The economics of dollar dominance

Out of the around 180 currencies in the world, the US dollar plays an outsized role, relative to the US share of global GDP, in global trade invoicing, finance, and foreign exchange reserves. The price of the dollar is currently at a 20-year high and counting. The international role of the "strong" dollar is therefore up for discussion yet again.

The dollar is on autopilot

Global trade needs a dominant currency for the same reason domestic trade needs a national currency. A double coincidence of exports and imports is needed for every country to use its own nonconvertible currency in international exchange. The transaction costs in trade is lower when all households and firms can buy and sell beyond national borders using the same unit of account and means of settlement.

Dominant currency choice shows path dependence and non-linearities. The British pound lost dominance in the 1930s long after the UK slipped from the leading world economy. A new international monetary system created out of the Bretton Woods Agreement in 1944 established the USD as the world's reserve currency. Central banks fixed exchange rates between the USD and their currencies. Following the termination of the BWA by 1973, the international monetary system evolved dramatically from a regime of pegged rates into flexible exchange rates.

The USD remains uncontested nearly five decades since. The USD share in global foreign exchange transactions has been stable at 88% over the past 20 years (The Triennial Central Bank Survey for 2019 of the Bank for International Settlement). The dollar accounted for 96% of trade invoicing in the Americas, 74% in the Asia-Pacific region, and 79% in the rest of the world over 1999-2019 (FEDS Notes 2021).

Strategic complementarities in pricing, hedging against macroeconomic shocks, and monetary policy anchoring underpin dollar dominance. Exporters opt for an invoicing currency similar to their competitors. The need to hedge against macroeconomic shocks favours currencies usable in hedging. This rules out unstable currencies. Exporters from a country with a volatile exchange rate do not use their own currency.

Dominance in trade has led to a mutually reinforcing dominance in finance. Trade invoicing in dollars generates demand for dollar safe assets which reduces the dollar interest rates. This induces borrowing in dollars which in turn encourages exporters to invoice in dollars to tap cheap dollar funding. Foreign banks are currently building up precautionary USD reserves in case the Fed's Quantitative Tightening triggers a funding problem. According to the BIS, about 60% of international foreign currency liabilities (deposits) and claims (loans) are denominated in USD.

Anchoring institutionalises dollar dominance. Over 65 countries currently peg their currencies to the USD while five US territories and eleven nations use it as their official medium of exchange, some in addition to their local currency. Exporters from countries with a USD anchor use USD more. China's ascent with a policy to narrowly bound the yuan with respect to the dollar fed dollar dominance.

Strong dollar can be contractionary

Advances in economics capturing salient empirical features of international economic interactions have refined and extended open-economy macroeconomics to nail the differences made by a dominant currency to the functioning of the global economy. Geeta Gopinath of the IMF and several others have developed a Dominant Currency Paradigm tracing the international transmission of exchange rate movements and their immediate consequences. The higher the share of a country's dollar-denominated goods, the more sensitive is its trade to USD fluctuations. Bilateral exchange rates are order of magnitude less relevant.

A country's depreciation does not make goods and services cheaper for foreign buyers right away when export prices are set in USD. This mutes the short-term boost to the domestic economy from reaction of export quantities to the USD rate. The exporters benefit mainly through increases in profits. Use of imported intermediate inputs dampens the effect on profits. The only immediate boost is from expenditure switching to domestic goods because imports in local currency are more expensive.

A global strengthening of the USD can shrink international trade in the short run. When most countries price their imports in dollars, the simultaneous expenditure switching results in a reduction in global trade. What is true of an individual country is not true for all countries. Gopinath et al (2020) find a 1% USD appreciation against all other currencies associates with a 0.6% decline within a year in the volume of total trade between non-US countries, controlling for business cycles. Proportional increase in all international trade prices in local currencies leads to a decline in global export and import quantities without an equivalent increase in US imports.

This trade destruction effect is reinforced by the dominance of USD in corporate financing in developing countries. A depreciation increases the value of a firm's liabilities relative to its revenues. Exporting firms are naturally hedged but importing firms typically are not. USD appreciation weakens their balance sheets. These effects are attenuated, probably not materially, by long positions on USD held by financial institutions, including central banks, and debts denominated in SDRs to the World Bank and IMF.

The possible simultaneous macroeconomic slowdown across all countries except the US is not just a zero-sum redistribution of production and consumption. The conventional wisdom on a weaker currency stimulating the domestic economy is humbled in nontrivial ways by the dominant currency phenomenon. The global strengthening of the USD in 2022 could be amplifying the global recessionary tendencies caused by the inflationary fall out of the pandemic, geopolitical uncertainties, and belated synchronisation of monetary tightening by major central banks.

Spillovers, a one-way street

The US is largely protected from the exchange rate risk in trade and finance. Appreciation of the USD affects import prices from all countries at once without any deflationary pressures in the US. Invoicing of 95% of US imports in USD dampens the effect of USD movements on consumer prices in the US.

When the dollar falls by one percent, inflation rises in the US by just 0.03%. The inflation responses are three times faster in other developed economies and six times in emerging economies (Ruchir Sharma, The Financial Times, October 10, 2022). Import price inflation in many countries depends mainly on movements in their exchange rate vis-a-vis the USD regardless of their share of trade with the US.

There are some significant exceptions. US companies with sizable foreign operations such as Apple, Google, Microsoft, FedEx, Ford, IBM, Netflix, Johnson & Johnson, Philip Morris, and others take billion-dollar hits in their business outside of the US. Morgan Stanley reckons every 1% change in the Dollar Index negatively impacts profits by 0.5%. For most US-based corporations, big tech in particular, the strong dollar is a wrecking headwind.

High-interest rate environment in the US is almost always associated with macroeconomic stress in developing economies. Dollar dominance leads to a co-movement of interest rates across economies even when fundamental shocks are not correlated. Monetary tightening in the US generates inflationary pressures in countries using dollar invoiced prices. This induces them to tighten their monetary policy. The converse is not true as long as US import prices are sticky in USD.

The world is not flat after all

Dependence on the USD diminishes the potency of monetary policy in non-US economies by taking the terms of trade out of the equation. The relative price of home exports in international markets is beyond its jurisdiction. Remittances and tourism provide limited room for monetary policy to do its work on external balance. These channels are of course important in many developing economies, as Sri Lanka learnt the hard way most recently.

The best the central bank can do is to stabilise domestic prices while floating nominal exchange rates. Floating allows gearing monetary policy to a country's own stabilisation imperatives. Given the effects of sharply fluctuating exchange rates on the balance sheet of firms exposed to the dollars on the short side, there is a case for smoothing exchange rate volatility. Macroprudential policy might be important for insulation from forces other than dollar dominance. Unilateral capital controls can do little to affect failing global demand due to dollar appreciation.

The dependencies do not seem to figure in the US policy calculus. Monetary tightening in the US increases inflation and decreases output in non-US economies. Ignoring these spillovers leads to tightening too much when inflation is rising, as currently may be the case, or expanding too little when recession is deepening, as was the case post global financial crisis. Aligning US monetary policy towards stabilising global demand for dollar-invoiced goods can internalise the spillovers. But the US would have to subordinate its domestic objectives without much immediate return.

Fuelled by speculative positions, the USD is at present "nearly 40% more expensive than at any point since 1980" (Ruchir Sharma, ibid). This is far higher than justified by interest rate, growth, external balance, and debt differentials in the US and the rest of the world. This needs correction sooner than later to prevent spillovers from causing financial meltdowns in developing economies.

Countries are better off if they coordinate policies. Renewed calls for macroeconomic policy coordination since the global financial crisis have eluded action. The perceptions of the sign of spillovers and proposals for the direction of coordination vary. The divergence of different domestic interests seem as important as the gains from coordination.

No obvious alternative to the USD

The replacement of the British pound by the dollar has been the only instance of a predominant currency switching in modern history. No country can unilaterally decide what currency to use in international trade without risking isolation. Pushing the use of too many currencies risks regression to a barter system in global trade.

The international division of labour requires all calculations to be tied to some equivalent. The USD's potential rival euro is part of a dysfunctional monetary union with declining share in the international monetary system over the last 15 years. China's managed system of capital controls and financial repression limits scaling up the use of RMB in international trade and finance.

A world currency managed by a world authority is a far-fetched fantasy. The world's dependence on the USD will continue. The challenge is to build binding checks against the abuse of dominance.

Zahid Hussain is former lead economist of World Bank Dhaka office