how much foreign companies are able and willing to invest and subsequently borrow in Chinese yuan, outside what is needed in direct trade with China.
Even with the capital controls, Chinese investment at home and in other countries will cause additional financing and invoicing of deals in the Chinese yuan. This will subsequently increase the need for other countries to maintain an inventory of yuan as a reserve currency. Despite this, the Chinese yuan currently amounts to only 2.5% of total Central bank reserves (CNBC.com; April 2023). Seeing this statistic alone makes one think that it will likely take a long time if the yuan were to replace the U.S. dollar as a more viable global reserve currency.
The biggest competitor to the dollar’s position is the Euro, which took the largest chunk out of the U.S.’s share of the global currency reserve basket in recent decades (as seen in the chart above on page 1). However, the Euro’s share is well off its peak of 36% of global currency reserves in the early 1990’s. It is unlikely to see a significant rebound of this level, particularly as the European Union continues to deal with the economic and political effects from Russia’s invasion of Ukraine and the ensuing energy cutoff from Russia.
What would be the ramifications if global trade in commodities, such as oil, wasn’t conducted in U.S. dollars?
The U.S. dollar's status as the dominant global reserve currency is largely supported by its use in international trade, particularly in the trade of commodities such as oil. If oil, for example, was to be priced in another currency, it could potentially lead to a decline in demand for the U.S. dollar and subsequently, the need for holding the dollar for reserve purposes.
A shift away from the relatively stable U.S. dollar as the currency of choice for pricing global commodities could also lead to increased volatility in currency exchange rates, subsequently affecting trade flows and investment decisions. This could potentially create uncertainty and disrupt global financial markets.
Also, if global commodities such as oil were priced in a different currency, it could potentially affect the purchasing power of countries that are heavily reliant on importing commodities, including the United States. This could potentially lead to higher inflation and reduced economic growth.
Overall, a shift away from the U.S. dollar as the currency for pricing global commodities such as oil would have meaningful implications for the global economy which could potentially lead to increased volatility and uncertainty in financial markets. Despite this, it is unlikely that such a shift would happen in the near term given the widespread acceptance of the U.S. dollar in global trade and finance.
Will the emergence of digital currencies pose a possible threat to the U.S. dollar’s position as a dominant global reserve currency?
The past few years have made many financial pundits question whether the increasing use of digital currencies and blockchain technology could pose a potential challenge to the dollar and its role in the global financial system.
While the impact of these developments on the dollar's status is still uncertain, the rise of digital currencies, such as Bitcoin or central bank digital currencies (CBDC’s) could potentially disrupt the role of traditional currencies as a medium or exchange and store of value, as well as create new forms of currency that could compete with the dollar.
Digital currencies have the potential to offer faster and cheaper cross-border transactions compared to traditional currencies and since they are also decentralized, digital currencies do not rely on traditional financial intermediaries or institutions. This means that they could potentially reduce the dependence of other countries on the U.S. dollar within the current financial system, which has helped to support the U.S. dollar's position as the dominant global reserve currency.
It is highly unlikely that a digital currency such as Bitcoin will pose a consequential threat to the U.S. dollar’s reserve currency status in global capital markets. The reasons for that include the following:
Volatility: Digital currencies continue to trade with extreme volatility, which makes them a less stable store of value compared to the U.S. dollar. Their price volatility is still preventing digital currencies from gaining widespread global acceptance. Much of the attractiveness of the U.S. dollar is its relative stability against other currencies in foreign exchange markets and the confidence this brings to global investors.
Lack of regulation: Although many crypto investors would say that being unregulated is one of the major benefits of Bitcoin and other digital currencies, being unregulated is a reason for many governments and institutions to question their viability.
Limited acceptance: While digital currencies are gaining popularity in some countries and among certain groups of investors, they are not yet widely accepted as a means of exchange in everyday transactions. In contrast, the U.S. dollar is accepted as a means of exchange worldwide.
Government support: The U.S. government has a vested interest in maintaining the global reserve currency status of the U.S. dollar. The government has significant influence over the global financial system and can use its power to support the dollar's position as the dominant currency.
Network effects: The U.S. dollar's status as the global reserve currency has created a network effect that reinforces its dominance. Other countries and businesses are likely to continue using the U.S. dollar because it is widely accepted and has a deep and liquid market.
To follow up on what our team has previously written, digital currencies are still a relatively new and evolving technology and their role in the global financial system will most likely continue to increase over time. While it is unlikely that they will replace the need for the U.S. dollar as the dominant global reserve currency in the near term, they could still play a significant role in shaping the future of the global financial system.
In conclusion, the U.S. dollar's dominant position is not guaranteed by any means, and it will certainly continue to face challenges and potential threats in the years to come. But whether considering the Euro, the Chinese yuan, or a digital currency such as Bitcoin, none of these currencies currently offer a viable alternative to the U.S. dollar in terms of liquidity, stability, and global acceptance.
The Clearwater Capital Partners Investment Policy committee will continue to monitor the role of the U.S. dollar in the global financial system as well as other important currency-related issues which can impact various investments and the portfolio strategies we implement for our clients.
