De-dollarization is the process of reducing the reliance on the U.S. dollar (USD) as a reserve currency, a medium of exchange and a unit of account in the global economy. This process can involve the diversification of currency holdings in central banks, the use of alternative currencies for trade settlements, or the adoption of regional or local currencies for global transactions. It could have major implications for global financial markets, currency stability, and international trade, as today the US dollar is the global (reserve) currency of choice: over 80% of global FX transactions and 50%+ of global trades and payments happen in USD.
This phenomenon has been a subject of debate in recent years as several factors that could undermine dollar supremacy are emerging.
Firstly, political instability. Tensions between the US and other nations could lead the latter to seek alternatives to USD. For instance, sanctions imposed by the US to Russia and Iran, pushed these countries to reduce their dependence on the dollar. The two connected their interbank communication and transfer systems, to create an alternative payment system to SWIFT. Since the 2018 reimposition of sanctions, Iran has been disconnected from the western-based Swift financial messaging system, while many Russian banks were kicked off the platform following Moscow’s invasion of Ukraine.
Also, the emergence of new global economies is contributing to the diversification of currency reserves. BRICS countries (Brazil, Russia, India, China and South Africa) represent major emerging economies with rapid growth of GDP and abundant strategic natural resources and their main aim is the de-dollarization of financial markets. They started a discussion on a possible medium of exchange based on national currencies, which could promote the adoption of the Chinese Yuan and Russian Ruble in international transactions.
For instance, China has signed currency swap agreements with several countries, allowing them to trade using the Chinese Yuan (CNY) instead of the USD.
As shown above, Russia has nearly a third of all reserves in China’s Renminbi. This shift in trade settlement practices reduces the demand for the USD and contributes to de-dollarization.
Another event that could contribute to this phenomenon is the recent growth of American public debt, which could lead to a decrease of trust of international investors in USD and could drive them to prefer other safer currencies. Historically, the USD has been the primary reserve due to its widespread acceptance and stability. However, central banks have started diversifying their reserves to hedge against potential fluctuations in the USD and increase their exposure to other growing economies, such as China. By reducing their reliance on the USD, countries can better manage their currency risks and maintain greater control over their domestic monetary policies.
This is the currency composition of foreign exchange reserves in percentages:
In addition, the rise of cryptocurrencies, such as bitcoin, and the underlying blockchain technology have the potential to disrupt the traditional financial system and reduce the role of the USD in international transactions. As more businesses and individuals adopt digital currencies for cross-border payments, the dependence on the USD may decrease. For Example, Russia has been discussing the establishment of a gold backed digital token. That is essentially a digital technology reverting to the gold standard and would be measured against the daily price of gold.
Even if there are factors that could undermine dollar supremacy, de-dollarization is a slow process and will depend on several economic, political and geopolitical factors.
Challenges and Prospects of De-Dollarization - Arturo Napoli
The United States enjoys significant advantages as the world's dominant reserve currency, including the ability to control the global financial system, run federal deficits without consequences, and print trillions of dollars out of thin air. This advantageous position enables the U.S. to maintain low-interest rates on its growing debt and provide its citizens with a standard of living that would be challenging to achieve otherwise. But how long will it last?
China's remarkable economic ascent, coupled with America's growing debt and monetary policy decisions in the late 1990s, began to challenge the dominance of the U.S. dollar. The 2008 financial crisis further intensified this shift, with China accusing the U.S. of devaluing the dollar through debt accumulation and excessive money printing. China started advocating for a new global financial system that would reduce reliance on the dollar. Initially met with indifference, the landscape changed dramatically when the West imposed sanctions on Russia following its invasion of Ukraine. Seizing the opportunity presented by geopolitical tensions and the desire for a more diverse international monetary system, China actively encouraged other countries, including Saudi Arabia, Algeria, and ASEAN nations, to explore alternatives to the dollar for trade and settlement. These developments have sparked conversations about the potential creation of a common currency within the BRICS nations.
The BRICS bloc, with a combined population exceeding 40% of the world's total and contributing around 25% to global output, is poised to grow in importance even further in the coming years.
However, developing an alternative international reserve currency to reduce reliance on the U.S. dollar would be challenging. The dominance of the dollar, accounting for around 60% of global foreign exchange reserves, 50% of global trade, and engaging 90% of foreign currency transactions, is significant and necessitates a substantial shift within the global economy to overcome. Furthermore, the credibility of any new currency would be crucial for its acceptance by global investors. The U.S. economy's well-established and trusted financial system, coupled with the dollar's safe-haven status, consistently attracts investors even during times of economic uncertainty. To gain investors' trust, a prospective BRICS currency would need to be supported by a robust monetary policy framework and ensure stable and transparent economic governance. Additionally, many countries expressing interest in de-dollarization are heavily reliant on the U.S. economy for their trade and investment, such as China and Brazil, making an abrupt transition away from the dollar potentially detrimental to their own economic well-being. The coordination of de-dollarization efforts among countries with divergent economic interests and priorities would undoubtedly demand extensive diplomatic efforts and compromise.
While reports of the U.S. dollar's sudden demise as the dominant global currency may be overstated, discussions about de-dollarization are relevant and merit attention. According to the IMF's data, the dollar's share of allocated foreign exchange reserves was 58.4% in 2022 Q4, almost unchanged from 58.5% in 2021 Q4. Critics argue that these figures may be distorted by exchange rate fluctuations. While the dollar strengthened in the first three quarters of 2022, which could have increased the value of dollar reserves and its share in reserve portfolios, the exchange rate-adjusted data show a decline in the dollar's share from 59% in 2021 Q4 to 57% in 2022 Q4. However, it is worth noting that similar drops in the dollar's share have occurred in the past (such as in 2002, 2005, 2010, and 2015), without resulting in a significant shift away from its dominance.
One factor contributing to the fluctuations in the dollar's share is the necessity for central banks to intervene in foreign exchange markets. Due to its high liquidity, the dollar is often used by central banks to purchase their currencies, resulting in a reduction in dollar reserves. Changes in interest rates can also influence the dollar's share. If interest rates on dollar bonds rise more significantly than those on bonds denominated in other currencies, the market value of bonds held in reserves may be affected, potentially leading to a decline in the dollar's share.
As an alternative to the U.S. dollar as a reserve currency, there are limited options currently available. The euro and the Japanese yen are often considered potential alternatives, but both currencies face challenges. The euro, while being the world's second-largest reserve currency, still lags far behind the dollar, accounting for only 21% of foreign reserves compared to the dollar's nearly 60%. The National Bureau of Economic Research highlights the insufficient supply of high-quality, euro-denominated assets that international investors and central banks can use as a store of value, along with the absence of a safe eurozone-wide government-backed asset. Additionally, the eurozone has experienced economic instability and political uncertainty, while the Japanese economy has been grappling with a prolonged period of stagnation.
Central banks may also diversify their reserves by turning to gold and non-traditional reserve currencies. In recent years, several emerging market central banks have increased their gold holdings, with 2022 witnessing the largest net purchases of gold by central banks in the 21st century. While China's Renminbi (RMB) could serve as a potential heaven from sanctions, it currently accounts for only 2% of all foreign exchange reserves, as reported by the IMF, with nearly a third of that held by Russia. Moreover, the value of the yuan is not independent, as it is closely managed in relation to the U.S. dollar to maintain a low price, which contributes to the attractiveness of Chinese imports in global trade. China has made efforts to de-dollarize its economy, such as securing agreements for transactions in yuan and selling its currency to Russia, but these measures have had a limited impact on the overall dominance of the dollar in global markets.
Instead, the majority of the diversification away from the dollar has been towards non-traditional reserve currencies like the South Korean won, Norwegian krone, Canadian dollar, Australian dollar, and Singapore dollar. This shift is partly due to these currencies offering attractive risk/return profiles when interest rates on traditional reserve currencies were near zero or negative. With interest rates moving into positive territory, it remains to be seen whether this trend towards non-traditional currencies will continue or if traditional currencies like the dollar or the euro, now bearing positive yields, will regain favour.
In conclusion, while de-dollarization may not be easy, it remains an ongoing topic that will shape the future of the global monetary system.
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