Why the Dollar Still Reigns Supreme

Has De-Dollarization Started? Will the dollar remain the main currency in which countries hold their foreign exchange reserves and conduct international trade? Will it remain the main currency in which foreign exchange transactions and cross-border loans are made?

In addition, questions are also being asked about the excessive privilege of the dollar. Recently, Uday Kotak, Chief Executive Officer of Kotak Mahindra Bank, termed the dollar as the “world’s biggest financial terrorist”. He later said that he had inadvertently used the term “financial terrorist” and meant that a reserve currency, like the dollar, has disproportionate power.

Along with this, international investor and chairman of Rockefeller International Ruchir Sharma has written in a recent article financial TimesThat central banks are now rebelling against the dollar.

While there appear to be some chinks in the dollar’s armor, it is safe to say that there is still no substitute. In this piece we will try and understand why this is so. However, before we do that, it is important to understand how the dollar came to be central to the international financial and trading system.

extreme privilege

By mid-1944, during World War II, it was more or less clear that the Allied forces were about to defeat the forces led by German dictator Adolf Hitler. At this point, countries came together to design a new financial system for the world.

The emerging system placed the US dollar at its center. This was an era when money was backed by gold. In this new system, the US stood ready to convert dollars presented by other countries into gold for one ounce (31.1 grams) of gold at a rate of $35 per ounce. This made the dollar the dominant international currency of choice, as it was the only currency that could be converted into gold.

Simultaneously, in 1945, the US entered into an agreement with Saudi Arabia, which had the largest discovered oil reserves at the time. In exchange for full US military support to the ruling clan of al-Saud, Saudi Arabia fixed the price of oil in dollars.

These two steps ensured that the dollar emerged as the dominant international currency. Given that it was convertible into gold and the fact that most countries imported oil, the dollar became the main currency in which international trade was conducted. The only way to pay for oil-imports in dollars was to charge a fee for exports in dollars. Once this happened, countries began to store a good portion of their foreign exchange reserves in the dollar, making it the main reserve currency within a few decades.

On 15 August 1971, former US President Richard Nixon decided that the link between gold and the dollar needed to be temporarily suspended. This temporary suspension eventually became permanent. Essentially, the dollars that countries held could no longer be converted into gold. They were basically pieces of paper (or digital entries). Even this change didn’t faze the dollar applecart. At the same time, the price of oil remained in dollar. As Paul Volcker, former chairman of the US Federal Reserve, explained: “People were more willing to hold dollars that were not backed by gold than they were ever willing to hold dollars that were backed by gold.”

This gave the dollar an extreme privilege that continues to this day. Other countries need to earn these dollars to pay for goods such as oil. America can easily print all the dollars it needs.

In fact, this excessive privilege was helpful to the entire world when the US Federal Reserve printed a lot of dollars after the 2008 financial crisis, and in the process, managed to save financial institutions around the world. On the other hand, when the Fed printed money after covid, it created bubbles in stocks, real estate, bonds, crypto, etc. around the world.

Doubt

In the past few months, some small and medium-sized US banks have run into trouble. This has raised questions about the stability of the US financial system and the dollar’s ability to remain central to the global financial and trading system. This is a very weak reason.

The strong reason is Russia’s attack on Ukraine. America has used its overwhelming privilege to make things difficult for Russia. 10 Russian banks have been cut off from access to the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network.

As Robert D. Blackwell and Jennifer M. Harris write in war by other means: “The fact that SWIFT is domiciled in Belgium – as opposed to a country less sympathetic to US and European geopolitical interests – makes it much easier to take advantage of this network.”

So, why is Swift so important? Globally, more than 11,000 financial institutions use the system. While it does not move money around the world, it does provide messaging on how to receive and make payments, making them fast and secure. Banning a country’s financial institutions from using SWIFT makes it very difficult for it to conduct international business, given that much of its invoicing is in dollars.

This is not the first time that America has taken such a step. In the past, similar sanctions have been imposed on countries such as Iran and Venezuela. So, the big point here is that at any point in time there remains a risk of sanctions against any country that is hostile to US interests.

Perhaps this is why Brazilian President Luiz Inacio Lula da Silva recently said in China: “Every night, I ask myself why all countries have to base their trade on the dollar… But why can’t we trade with our own currencies?”

Even central bankers understand this and have ramped up gold purchases to diversify away from the dollar. As Sharma wrote in his piece: “Central banks are buying more tonnes of gold now than at any time since the data began in 1950.”

However, despite the rhetoric, is the world really moving away from the dollar? The data doesn’t suggest so.

the figure

Let’s take a look first chartWhich shows the percentage of foreign exchange reserves of countries in different currencies.

By December 2022, more than 58% of global foreign exchange reserves were in dollars. Now, if we want to make a case for the world moving away from the dollar, we can say that this ratio was over 70% in 1999 and has come down since then. If we wish to state the opposite, we can say that in 1995 59% of foreign exchange reserves were in dollars and in December the same stood at 58%.

The nuanced proposition is that the world is moving away from the dollar, but very slowly. At the same time, no other currency seems to be emerging as a challenge. In short, the euro threatened. But euro holdings as a proportion of global foreign exchange reserves peaked at 28% in September 2009. By December 2022, they were 20.5%. Also, the economic condition of much of Europe is weaker than that of the US. So, is the case with Japan.

In addition to foreign exchange reserves, data from the Bank for International Settlements tell us that half of global trade is still invoiced in dollars. When it comes to cross-border loans, half the loans are in dollars. In case of foreign exchange transactions, 88% of the transactions are in dollar one way. So, clearly the dollar remains the dominant international currency.

chime

This does not mean that there are no problems. there are. First, every time the US exercises its excessive prerogative through sanctions, it encourages countries to start looking for other options. As Blackwill and Harris write: “Whenever the United States uses these sanctions, [it] could accelerate other countries’ search for alternatives to the dollar, which would reduce the effectiveness of sanctions in the future.”

This seems to be happening on a smaller scale now. First, central banks are buying a lot of gold to move away from the dollar. second, as economist In December, 16% of Russia’s exports were paid for in Chinese renminbi, up from almost zero before the attack on Ukraine. In addition, transactions on the Cross-Border Interbank Payment System (CIPS), China’s alternative to SWIFT, are booming. Also, many countries are working towards their own central bank digital currency and as Sharma says, they are testing how these currencies can be used to pay for bilateral trade.

America recognizes this risk. As Treasury Secretary, Janet Yellen recently told CNN: “When we use financial sanctions … over time it can undermine the hegemony of the dollar.” It also explains why countries continue to buy oil and gas from Russia without facing any sanctions. economist Explains: “Gazprombank, which processes these payments, remains a member of SWIFT.”

Another quirk in the dollar’s arsenal is the fact that Saudi Arabia is trying to slowly move away from pricing oil in dollars. In addition, the US is no longer dependent on Saudi oil as it was in the past, becoming a net oil exporter. So, in that sense, the guarantee of security for the ruling clan of al-Saud may not be as important as it was before.

China’s challenge

The general view is that over time the Chinese renminbi will challenge the hegemony of the dollar as the dominant international currency. China has grown at a very fast pace and its GDP (in current dollar terms) in 2021 will be $17.7 trillion, compared to the US’s GDP of $23.3 trillion. Nonetheless, the Chinese economy remains largely closed. Capital cannot freely flow in and out of China.

How does this matter? Countries need to invest their accumulated foreign exchange reserves to be able to earn returns on the same. For that, money needs to be able to move freely in and out of China, as is the case with the US.

The US meets this demand with a wide variety of investment assets available in dollars – everything from stocks and startups to government bonds and private bonds. Plus, dollar-denominated assets have great liquidity, meaning investors can get in and get out very quickly. It states that as of December, only 2.7% of global foreign exchange reserves were held in renminbi.

further, as reuters According to SWIFT, the renminbi’s “share of global payments is only 2.5%, and is very small compared to the US dollar’s 39.4% and the euro’s 35.8%.”

China cannot allow money to move freely mainly because the Chinese development model relies on the government channeling large household savings towards huge infrastructure projects. Allowing money to move freely risks Chinese household savings moving out of China.

Clearly, while the political rhetoric around the renminbi may be strong, it is nowhere close to becoming a major international currency.

Countries hold the majority of their foreign exchange reserves in the British pound and the Japanese yen. Furthermore, if we look at the countries with the world’s largest foreign exchange reserves, except China, Russia, Hong Kong and perhaps Saudi Arabia, most countries are likely to prefer the US over China. So, clearly, China has a long way to go on this front.

Lastly, what should we prioritise, as far as India is concerned? A world in which the major reserve currency is American or a world in which it is Chinese? Now this is a no brainer. ‘Hindi Sugar Bhai Bhai’ is not something that works.

Vivek Kaul is the author of bad money