Is the end of US dollar’s reign in sight?

The fact that a currency is widely accepted, a role that is played by the US dollar, is crucial for the global economy. Photo: Reuters

There is an important economic and political term that refers to the decisive influence that a single state has over the functions of the international monetary system. This term is commonly known as monetary hegemony, and for it to occur, four main conditions are necessary: first of all, the state must have access to international credit; second, it must have foreign exchange markets; third, it would need to manage the balance of payments problems in a way that the hegemon operates without any balance of payments constraints; and fourth, it needs the direct and absolute power to enforce a unit of account in which economic calculations are made in the world economy.

Nowadays, when we think about the most popular currency in the world, the US dollar comes to mind. However, this has not always been the case. With the end of World War II and the establishment of the Bretton Woods system, in which the US dollar was designated as the world's primary reserve currency and other currencies were pegged to the dollar at fixed exchange rates, the global monetary hegemony shifted from British monetary hegemony, which began in 1871 with the adoption of the gold standard, to American monetary hegemony. In other words, the dollar is actually the currency of currencies, the one that is used as a benchmark for other currencies.

The fact that a currency is widely accepted, a role that is played by the US dollar, is crucial for the global economy. On the one hand, it helps to maintain price stability since it does not depend on several different currencies but on a single one. On the other hand, it fulfils one of the purposes for which money was created: to have a single unit for transactions recognised by everyone, and to eliminate "barter". However, it is not entirely clear that the United States has greater advantages because of the hegemony of its currency.

Gita Gopinath, an official at the International Monetary Fund, and Jeremy Stein explained in their 2021 paper how much of world trade is conducted in US dollars and how banks based outside the United States offer dollar-denominated deposits. On top of that, many non-US enterprises borrow in dollars; central banks hold a considerable portion of their reserves in dollar assets, and although it is not conclusively proven, interest rates tend to be lower when borrowing in dollars compared to borrowing in other currencies, ceteris paribus.

Even though it may seem that this is a crucial advantage, the reality is that the benefits the US enjoys from having the dominant currency are questionable. It is believed that the main benefit is that it allows them to have large deficits since the dollar will always be accepted by other nations. However, we can see that there are other countries that are able to run even bigger deficits than the United States relative to their GDP. 

For instance, Canada and Australia carry larger deficits relative to the size of their economies, and their currencies, the Canadian dollar and the Australian dollar, have never been used outside those economies. Another argument people make is that the US would have the ability to borrow cheaper since dollar bonds are seen as safer assets. However, that is hard to tell because there are many factors affecting the interest rates, and there is not much of a difference between the US borrowing costs and those of other developed nations.

There is a reason behind people's concern about a possible end to dollar dominance. Being able to claim that your currency is the chosen one is mysterious yet glamorous, which makes it seem relevant. But the reality is that, if you pay attention to the numbers, the significance of that fact is negligible.

Now that we have covered the importance of whether a country possesses the global currency or not, it is important to talk about the status of that supremacy. In the past couple of years, we have been hearing about the term "de-dedollarisation" and how detrimental it could be to the US economy. The term "de-dedollarisation" refers to the loss of the hegemony of the US dollar as a reserve currency. This term has been used, among others, by avid Bitcoin followers or by Putin sympathisers who demand consequences for the US due to its actions in the conflict between Russia and Ukraine.

However, beyond those individuals who may be influenced by external factors, there are also authoritative voices that have recently raised concerns about this topic. Fareed Zakaria, the Indian-American international relations expert, has already expressed his concern regarding this issue, warning that there is a potential danger of the dollar losing its superpower status. Additionally, Michael Pettis, whose insights about China are highly regarded, believes that the sole reason America can run persistently large trade deficits and see its debt increase without stopping is the dollar's dominance.

There have been hints that de-dollarization may actually be a possibility. Some supporting facts include Saudi Arabia's suggestion of accepting the Chinese yuan as a payment method for oil and Elon Musk's expression of the opinion that America's use of the dollar as a weapon against Vladimir Putin has accelerated de-dollarization. However, when we examine the numerical data, we see that dollar dominance has remained unaffected over the past 20 years, suggesting that a decline in the dollar's status is highly unlikely in the short run.

Despite that fact, there is another reason that may lead us to believe that the US dollar is losing its strength. To prepare for potential economic turmoil, nations tend to hold large amounts of dollars as a safeguard. If we look at the Federal Reserve data, it indicates that countries have gradually reduced their dollar holdings, decreasing from 71% in 2000 to 58% in 2022. This should not pose a significant threat to the dollar, as the reduction in dollar holdings is distributed among various smaller currencies rather than concentrated in a single powerful one. 

Furthermore, the private sector, which represents the majority of the dollar's international dominance, has remained stable at around 88%, indicating that 7 out of 8 transactions are done in dollars. The Fed, after combining all the aforementioned data, comes up with an index that shows no challenge for the US dollar.

It seems that as long as the US dollar continues to be used as a medium of exchange for other currencies, its dominance will persist. The widespread acceptance of the US dollar in transactions adds value to its supremacy, as increased transactions lead to greater liquidity, further enhancing its advantage. 

Consequently, transactions reinforce the dollar's role as an exchange medium. While domestic transactions may still be conducted in local currencies, for any international transaction, businesses will likely require dollars. When people go abroad, they don't try to impose their native language. Rather, they strive to learn English since it has been adopted as an international language. This analogy, proposed by M.I.T. economist Charles Kindleberger, accurately illustrates what is happening with the US dollar.

After conducting a thorough examination of the reasons behind the discussions on de-dollarisation, it becomes clear that the idea of other currencies, particularly the Chinese Yuan, overthrowing the US dollar is far from reality. It is just as unlikely as the belief that people would suddenly start communicating in Chinese when travelling abroad. While it is true that China exports more than the US and that its GDP is, by some measures, larger than that of the US, these factors alone do not seem sufficient for the widespread adoption of the Yuan as the new global currency.

The case of the Yuan is unique due to China's capital controls, which restrict the free movement of money in and out of the country. It is difficult to imagine that people would prefer to hold a currency that brings uncertainty rather than one that does not.

It is important to mention that things do not last forever. In the same way the dominance of the Sterling pound eventually ended, it is likely that the same fate will befall the US dollar, but there are no solid indicators that suggest it will happen in the near future. The main reason for this is the absence of better alternatives that could effectively fulfil the role of a global currency like the US dollar does. Some individuals believe that cryptocurrencies, particularly Bitcoin, may address some of the issues associated with traditional money. Only time will reveal whether this belief holds true or not.

M Kabir Hassan is a Professor of Finance at the University of New Orleans, US.

José Antonio Pérez Amuedo is a doctoral Student at the University of New Orleans, US.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.