Dominance of US Dollar in international trade & finance

 

US Dollar (USD) is the most accepted currency across the globe although it may not be the strongest in nominal terms. USD ranks as 10^th strongest behind Kuwaiti Dinar (1^st spot), British pound (5^th spot) and the Euro (8^th spot). Despite its relatively low strength, USD is still considered and accepted as the World’s foremost reserve currency.

 When US Federal Reserve first issued USD as the nation’s currency in 1914, British Pound was already dominating the globe, in line with Britain’s reigning status as the largest colonial power. However, during World War I (1914-18), the allies (France, Britain, Russia, Italy, Japan) had to depend on US for supplies (US joined the war in 1917) with payment being made in gold. This made US as the biggest holder of gold reserves and strengthened its currency (since it was backed by Gold reserves) as compared to British Pound which had weakened post war. This in turn led to various countries pegging their currency to USD itself instead of gold and kick started USD’s journey towards being global currency. But international monetary system still depended on gold as primary standard.

The Bretton Woods Agreement
World war II started on 1^st September 1939 with German invasion of Poland. US joined the war on 8^th December 1941 after Japanese air raid on US naval base of Pearl Harbour (Hawaii). But even before it formally joined the war, US had started supporting allied forces in Europe through supplies of weapons and other goods. Payment for these supplies was made in the form of gold thus increasing US’s gold reserves and depleting the same for other European countries. This lopsided concentration of gold reserves with US, made it impossible to continue with gold as international standard.

 After the end of WW II, delegates from 44 countries met in Bretton Wood, United States to chalk out a program for international monetary and financial stability. The conference decided on an exchange system adopting US Dollar as the pegging currency whereby currencies of all countries would be linked to USD, discarding whatever remained of gold standard. Central banks could fix exchange rates of their local currency vis-à-vis USD, with the US guaranteeing to redeem USD held by other countries for gold. This firmly established USD’s position as international reserve currency.

The Nixon Shock - Switch from Fixed rate to floating rate system
As USD got established as an universally acceptable exchange medium, countries started accumulating USD in place of gold. US facilitated this by issuing USD denominated treasury bonds, which were considered as super safe investment. These treasury bonds were linked to gold reserve held by US Federal Reserve. In 1960s, heavy deficit financing triggered by Vietnam War forced US to print huge amount of paper currency. This weakened the USD and countries around the globe started pressing US for converting their USD reserves into gold. The demand for gold became so huge that on 15^th August 1971, President Richard Nixon announced formal delinking of USD with Gold, thus leading to abolition of Fixed rate exchange system and establishment of Floating rate system, as is prevalent today. 

USD Today
In spite of historical ups and downs, USD continues to be the most popular global reserve currency. It’s reported that Central Banks worldwide, hold about 60 % of their reserves in USD (although this has declined from 2000’s status of 71 % reserves being held in USD). About 80 % of global crude trade is conducted in USD, leading to coinage of term petrodollars. About 40 % of global debt is denominated in USD. Though USD is one of the 185 global currencies, but it’s pre dominant position as an anchor currency, results from its usage as the most acceptable medium of exchange amongst different countries.

 According to a report published in October 2021 by the US Fed, “over the period 1999-2019, the dollar accounted for 96 per cent of trade invoicing in the Americas, 74 per cent in the Asia-Pacific region, and 79 per cent in the rest of the world. The only exception is Europe, where the euro is dominant.”

Challenges to USD dominance
USD’s dominance of international finance has also been supported by the size of US economy, its stability and openness. But over the years, there has been a marked weakening in USD’s position. In a paper published on 24^th March, 2022 by the International Monetary Fund (IMF) titled The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies, it was observed that there has been “a decline in the dollar share of international reserves since the turn of the century……. Strikingly, the decline in the dollar’s share has not been accompanied by an increase in the shares of the pound sterling, yen and euro…Rather, the shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three quarters into the currencies of smaller countries that have played a more limited role as reserve currencies.”

 

This brings us to the question of current challenges to USD’s dominance as global currency and how long can this dominance continue. In this context, let’s look at some of the challenges –

 

·        After USD, Euro is the most preferred currency with 20 % of known global reserves being held in Euros. Europe presents a large integrated market economy and in course of time, can claim to replace USD as the global reserve currency.

·        China’s economic growth- China’s GDP touched USD 17.7 trillion in 2021 as compared to US’s GDP of USD 22.99 trillion (in nominal terms).  China is expected to overtake US by 2030s and someday Yuan may replace USD as the most widely accepted currency. Currently, renminbi is ranked as 5^th  or 6^th most widely used currency for global transactions, but it suffers from serious hiccups in its march towards a global reserve currency. It is not freely exchangeable and China doesn’t have an open capital account. 

·        Russia and China have been forming an axis to take on dominance of USD. While in 2015, about 90 % of trade between the two countries was conducted in USD, it came down to 45% in 2020. Sanctions imposed on Russia on account of the ongoing war with Ukraine shall further push these two countries so as to increase trading in their domestic currencies, instead of USD, thus further damaging USD’s prospects as a global reserve currency.

·        Crypto currencies-  the exponential growth in digital currencies over past few years, threatens to dislodge USD as a major trading currency, unless Central Banks the world over, move to regulate the Crypto world as soon as possible.

Russia-Ukraine crisis

Imposition of financial sanctions on Russia by western countries led by US, may be an effective political tool, but they threaten stability of international monetary system and may consequently lead to a diminishing role for USD.

Whatever the outcome of Russia-Ukraine conflict and its impact on geo-politics, its implications for the international monetary system shall be far reaching. Past experience shows that sanctions against Cuba, Libya, Iraq, North Korea, Iran, Venezuela etc, although severely impacted their domestic economies but at the same time strengthened the anti US sentiment and has led to a gradual decline of US political dominance. The current scenario is even worse, since Europe is heavily dependent on Russia for its Oil and gas needs and despite the sanctions being in force, countries like France and Germany have continued to import Russian Gas. This dependence on Russia has reduced effectiveness of financial sanctions.

 

This has also prompted Russian President Vladimir Putin to demand payment for oil and gas in Russian Roubles instead of USD. There have been reports of talks between Saudi Arabia and China for transacting trade of crude oil in Renminbi instead of USD. Both these moves combined, may hugely impact USD’s strength and stability drawn from its commanding status as petrodollar. Closer cooperation between China and Russia on currency, may hasten demise of USD as the sole global reserve currency.

 

Financial sanctions on Russia include blocking access to SWIFT (please refer to my last blog) and freezing of hundreds of billions of dollars of Russian assets in US. This may lead to shaking of confidence in US financial system. A primary contributor to USD’s acceptance as a global reserve currency, is the belief and guarantee of US Fed that investments in USD are safest in the world.  In view of Russia’s experience, many Central Banks may think twice before using USD as a reserve and may opt for other currencies, even if they are weaker. Also, western sanctions against Russia have increased its dependence on China which anyways is its biggest trading partner. This “war” against US’s financial muscle, may result in diminishing dominance of USD in international trade and finance.

 

I would end by quoting Zoltan Pozsar, Managing Director and Global head of short-term interest rate strategy at Credit Suisse, New York “this crisis is not like anything we have seen since President Nixon took the U.S. dollar off gold in 1971 – the end of the era of commodity-based money. When this crisis is over, the U.S. dollar should be much weaker.” He further believes that the global monetary system will never be the same post the crisis.