Some started predicting the end of the dominance of the U.S. dollar after the global financial crisis of 2008. The freezing of Russia’s U.S. dollar reserves following the Russia-Ukraine conflict has renewed that belief.
This article covers the history of the U.S. dollar as a reserve currency and the considerations that may determine its future.
A century of the Dollar
The U.S. emerged from World War II as the leading superpower in the western hemisphere. At the Bretton Woods Conference in 1944 (also known as the United Nations Monetary and Financial Conference), 44 countries agreed to peg their currencies to the U.S. dollar. The central banks of the signatory nations would buy and sell U.S. dollars using their own currency to maintain a fixed exchange rate and stabilize international trade.
At the time, the U.S. controlled three-quarters of the world’s gold supply[3], and the value of the U.S. dollar was backed by gold. The system known as the “gold standard” continued until it was abandoned by President Richard Nixon in 1971 in response to many global and domestic economic issues.
The U.S. dollar continued to be the world’s most popular currency as a means of exchange and a store of value long after the dissolution of the gold standard. Oil exporters received their payments in U.S. dollars, which became known as “petrodollars.”
Clouds on the horizon
Predictions of the fall of the U.S. dollar may be exaggerated, but its long-term supremacy is far from assured. Without the backing of a concrete commodity such as gold, faith in a currency depends on the entity that issues it.
Recently, U.S. investment bank Goldman Sachs indicated that the large foreign debt of the U.S. government relative to GDP is similar to the situation in Britain in the early 20th century, just before the British sterling ceded its position as the global reserve currency[4].
In the past two decades, the share of the U.S. dollar in foreign reserves has declined from 71% in 1999 (when the euro was launched) to 59%.
Source: IMF and Financial Times
Potential challengers
While the euro is the second largest reserve currency, the Chinese yuan renminbi may be the next global reserve currency-in-waiting.
While Europe is threatened by an increasingly assertive Russia, China could benefit from the geopolitical tensions. China has developed the Cross-Border Interbank Payments System (CIPS), which enables international transfers of yuan-denominated payments across 100 countries[5].
While it is still small compared to the SWIFT network, banning Russian banks from SWIFT could cause more nations to adopt CIPS to hedge against similar actions by the U.S. This may threaten the status of the U.S. dollar as the leading means of global payment.
The uncertain road ahead
Globalization has made countries increasingly interdependent in terms of national reserves and trade, where the law of comparative advantage has tended to concentrate the supply of certain goods and commodities in a handful of countries.
Source: Bloomberg
The above chart shows that China has $3.2 trillion of exposure to the U.S. dollar, giving it a significant stake in the viability of the U.S. government and economy.
More importantly, if the Chinese yuan renminbi were to become the leading global reserve currency, it would substantially decrease China’s control over it. This development would be a particular problem for China, given the level of control it requires over its domestic economy and financial system.
Conclusion
The waning dominance of the U.S. dollar does not mean its imminent collapse, as the extent of uncoupling needed to effect the transfer of dominance to another currency would probably take years.
Moreover, the transfer of dominance from one currency to another would not mitigate the use of the incumbent currency to apply geopolitical pressure. A possible scenario would be a shift from global to regional dominance, which would dilute the power of the U.S. dollar rather than displace it.
History has shown that currency markets are not always rational, and change may be slow. Meanwhile, the U.S. dollar continues to reign supreme.
[1] Statista
[2] IMF
[3] Federal Reserve History
[4] Business Insider
[5] Euromoney