Why dollar will remain dominant

“The dollar’s reign is coming to an end. I believe that over the next 10 years, we’re going to see a profound shift toward a world in which several currencies compete for dominance,” noted economist Barry Eichengreen in a March 2011 column published in The Wall Street Journal. His book Exorbitant Privilege: The Rise and Fall of the Dollar, also published in the same year, dealt with the issue in greater detail. The actual outcome clearly has not been as predicted. Although the US dollar’s share in global reserves has declined over the years, and attempts are being made to popularise other currencies, there has been no real threat to its dominance.

Questions, however, are once again being raised about the position of the US dollar in the coming years. The immediate context is the unprecedented level of sanctions imposed on Russia. It is being argued that the US-led Western alliance has weaponised the global financial system to almost completely cut off Russia. Sanctions also froze nearly $300 billion worth of foreign exchange reserves. All this lends credence to the view that it makes sense for reserve holders to aggressively diversify and also develop alternative systems of clearing international payments. The urgency increases considerably if seen from China’s standpoint. China holds over $1 trillion worth of US government bonds. It has also been trying to build an alternative payment system and popularise its currency for international transactions in various ways.

Although the size of the Chinese economy has increased rapidly in recent decades, it has inherent weaknesses which will not allow the renminbi to challenge the US dollar in a meaningful way. The biggest problem is that it’s not fully convertible. It is highly unlikely that the Chinese authorities will remove capital controls in a hurry, particularly at this juncture when growth is slowing and the financial system is looking vulnerable, partly because of excesses in sectors such as real estate. Capital control has been an essential element of the Chinese growth model and there is no reason why policymakers would remove them now. Nonetheless, there has been an increase in the level of trade being settled in Chinese currency and its holding as reserves.

To be fair, China is a trading powerhouse and has also been lending aggressively to various countries in recent years. It makes sense for China’s trading partners and debtors to maintain some reserves in renminbi to lower the cost of transactions and avoid volatility. Even if the renminbi gains acceptance in the coming years, it’s not clear where China would take its reserves denominated in US dollars.

The other currency which is seen by many as a challenger to the dollar is the euro. It is also far more popular as a reserve currency compared to the renminbi but, again, does not pose any serious threat to the US dollar. Its share in global reserves has remained fairly stable at around 20 per cent since 1999. It’s worth noting here that while the eurozone has the size advantage, its constituents are not at the same level, as was visible during the last decade’s debt crisis. Also, even before the adoption of the euro, deutschemark used to account for the biggest share in reserve currencies after the dollar. According to one estimate, its share remained in the range of 10-18 per cent between 1979 and 1998. The German securities market, however, is very small compared to the US.

Aside from geopolitical tensions and China’s position in the emerging global order, a new International Monetary Fund paper co-authored by Prof Eichengreen has revived the debate over the dollar’s dominance. The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies, highlights that the dollar’s share in currency reserves has declined from 71 per cent to 59 per cent since 1999. But the decline in the dollar’s share has not resulted in an increase in the share of other traditional reserve currencies, such as the pound, euro, or yen. The surplus has instead gone to what the paper terms non-traditional currencies. This shift is not necessarily a result of a preference for other currencies, but reflects diversification by active reserve managers for higher yields. However, the preference of some of the large acquirers of reserves has also led to the decline. For instance, just removing the Swiss National Bank from the calculation pushes up the dollar’s share in reserves by 2 percentage points.

Therefore, even as the share of the US dollar in global reserves has declined, this doesn’t pose a significant threat to its position because central banks would want to keep their core reserves in the most liquid assets. To be sure, the US benefits a great deal from the status of its currency. Among other things, capital flows from around the world allow it to easily fund the current account deficit and keep the cost of capital low. Most countries would want their currencies to acquire such a status. But it’s important to recognise that the dollar is backed by the strength of the US economy and the most liquid securities market in the world.