by Paul Stafford
Back in September of last year, even by its own lofty standards, the US dollar was riding high. According to the ICE US Dollar Index (USDX), a measure of the greenback against a basket of six major rivals, it was at its strongest level in over twenty years. Driven by the Fed’s aggressive interest-rate hikes, and a scramble for the stability of the world’s premium safe haven currency, times were good.
But eight months is an awfully long time in the global economy – especially in volatile times like these. Fast forward to April 2023 and the USDX had the dollar down by 10%, making it the worst performing currency in the G-10. To top it off, economies around the world were making their feelings towards the currency’s global reserve status known and attempting to shed their holdings of USD. All of which has fuelled talk among investors, analysts and the global business community of ‘de-dollarization’. As anyone who has been around for a while knows, talks around the topic tend to emerge every few years. Often, as Joe Weisenthal pointed out in a recent Odd Lots podcast, when rumours abound of someone paying for a barrel of oil in any other currency than dollars. This time, however, things seem a little different, and the market is taking the prospect a lot more seriously.
What We Know Now
USD as a safe haven currency: A brief history
As long as there has been global trade, there have been a form of safe haven currencies. In Roman times, there were gold and silver coins. During the Middle Ages, the Florentine florin and the Venetian ducat took over. The Dutch guilder had a good run in the 17th and 18th centuries until the British pound sterling took over the following century. GBP reigned supreme until World War II, although its power had been waning since the First World War and the subsequent unravelling of the gold standard. At which point, in 1944, the Bretton Woods Agreement was established, pegging the dollar to gold at a fixed rate of $35 per ounce. This system provided stability and confidence in the dollar and, as it was gold-backed, other economies anchored their currencies to it. All of which cemented its status as the global reserve currency of choice. Even when the Bretton Woods system was halted in 1971, when Nixon suspended the dollar’s convertibility to gold, opting to leave currencies values at the mercy of market forces, its status continued.
And ever since then, both as a transactional and reserve currency, USD has been the global market’s choice, offering unrivalled market depth, liquidity, ease of convertibility and credibility.
What’s changed?
While talk of de-dollarization does tend to rear its head from time to time, the key difference now is that there’s a political and combative edge that previous flirtations have lacked, at least on a scale of this size. Following the US’s freeze on over $330bn of oligarch-owned global reserves and the kicking out of Russia from the SWIFT system in retaliation for the invasion of Ukraine, many global economies outside the West have grown deeply concerned over what they see as a weaponization of the greenback. While across Europe condemnation of Putin’s invasion was broadly universal, relations with Russia – and distrust of the US – remain strong elsewhere in the world. What’s more, many governments worry that, if they were to aggravate the US, they too could be frozen out of large parts of the global economy.
In truth, a number of economies have been trying to ease their reliance on the dollar for a while, as the currency’s credibility has begun to wane somewhat, following years of quantitative easing, low interest rates and, more recently – and because what goes up must come down – rocketing inflation. Fears of currency weaponization have only bolstered this.
The share of USD reserves held by central banks has been declining, dropping from 71% in 1999 to 59% in 2021. In 2022, this dropped by a further 8%, equivalent to 10 times the average annual pace of erosion.
As a transactional currency, however, the dollar is still king, and in 2022 was used in one side of 88% of all daily transactions. For context, the euro accounted for 30% and the yuan just 7%. But attempts are being ramped up on this front too. China has been buying oil in gold-backed yuan since 2018 and in March of last year, China and Saudi Arabia began talks about trading oil in yuan instead of dollars. This developed further, when in 2023, the Saudi Finance Minister stated that, for the first time in almost 50 years, the Kingdom was open to trade in currencies beside the dollar. Russia, understandably, has also been looking at ways to move away from the dollar, agreeing deals with Turkey and China to buy natural gas in rubles and demanding any “non-friendly” countries to do the same. In March of this year, China and Brazil also reached a deal to trade in their own currencies, ditching the dollar as an intermediary. While Brazil’s new President, Lula, has floated the idea of a new BRICs currency to wean South America off the dollar. Even in the West, Macron has stated the EU should reduce its dependence on the “extraterritoriality of the US dollar.”
All of which is a way of saying that this de-dollarization talk has legs. For the dollar, the timing couldn’t be worse. April’s worst performing G-10 currency has continued its run of poor form into May, with another Fed rate hike failing to stop the rot – not substantially anyway – or quell the de-dollarization chatter. Despite this, market sentiment towards a move remains mixed, and while some are unconvinced, others have declared it a “matter of when not if”.
A hypothetical near-future
If the dollar was to cease being the safe haven currency of choice, the first question would be which currency would replace it? The Russian ruble and Chinese yuan are increasingly used in transactions, but there are limitations to their adoption as reserve currencies. The ruble, frankly, is just too volatile. The yuan, meanwhile, is managed not by the market, but with Beijing setting an exchange rate spread, making the currency particularly hard to swap for other currencies. Furthermore, foreign investors remain wary of buying into Chinese equities and bonds. Unless the currency is allowed to freely float and that overseas demand is there, it’s unlikely to usurp USD anytime soon. The world’s second most widely held reserve currency and second most used transactional currency is the euro. However, considering its use is largely confined to the eurozone, having failed to make a dent internationally, it also seems unlikely to take the throne. Many nations are currently working on their own central bank digital currency (CDBC). Around 80% of central banks are currently engaged in CBDC work, with China leading the way. For the last three years, it has been piloting its e-CNY, a digital form of yuan, and distributed it to 15 of its 23 provinces. To date, it has been used in more than 360 million transactions totaling north of 100bn yuan, or $13.9bn. Another alternative could be some kind of foreign exchange reserve asset based on a basket of currencies, similar to the IMF’s Special Drawing Rights (SDRs) or the Project Dunbar and Project mBridge multi-CBDCs. All of these efforts, however, are still at very early stages. Even China’s impressive sounding e-CNY numbers from the last three years amount to one-third of the physical yuan transferred in a single day across China’s two largest mobile payment processors, Alibaba and Tencent Pay.
With a lack of a genuine physical or digital alternative clear, but with an understanding that the dollar may not be quite as safe a haven as it once was, many central banks are massively increasing their gold reserves to boost strength in their own currencies. In 2022, central banks bought 1,136 metric tons of gold in 2022 – the most recorded in over 70 years – with heavy buying from central banks in Russia, China, the Middle East and India, suggesting a push to drive confidence in their own currency.
If we imagine what a de-dollarized near future might look like, we get a pretty clear idea of why it probably isn’t going to happen right now. In terms of investment, de-dollarization would make cross-border transactions more expensive and could lead to higher interest rates on US Treasuries, impacting foreign direct investment. That surge in interest rates would also make borrowing more expensive for both consumers and corporations. This would have knock-on effects on the global economy, as countries holding US Treasuries would see their value decline. For example, China currently holds almost $900bn in US Treasuries, which would decrease in value if US interest rates were to rise. Taking a huge hit on that would be an act of enormous self sabotage.
Safe for now?
There is undoubtedly a concerted de-dollarization effort from economies hostile to the US and who are less than pleased with the dollar’s dominance and the geo-political weapons that it places in the US’s hands. But sudden de-dollarization simply isn’t going to happen; the appetite outside of a handful of countries currently isn’t there yet and as a transactional currency, there is no real alternative right now, with no currencies matching it in terms of liquidity, ease of convertibility and credibility. And as a reserve currency, central banks are currently sitting on too many dollar bills to afford for it to take such a sharp hit in value.
Longer term, it’s not so clear. While global USD reserves are declining, it often takes decades, even centuries, for a currency’s reserve status to fade. Meanwhile, the obvious successor, the yuan, is restricted in its effectiveness by domestic government controls. One option, floated recently by economist and CEO of Eurizon SLJ, Stephen Jen, was more of a “tripolar” currency system, wherein the dollar, euro and yuan have a “roughly equal presence [...] more aligned with the economic heft of the three blocs." Considering the decline of the dollar’s status and moderate growth of its rivals, this certainly seems possible in the not-so-distant future. CBDCs are also likely to play an increased role, though whether they have the power to replace the dollar anytime soon remains to be seen.
For now, at least, the dollar’s status is safe. But the cracks are starting to show.