With Saudi Arabia announcing oil priced in Chinese yuan, France’s Total Energies executed China’s first yean-settled LNG trade, Russia and China agreeing to trade in their own currencies, BRICS and African countries starting to abandon the dollar, Brazil and Argentina announcing the creation of a joint currency, the dollar status as a reserve currency is now in question.
Meanwhile, BRICS are surpassing G7’s GDP and they all seem to agree in the de-dollarization of their bilateral trade-flows. In this article, we explore the potential impacts of a hypothetical de-dollarization.
How did the dollar achieve reserve currency status?
First, let’s understand how the dollar achieved reserve currency status in a worldwide economy. It is important to understand the history. Those who ignore the history are doomed to repeat it.
The US dollar became the world's reserve currency following a series of historical events that took place over the 20th century. During the 1920s, the US economy experienced significant growth and became the world's largest economy. This economic growth was fueled by technological innovation, a large population, and vast natural resources. Additionally, the US dollar was backed by gold, which gave it credibility and made it a stable currency.
However, in 1929, the stock market crashed, leading to a global economic depression. The depression was worsened by the inability of countries to cooperate and manage their economies effectively. The depression eventually led to World War II, which caused massive destruction and displacement worldwide.
In 1944, after the war, representatives from 44 countries met in Bretton Woods, New Hampshire, to establish a new international monetary system. The Bretton Woods agreement made the US dollar the world's reserve currency, backed by gold. Other countries were required to peg their currencies to the US dollar at a fixed exchange rate, and the US agreed to exchange dollars for gold at a fixed rate of $35 per ounce.
However, in the 1960s, the US faced rising inflation and a growing trade deficit. This led to a depletion of gold reserves as countries began to exchange their dollars for gold. In 1971, President Nixon announced that the US would no longer exchange dollars for gold, effectively ending the gold standard.
This decision left the US dollar as the backbone of the global economy, solely based on the trust that other countries had in its stability and value. This gave the US tremendous power, as its monetary policy could affect the entire trade balance of the world. The dollar's reserve currency status has enabled the US to carry large deficits and fund its military and other projects while keeping low interest rates.
While the dollar's reserve currency status has given the US significant economic and political power, it also carries a great responsibility to maintain its stability and value for the benefit of the global economy. The increasing lack of trust in the US economy further fueled by geopolitical polarization and the tremendous burden on the growing economies carrying foreign debt has made many countries gravitate towards de-dollarization.
De-dollarization is not a new topic. It has been brewing for over a decade. An editorial in India's Economic Times newspaper on 26 March 2012 already called for discussions "about moving to a trade system that uses the currencies of the five nations only". However, the discussions seemed utopic until very recently.
Is it better to depend on China than the USA?
While some experts argue that it is necessary to reduce dependence on the US dollar and promote a more balanced global economic system, others express concerns about the potential risks of such a move. One of the key concerns is whether the alternatives to the US dollar are more transparent and reliable. For example, some economists question whether it is better to rely on China, a country with a communist regime and limited transparency, than on the more transparent capitalist democracies in the West. There are also concerns that using alternative currencies, like the yuan, could pose risks such as the potential for China's central bank to devalue its currency. As a result, even Russian are questioning the riskier dependance on China’s economic agenda.
What privileges does a reserve currency bring?
As the world's reserve currency, the US dollar holds significant global importance. It is widely accepted in international trade, and central banks worldwide hold it as foreign exchange reserves. The status of a reserve currency comes with several privileges.
Lower borrowing costs: One of the primary benefits of being a reserve currency is that it allows the issuing country to borrow at lower costs. As the US dollar is the world's reserve currency, countries hold significant amounts of it as foreign exchange reserves. This creates a high demand for the currency, which lowers the borrowing costs for the issuing country. This privilege has allowed the US to run and finance deficits at lower costs.
Increased international trade: The US dollar's status as the world's reserve currency has made it widely accepted in international trade. This reduces the need for currency exchange and lowers transaction costs, promoting more trade and investment. This benefit has allowed the US to export its goods and services worldwide, boosting its economy's growth and creating job opportunities.
Ability to finance deficits: Countries with reserve currencies can borrow significant amounts of money at low-interest rates from other countries. This privilege can be used to finance large deficits, such as military spending or infrastructure projects, without negatively affecting the economy's growth. The US has been able to finance its deficits, both domestically and internationally, and maintain its status as the world's largest economy.
Increased geopolitical power: Reserve currencies provide countries with increased geopolitical power and influence over other countries. The issuing country can use its currency as leverage in diplomatic negotiations and international trade agreements. The US has leveraged its reserve currency status to negotiate favorable trade deals and diplomatic agreements, increasing its political influence worldwide.
Greater stability and liquidity: Reserve currencies are considered to be more stable and liquid than other currencies, making them a preferred store of value for investors and central banks worldwide. This privilege increases confidence in the issuing country's economy and currency, which can attract foreign investments and boost economic growth.
Reserve currency status is often viewed as a great advantage for the United States, but it's crucial to consider who really benefits from it. The US gets to print stacks of dollar bills, which foreign countries use to trade and invest in dollar-denominated assets. However, if foreign demand for the dollar were to decline, it would lead to a surplus of unwanted dollars and a drop in the currency's value. Printing too many dollars could also cause inflation and backlash from voters. Consequently, the benefits from reserve currency status would vanish, and the American people would suffer. Moreover, if the dollar were to collapse, holders of the currency would be severely impacted, and hyperinflation could ensue in both the US and other countries that use the dollar. In essence, the advantages of reserve currency status have mainly benefited those who designed the financial system, rather than the ordinary people.
So what could happen next?
The prospect of the US dollar losing its position as the world's reserve currency is a topic of great concern. If this were to occur, it would cause the value of the dollar to weaken, which would initially be a gradual process, but could rapidly accelerate if the trend continues. The result would be a rush to exit the dollar, which would in turn drive up the prices of any goods or services traded on the global markets, with potential significant increase in commodity and input prices throughout supply chains, which would likely lead to significant capital flows. China is a dominant player in global trade, with particular semi-monopolistic control in key products and commodities, which could exacerbate the whole process and open the door to a whole new economic paradigm where both currency, trade and commodities are dominated by the same party.
The impact of such a situation would be dire, as one third of US treasuries are owned by foreign countries, with China having a particularly strong hold in this area. Additionally, around 40% of American stocks and 1/3 of corporate bonds are owned by foreign investors. If these investors start to get nervous and pull out, selling not only dollars but also other assets and other financial instruments denominated in dollars, it could lead to a collapse of the economy, driving up borrowing costs, making debt servicing more difficult causing further bankruptcies. In this scenario the Federal Reserve could try to cover up the drop in foreign demand by printing more money, but this would further drive up inflation and damage both the American economy and the economies of other countries that rely on the dollar.
While the scenario portrayed is still hypothetical, the fact that the US dollar has been the dominant global currency for 70 years may not be set in stone. The yuan is still far away from the USD as a global reserve currency, and central banks still hold about 60% of their foreign exchange reserves in dollars. So a potential de-dollarization won’t happen right away. However, the latest developments seem to be shaking up the foundations of international trade relationships and the geopolitical scene. As Xi Jinping told Putin, we may be facing changes not seen in a century. We should be prepared for a new multipolar currency world.
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