The dollar’s position as the main currency in the world has come under new scrutiny due to rivalry with China, the effects of Russia’s war in Ukraine, and ongoing disputes in Washington over the country’s debt ceiling.

The idea that non-American partners would diversify away from dollars was further fueled by Russia’s isolation from international financial systems due to sanctions last year.

Reduced Reserve Status

IMF figures show that in the fourth quarter of 2022, the dollar proportion of official FX reserves reached a 20-year low of 58%.

When the currency rate was taken into account, according to Stephen Jen, CEO of Eurizon SLJ Capital Limited, the movement was more noticeable.

“What happened in 2022 was a very sharp plummeting in the dollar share in real-terms,” Jen said, adding this was a reaction to the freezing of half of Russia’s $640 billion in gold and FX reserves following its 2022 invasion of Ukraine. This had sparked a re-think in countries such as Saudi Arabia, China, India and Turkey about diversifying to other currencies.

Taking A Longer Perspective

The dollar share of central banks’ foreign reserves did reach a two-decade low in the fourth quarter of 2022, but the decline was gradual, and it is currently practically at the same level as in 1995.

Rainy day funds are kept in dollars by central banks in case they need to support exchange rates during economic downturns. Oil and other commodities that are traded in U.S. dollars become more expensive when a currency depreciates too much against the greenback, increasing living expenses and stoking inflation.

For similar reasons, other currencies, like the Hong Kong dollar and Panamanian balboa, are tied to the US dollar.

Reducing Control Over Commodities

The all-powerful dollar has a monopoly on the commodity market, allowing Washington to stifle producer nations like Russia, Venezuela, and Iran from accessing the market.

However, trade is changing. In exchange for roubles and UAE dirhams, India buys Russian oil. For around $88 billion in purchases of Russian metals, coal, and oil, China moved to the yuan. The first LNG trade involving the Chinese national oil corporation CNOOC and TotalEnergies of France was finished in March.

According to BNY Mellon strategist Geoffrey Yu, after Russia, nations are asking themselves, “what if you fall on the wrong side of sanctions?”

The Bank for International Settlements (BIS) reports that the yuan’s percentage of global over-the-counter forex transactions increased from nearly nothing 15 years ago to 7%.

However, Too Complicated A System

Dedollarization would necessitate the independent decision to switch to other currencies by a vast and intricate network of exporters, importers, currency traders, debt issuers, and lenders. Unlikely.

According to BIS figures, the dollar will represent around $6.6 trillion in worldwide currency transactions in 2022, or about 90% of all transactions.

According to the BIS, 50% of all foreign debt is in dollars, and this is also true of invoices for international trade.

According to Barry Eichengreen, a professor of political science and economics at Berkeley, the functions of the dollar “all reinforce each other.”

“There just isn’t a mechanism for getting banks and firms and governments all to change their behaviours at the same time.”

A Dispersed Future

Although there might not be a single dollar replacement, the proliferation of alternatives could usher in a multipolar era.

According to Yu of BNY Mellon, countries are realising that having one or two major reserve asset blocks is “just not diversified enough.”

A larger range of assets are being examined by global central banks, including corporate debt, movable assets like real estate, and other currencies.

“This is the process that is underway,” said Mark Tinker, managing director of Toscafund Hong Kong. “The dollar is going to be used less in the global system.”

An Unwavering Foundation

Businesses utilise government bonds as an alternative to cash because substantial bank deposits aren’t always protected. As a result, the $23 trillion U.S. Treasury market, which is regarded as a financial refuge, supports the standing of the dollar.

“The depth, liquidity and safety of the Treasury market is a big reason why the dollar is a leading reserve currency,” said Brad Setser, a Council on Foreign Relations fellow who tracks cross-border currency flows.

There are substantial international Treasury holdings, and there is currently no reliable substitute. At just over $2 trillion, the German bond market is very tiny.

Producers of commodities may agree to transact with China in yuan, but recycling money into Chinese government bonds is still challenging since creating accounts is difficult and there is regulatory ambiguity.

“But you can hop on an app and trade Treasuries from anywhere,” Natwest Markets emerging markets strategist Galvin Chia said.

(Adapted from Reuters.com)

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