There has been much excitable talk recently about the demise of the US dollar (USD) as the dominant global reserve currency. A rising China is challenging the hegemonic power of the US in so many areas.
So, proponents argue, China’s rise would eventually lead to the Chinese yuan displacing the USD — just like how the USD eventually overcame the British pound.
Others point to how growing structural weaknesses such as its extreme political polarisation and its parlous fiscal position threaten the long-term health of the US economy which would in time no longer be able to sustain USD dominance.
The answer from serious people who study these issues is that while the USD is seeing more challenges, there is little or no chance that any other currency could displace the USD within a reasonable time frame.
Broadly, we agree with this conventional view. However, we also believe that the bigger picture is that the USD-dominated international financial architecture is not serving the interests of all countries effectively.
Countries in Asia should re-shape this global financial system and so improve their strategic positioning — but the means of doing so will not be by displacing the USD’s dominance.
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A global currency
It might be useful to clarify what is meant by a “global currency” or a “reserve currency”. For a financial instrument to count as money or a currency, three roles have to be fulfilled.
First, it must be a medium of exchange: people must use it to transact trade.
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Second, it must be a store of value: it must be something people can put their savings in and feel safe about it.
Third, it should be a unit of account: people must use it to denominate contracts or measure value in some way.
Former US Federal Reserve Bank vice-chairman Alan Blinder extended this by saying that an international currency should: (a) constitute a significant share of official reserves held by central banks; (b) be used as money in many countries around the world; (c) denominate a very large share of international trade transactions; and (d) hold a dominant role in financial markets as a currency of choice.
The USD fulfils all these functions at an international level and so it is deemed to be an international currency. And because no other currency comes close to fulfilling this role to the extent that the USD does, the USD is deemed to be the dominant international currency. It is also important to appreciate the powerful network effects that can entrench the dominance of an international currency. The value of using a specific currency increases the more other actors use it.
The fact is that cross-border transactions have largely operated using a dominant currency for most of modern economic history: firms tend to converge on whichever currency played that role at the time in a “follow the crowd” manner.
So, once enough economic actors converge on a certain currency, attempts to use alternatives will falter because the initial focal currency has become entrenched in systems to facilitate cross-border transactions. It will be costly to reorient existing systems centred around the USD to use another currency. It is expensive to establish such systems, so they will be built only for currencies with widespread-enough usage to enable economies of scale that justify the costs. The USD has become so entrenched that it would take a lot to persuade enough actors to shift out of the USD.
In fact, the history of global currency transitions shows that they exhibit high degrees of endurance and require massive disruptions to dislodge. The network effects described above mean that without large-scale switching to a feasible alternative, parties in transactions will continue sticking with an incumbent currency even if the currency’s issuing country faces a deteriorating global position.
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It is striking how it took two world wars for the British pound to lose its status as a global currency, despite its long relative decline and loss of empire. Even then, the pound still constitutes a significant proportion of international reserves today.
Growing unease with USD dominance
One major source of frustration is that the dollar’s outsized role in international trade and capital markets means that US monetary policy has a disproportionate influence on monetary conditions in the rest of the world. Such spillovers are not always benign.
The current cycle of rate hikes has forced most other central banks to raise rates whether or not their specific economic conditions require tighter monetary conditions or not. Failure to do so would lead to capital flight and dislocations in local bond and equity markets.
Such less-than-benign spillovers have been evident for several decades, beginning in particular with the monetary tightening shock in the early 1980s when then-Fed chair Paul Volcker was determined to achieve disinflation even at the expense of inducing recessions in the US. The fact is that the Fed’s measures to meet its domestic mandate of price stability complicate the decision-making for other economies and impose real costs on them.
The trouble is that this unease with the disproportionate impact of US monetary policy has grown because more economic policy volatility in the US is feared as a result of the intense domestic political polarisation there. Criticism of Fed policy has come from both the right and left wings of American politics, eroding long-standing norms of respecting the Fed’s institutional independence.
The conduct of fiscal policy is also not much better, as evidenced by the over-stimulus during the pandemic, and the game of chicken being played right now over the debt ceiling.
Given the importance of sound institutions, including stable and independent monetary policy, judicial integrity, and the rule of law in underpinning a global currency, it is understandable to see why the trends in US domestic politics are starting to look less reassuring for others who continue to rely on the USD.
Geo-political concerns are also playing a critical role today. Most other countries were prepared to find ways to manage the economic risks of dollar hegemony. However, a recent and disturbing shift has been Washington’s willingness to wield its currency as a weapon of economic warfare.
For most of post-war history, there was a tacit understanding that the US would refrain from using its extraordinary financial powers that came from USD dominance for political purposes.
But recent years have seen the US use the dollar and its considerable leverage over the SWIFT payment network against international counterparties. When it did so against Iran in 2018, it brought howls of protest not just from America’s foes but also from its allies in Europe who were appalled by the breadth and stringency of US financial aggression against Iran.
European banks felt intimidated by the risk of US sanctions and cut off links with Iran, leaving the European powers who were not in favour of such harsh action against Iran with little room for manoeuvre.
This weaponisation of the USD took on even more severe forms with the sanctions imposed on Russia for its invasion of Ukraine.
USD dominance thus provides a high degree of extraterritoriality for the pursuit of US foreign policy and an additional source of pressure on other countries that may prefer alternative courses of action, ultimately undermining their strategic policy autonomy.
What about the Chinese yuan?
Given its extraordinary economic rise and its rapidly expanding political and military heft, it is the Chinese yuan which is touted as the currency most likely to displace the USD. However, if we take stock of the yuan’s current position vis-à-vis other major currencies, it is clear that China’s rise as a global economic powerhouse has not endowed the yuan with anything but a relatively minor role.
• The yuan is struggling to be an international store of value: The yuan’s presence in central bank portfolios is a mere 2% of global allocated reserves. This not only places it far behind the USD and the euro, it is even well behind second-tier currencies such as the pound and the yen. The lack of capital market liberalisation means that the yuan cannot be traded easily, thus reducing its attractiveness to other central banks.
• The yuan has made small but uneven progress as a medium of exchange for cross-border transactions: There have been recent moves to bolster the yuan’s role in international payments, including Beijing-Riyadh talks to invoice oil exports to China in yuan, or France’s first yuan-denominated liquefied natural gas export to China. Such moves do dent the USD’s monopoly position in global energy markets, but only slightly.
The rising adoption of yuan in cross-border payments is very much limited to around a quarter of the world’s economies, with another quarter barely seeing any progress in the last decade.
Many yuan adopters in South America and Africa might be doing so because of their Beijing-friendly foreign policy stances rather than for compelling economic reasons. The latest SWIFT data shows that the yuan only accounts for 2.2% of value in SWIFT-exchanged messengers, ranking below even the British pound (6.6%) and Japanese yen (3.0%), with the US dollar (41.1%) and euro (36.4%) far ahead.
• The yuan has made even less progress as a unit of account: Oil and commodity contracts continue to be predominantly denominated in USD. Despite all the rhetoric, even Saudi Arabia will continue prioritising the USD, which is crucial for the country’s arms purchases and international investments. Neither is the yuan gaining as an anchor currency for countries operating a fixed exchange rate unlike the USD and even the pound which other countries link their exchange rates to.
The key barrier is China’s own regime of semi-fixed exchange rates vis-àvis the USD. Given that a potential peg to the yuan is de facto a semi-peg to the USD, why would countries link their exchange rates to the yuan — they might as well manage their exchange rates visa-vis the USD directly.
USD dominance will erode only slowly
We could say a lot more about this complex issue if we had the space, but the broad thrust is clear from the discussion above: the USD is entrenched and even the currency of the only possible future superpower will be unable to shake that for a long time — despite the many weaknesses that are evident in the US.
What this means is that those who are unhappy with the current international financial architecture should look to other means of change than replacing the USD in its multiple roles. It is right for Asian countries to seek greater strategic autonomy — more leeway in conducting an independent monetary policy, greater freedom to pursue foreign policies without worrying about US sanctions and so on. But the way to do it will not be through waiting for the USD’s dominance to fade. There are more practical approaches to reduce the downsides of the existing financial architecture.
One way would be to build multilateral financial institutions which are credible and effective. With enough commitment and imagination, the current swap arrangements under the Chiang Mai Initiative and the increasingly credible and effective Asean+3 Macroeconomic Research Office could evolve into an Asian Monetary Fund, which would give Asian countries more clout in global finance.
Technology could also offer ways of reducing dependence on the USD. It might be possible, for example, to design central bank digital currencies jointly and encourage their use in international transactions. The coming years will see more such efforts and the result will be a more complex international financial system — but one still dominated by the USD!
Manu Bhaskaran is CEO at Centennial Asia Advisors
