- The US dollar is the world reserve currency and primary international trade instrument, yet there is speculation around decreasing its use
- Motivation behind de-dollarization includes desires to diversify, limit dependence on the US, reduce currency risk, and geopolitical factors
- The share of Chinese yuan in global central bank reserves has increased, but due to instability seems as the unlikely candidate to replace the dollar
- The euro is increasingly used due to its stability and wide acceptance, but issues linked to its lack of political union and fragmented fiscal policies exist
The global economy has historically relied heavily on the US dollar as its primary international reserve and foreign trade currency. However, recent discussions suggest a de-dollarization trend, where central banks have shown interest in shifting away from holding the dollar as their primary reserve currency. This shift may be a genuine attempt to weaken the US's position, but the historical prominence of the US dollar raises questions about its real-world implications.
How the US Dollar Became King
Let's start at the beginning. After World War II, the US dollar became the world's primary reserve currency due to economic and geopolitical factors. The Marshall Plan and Petro-dollar system strengthened its position, while Wall Street's dominance in well-regulated markets and large institutions made it appear safe and reliable. Institutions like the International Monetary Fund (IMF) and World Bank, which operate in dollars, further solidified its dominance and stability. Today, the US dollar is the primary foreign exchange reserve currency in central banks worldwide, while the euro trails behind by ca 38% (see Figure 1).
Figure 1: Foreign exchange reserves by currency in Q4 2022
Source: IMF Currency Composition of Official Foreign Exchange Reserves (COFER)
The dollar has experienced some troubles recently, including, but not limited to, the continuous rate hikes by the Fed, criticisms of weaponizing the dollar while illegally imposing sanctions or freezing assets raised by Russian allies in the Ukraine-Russia war, and China’s grind to elevate the yuan into a reserve currency. Some have quickly jumped into speculations of dethroning the King Dollar. However, none of these are very strong arguments. The Fed has already slowed rate hikes and is expected to follow this trend, even stopping the hikes altogether. The weaponization allegations extend only to the few Russian allies, but issues may arise when China, a potential covert ally, pushes these allegations as they also serve China’s desire to propel its yuan to become the top reserve currency. These events and speculation around them bring us to the talks of de-dollarization.
What is De-Dollarization?
De-dollarization means countries are interested in reducing their dependence on the US dollar in international trade, investments, and reserves, viewed as efforts of countries to diversify. Aside from the geopolitical factors and speculation that the dollar is not as stable as it used to be, some nations wish to de-dollarize to let the US have less power over their economy. They simply want to be less affected by US economic policies, sanctions, and trade restrictions. Another argument is economic diversification – the old saying in investing goes “Do not put all your eggs in one basket” and holds for currency reserves as well. Diversifying helps with exposure to the country’s currency risk, adverse movements in exchange and interest rates, etc. In general, proponents desire a rebalance of leading currencies rather than one main commander. Signs of de-dollarization emerge as central banks globally have increased the share of gold in their reserves from 11% to 15% in the last 5 years as a dollar replacement, showing CBs are seeking more stability in reserves.
To reduce the US dollar's dominance in transactions like oil agreements, commodity trades, and foreign exchange reserves, countries are considering a substitute currency. However, the intricacies of establishing a new currency as the primary currency, which involves shifting central bank reserves and replacing existing trade agreements, are complex. Additionally, OPEC countries may be skeptical about trading solely in the new currency due to their lack of trust in it. Despite the solid reasons why the US dollar became the primary currency, countries may start considering alternative currencies to fill the role of the US dollar.
If it fully ensues, de-dollarization is expected to be a slow process, taking decades or even generations, according to economists. The US dollar's share of central bank reserves has reached a record low of 58.8%, a gradual decline from its standard 70% share 25 years ago. However, since Q4 2020, the dollar share in reserves has remained steady, with a large gap to other currencies, see Figure 2.
Figure 2: Share of foreign currencies in worldwide central bank reserves
Source: IMF Currency Composition of Official Foreign Exchange Reserves (COFER)
Alternatives to the Dollar - Is It Beatable?
Figure 2 shows a slight decline in dollars due to the growth of other currencies, including the Australian dollar, Canadian dollar, and Chinese yuan. China is promoting its currency through bilateral trade agreements with BRICS and has made the yuan part of the Special Drawing Rights of the International Monetary Fund (IMF) in 2016 to support its stability. The Chinese economy, currently the world's second-largest, has seen stagnant post-Covid growth, with a 4.5% increase in Q1 2023 due to increased retail sales and industrial output. However, growth has slowed in Q2, and further slowdowns are expected. This instability and unpromising economic outlook have led to doubt among economists about the yuan's potential to become the leading currency.
The yuan has a small share of SWIFT payments, accounting for only 2.3%, while the dollar holds a strong 43% share, and the euro has a 32% share. This confirms the yuan's non-threatening status, and we may consider another contender. The euro, introduced in 1999, has established itself as a major global currency, gaining widespread usage, stability, and credibility over the years. In SWIFT payments and other areas, it closely tails behind the dollar.
Trade invoicing is a crucial aspect of the global economy, allowing invoices in a country's currency. A stable, reliable currency is preferred. The euro has nearly reached the dollar's level, but an IMF study confirms that both the dollar and euro are increasingly used for invoicing, indicating their stability. Although more recent data is unavailable, both currencies are viewed as stable.
Figure 3: Share of global payments made in US dollar and Euro based on transaction value
The IMF's study reveals that the euro is used as a vehicle currency in Africa, where it is used to invoice international trade transactions, especially when it is not the national currency of the exporter or importer. Nevertheless, the euro faces challenges due to the lack of unity within the European Union, leading to fragmented fiscal policy and a lack of political union. This results in the euro being seen as less stable than the dollar, which still has more global trust and confidence due to its historical stability and united fiscal policy. The eurozone would need to act as a single country, making decisions to benefit the EU as a whole, to have a chance at becoming a trusted leading currency, especially considering the dollar still accounts for 88% of foreign exchange global trade.
Figure 4: Share of foreign exchange global trade
Source: Bank for International Settlements, Bloomberg
The shift away from the dollar is unlikely to be a significant macroeconomic development, as central banks will likely hold less of their reserves in dollars. The yuan is unlikely to replace the dollar due to the Chinese economy's instability and lack of global presence. The euro performs second in global trade transactions but is less reliable due to fragmented fiscal policy in the eurozone. The dollar's reign is expected to continue for years and decades. As the ECB announced its digital euro, speculation around digital currencies becoming the future of money unfolds, potentially leading to the displacement of the traditional euro in favour of its digital counterpart, and perhaps even the replacement of the dollar as the world's primary reserve currency by a digital alternative.