Reports of the dollar’s demise are greatly exaggerated. An erosion in the greenback’s share of global foreign exchange reserves, combined with rising geopolitical tensions, have rekindled talk of an end to the US currency’s dominance. In fact, its lynchpin status remains unshaken. The outsized role played by the United States in capital markets, trade and debt reinforces the status quo. Unless the global economy undergoes a complete overhaul, the dollar will remain on top.
America may have never “run on Dunkin’”, as the donut-maker’s slogan claimed, but the global economy runs on the dollar. That makes many foreigners uneasy. Over-reliance on the American currency can lead to instability in emerging markets, dampen trade flows and create global spillovers, such as when financial markets melted down in March 2020.
This has been the case ever since the dollar’s coronation as the leading reserve currency after World War Two. In 1971 US Treasury Secretary John Connally famously quipped that “the dollar is our currency but it is your problem”. In 2019, almost 50 years later, Bank of England Governor Mark Carney endorsed the same sentiment.
Current pretenders to the throne include the Chinese yuan and digital currencies. The People’s Republic has long tried to promote international use of its currency. Its latest gambit is to offer to oil exporters payment in yuan to widen the reach of the Chinese currency. Meanwhile some central banks are touting digital currencies as a way to create a more balanced global economy where no single country dominates.
The United States has spurred the search for alternatives by wielding its currency as a weapon against its adversaries. After Russia invaded Ukraine, America and its allies froze nearly half of the country’s $640 billion in foreign exchange reserves. The US has also targeted dollars held by Afghanistan, Iran and Venezuela, while banks that circumvent American sanctions face hefty fines.
Proponents of regime change point to the steady fall in the dollar’s share of central banks’ foreign exchange reserves. That stood at around 59% in 2022, down from over 70% in 1999, according to the International Monetary Fund.
Meanwhile, the US share of the world economic output has fallen from 32% in 1980 to 24% in 2020, according to calculations by the U.S. Federal Reserve, while the country’s share of global trade dropped from 14% to 11% in the same period.
Yet in other respects the dollar’s grip is as tight as ever. The dollar was on one side of 88% of all foreign exchange trades in April last year, according to the Bank for International Settlements. The Fed estimates that between 1999 and 2019 the dollar accounted for 96% of trade invoicing in the Americas, 74% in the Asia-Pacific region, and 79% in the rest of the world. Banks used the greenback for around 60% of all international deposits and loans.
Structural factors also help. US capital markets are deep and liquid enough to absorb the savings of emerging and developed countries. The proceeds of an international “savings glut” are therefore recycled into US assets.
The greenback’s function as the lubricant of global economic activity has another important effect: a stronger dollar curbs global trade. Research by American University’s Valentina Bruno and Hyun Song Shin of the BIS shows that when the US currency appreciates, trading for companies in other countries becomes more expensive. This more than offsets the traditional export-boosting effect of a weaker domestic currency.
This contributes to what Fed researchers have dubbed an “Imperial Circle”. When the dollar strengthens, it puts the brakes on trade and global growth. Since US economic growth is less dependent on the rest of the world, this increases the attractiveness of dollar-denominated assets for foreign investors. That, in turn, bolsters the dollar’s dominance of the world’s economy, further pushing up the currency’s value.
The trigger for this cycle is often an interest rate increase by the US central bank, the Fed researchers found. What puts an end to it is the fact that, eventually, global weakness in the manufacturing sector spills over into US production. Rate rises also lead to tighter financial conditions for companies and households, slowing down the US economy. The central role of the dollar in capital markets, however, discourages investors from fleeing the United States, ensuring that the cycle soon starts again.
The period between December 2015, when the Fed raised rates, and December 2018, when the official cost of borrowing peaked at 2.25%-2.50%, illustrates the point. The dollar rose around 10% against other major currencies between mid-2015 and the beginning of 2017. During that period, manufacturing growth in the United States – measured by purchasing managers' index surveys – outstripped that of the rest of the world while financing conditions overseas tightened. By mid-2017 the circle closed as US manufacturing slowed down, domestic financial conditions tightened, and the dollar weakened.
Of course America cannot take its key role in global capitalism for granted. The weaponisation of the dollar, geopolitical tensions with China and the United States’ own political failings – from elected representatives disputing the results of the 2020 presidential election to squabbles over the debt ceiling – have increased the desire for alternatives.
For those factors to pose a serious threat to the dollar, though, they would have to trigger a shift in capital flows. China would need to recycle its savings domestically, running a current account deficit for the first time since 1993. And Japanese investors would have to repatriate at least some of their $1.3 trillion in US Treasury bonds. Central banks, meanwhile, would have to find a safe and liquid alternative currency, or crypto asset, in which to park their reserves.
In the past such financial revolutions have generally coincided with other upheavals such as world wars. In the absence of such a seismic shift, King Dollar will remain on its throne. — Reuters
Francesco Guerrera is global economics editor for Breakingviews, based in London.
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