My best White Papers come from client questions.
One of the most frequently asked questions in the last 90 days has been, "I hear about the dollar being de-emphasized as a global reserve currency. What is the impact of that?" Many times, I don't already know the answers to such questions. But it leads me to hours of research and information gathering in order to be able to offer an informed opinion; something beyond simply regurgitating the headlines.
In the News
As I, and our clients, watch the headlines on CNBC or read the Wall Street Journal, we hear whispers that the U.S. dollar's dominance is being challenged on several fronts simultaneously. Here are five major news points that investors are talking about.
The US Dollar as the World's Reserve Currency
- China and Russia, recently, stepped up their efforts to ditch the U.S. dollar. Russia has been moving away from the greenback for some time, but efforts accelerated after Western sanctions were introduced following the invasion of Ukraine. For years many world leaders who were not US friendly have felt the U.S. dollar plays a far too dominant role in global finance. Discussions of a more politically neutral reserve currency have gone on for decades. (1)
- A BRIC summit, to be held in August includes a main agenda item to discuss a new global trade currency. The current BRIC countries (Brazil, Russia, India, China) account for 40% of the global population and one-fourth of the global GDP. The BRIC alliance is now set to expand with Iran & Saudi Arabia having initiated the formal process to join. Over 10 other countries, including Egypt, Algeria, the UAE, Mexico, Argentina, and Nigeria, have also expressed interest in joining the BRIC block. (2)
- In other recent developments involving global trade away from the dollar, I learned that China recently completed the first yuan-settled Liquid Natural Gas (LNG) trade, which was done between the Chinese national oil company and France's Total Energies through the Shanghai Petroleum and Natural Gas Exchange.
- Also in the news, China and Malaysia recently announced that they were open to discussing the creation of an Asian Monetary Fund to reduce reliance on the U.S. dollar. Meanwhile, India & Malaysia announced that they abandoned trading in U.S. dollars and can now settle in Indian Rupees. (3)
- We all hear regularly about the impact of crypto currency, as well as other forms of electronic currencies such as central bank digital currencies, and their potential to change the international financing landscape. While many regulatory and stability hurdles still remain, these modern technologies are showing the world there could be alternatives (especially electronic alternatives) for faster execution and the elimination of currency risk. They will undoubtedly have powerful impact in the future.
The US dollar is the default currency in much international trade, making it the world's reserve currency. Because of this dominance, every central bank and major company that conducts international trade keeps a large portion of their foreign exchange holdings in US dollars. Because holders of dollars seek returns on those balances, the dollar drives a substantial portion of the demand for US government bonds in world financial markets.
Today, central banks hold about 60% of their foreign exchange reserves in dollars.
Central Bank Reserves, Q2 2022
Source: International Monetary Fund (149 countries reporting)
About half of international trade is invoiced in US dollars, and about half of all international loans and global debt securities are denominated in US dollars. In foreign exchange markets, where currencies are traded, US dollars are involved in nearly 90% of all transactions. (4)
The US dollar's status as the world's reserve currency has significant economic and geopolitical benefits. The US can borrow money at lower interest rates than other countries, because investors see US government bonds as a safe and stable investment. The dollar's dominance also gives the US significant influence over global economic activity, allowing America to use economic sanctions and other policies to exert pressure on other countries. And of course, the Federal Reserve can simply print more money when it needs it.
A Brief History Lesson
The US dollar has been the world's primary reserve currency for almost 80 years. Under the Bretton Woods system, established near the end of World War II in 1944, the dollar was pegged to gold and most other currencies were pegged to the dollar. (5)
Thanks to the Bretton Woods Agreement, the US dollar was officially crowned the world's reserve currency and was backed by the world's largest gold reserves. Instead of gold reserves, other countries accumulated reserves of U.S. dollars. Needing a place to store their dollars, countries began buying US Treasury securities, which they considered to be a safe store of money. (6)
The Bretton Woods system collapsed in the 1970s when President Nixon delinked the US dollar from gold. Currency values, including the US dollar's, have fluctuated under the floating exchange rate system that followed. This, along with the rise of other economic powers (think the Eurozone or China) has led to various predictions of the demise of the dollar as the primary reserve currency. Yet, data on currency composition of reserves indicate that the US dollar's share of reserves today remains roughly the same as 30 years ago. There have been variations in the US dollar's share, but it has never fallen below 50 percent. (5)
The timeline below shows both the rise of the US dollar as the world's reserve currency as well as some of the recent challenges to its preeminence.
A Need for Caution
Many countries believe that the United States over-uses the dollar's dominance as the world's reserve currency as an economic weapon for arm-twisting other nations. For example, following the economic sanctions imposed by the United States and other Western nations against Russia in response to its invasion of Ukraine, Moscow and the Chinese government have been collaborating to reduce their reliance on the US dollar and establish greater cooperation between their financial systems.
Since the Russian invasion in 2022, the Ruble-Yuan trade has increased by eighty-fold. Additionally, Russia and Iran are reportedly working together to launch a cryptocurrency backed by gold and central banks, particularly those of Russia and China, have been purchasing gold at the most rapid pace since 1967, as countries seek to diversify their reserves away from the dollar.
In fact, U.S. Treasury Secretary Janet Yellen recently spoke with Reuters about the dangers that sanctions based on the U.S. dollar might pose for the US currency in international markets.
There is a risk when we use financial sanctions that are linked to the role of the dollar, that over time it could undermine the hegemony of the dollar, as you said. But this is an extremely important tool we try to use judiciously. (7)
It only stands to reason that if you have less "friends" in the world, those "enemies" will not want to own, hold and trade in your currency.
The Slow Process of Change
But simply replacing the currency of the largest economy is not easy. There are substantial barriers to moving away from the US dollar as the world's reserve currency. The US dollar is the de facto currency of East Timor, Ecuador, El Salvador, the Federated States of Micronesia, the Marshall Islands, Palau, Panama, and Zimbabwe. Further, the comparatively transparent conduct of monetary policy in the US has led no less than 22 foreign central banks and currency boards to peg their currencies to the US dollar. And US dollars are the cheapest means of access to acquire nominally risk-free US Treasury instruments. (8)
The US dollar's role as the world's primary reserve currency came about because of the emergence of the US as the world's major economy. The size of the US economy and its importance in international trade, the size, the depth and openness of US financial markets, stable and open domestic macroeconomic policies, and the convertibility of the US dollar are all acknowledged as important factors that both brought about and continue to support the US dollar in its preeminent position as the world's reserve currency. These same factors also explain why the Euro, although sharing some of the same characteristics, has never really stepped up to rival the US dollar and why no emerging market currency accounts for a visible share of global foreign currency reserves. (5)
While there's no denying that the US dollar's dominance has waned in the last two decades, it nonetheless still comprises 60% of world foreign exchange reserves. At WT Wealth Management we don't see a swift end to this dominance anytime soon. And we believe the US government and Federal Reserve will work to retain the dollar's position as the world's reserve currency. But this trend bears watching over the next several years to understand the future impact of what appears to be a shift in sentiment away from the US dollar.
The experts at WT Wealth Management eat, sleep and live to learn about these issues and translate them into digestible chunks for our clients. This is one of the reasons why investors are best served by professional investment advisors and asset managers. Please reach out to your advisor to learn or discuss more.
I look forward to the next impressive question a client throws my way.
- Russia and China have been teaming up to reduce reliance on the dollar. Here's how it's going.
- BRICS summit to discuss mechanism for trade in national currencies among members
The Economic Times
- China, Malaysia to discuss Asian Monetary Fund to reduce dependence on US dollar
- The U.S. Dollar as the World's Dominant Reserve Currency
Congressional Research Service
- An Historical Perspective on the Reserve Currency Status of the U.S. Dollar
U.S. Department of the Treasury
- How the U.S. Dollar Became the World's Reserve Currency
- Financial Sanctions Could Undermine The Hegemony Of The Dollar, Admits U.S. Treasury Secretary
- De-dollarization Has Begun.
American Institute for Economic Research