Down With Dollar Dominance?

Down With Dollar Dominance?

In short – no. But this may be one to keep an eye out for in the future, though.

In a move not too unsurprising to many market watchers, Goldman Sachs has recently opined that downside risks to the greenback’s global dominance are today greater than ever – and somewhat akin to what the pound sterling faced in the early 1900s.

This comes only days after similar concerns were aired by Gita Gopinath – the First Deputy Managing Director of the International Monetary Fund (IMF) – of how Western sanctions on Russia, such as their exclusion from the global SWIFT (Society for Worldwide Interbank Financial Telecommunication) payments system, could possibly end up eroding the strength of the US dollar – a ‘de-dollarisation’ of sorts – promoting a spurt of digital and non-traditional currencies instead.

These comments come off as evidence of some countries having already started renegotiating the currency being used to pay for global trade.

“The dollar would remain the major global currency even in that landscape, but fragmentation at a smaller level is certainly quite possible,” Gopinath told the Financial Times in a recent interview.

Image: Currency composition of global foreign exchange reserves, in percent (1999-2021);
Source: Arslanalp, Eichengreen, Simpson-Bell (2022), IMF Working Paper WP/22/58, “The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Non-traditional Reserve Currencies”

The stealth erosion of dollar dominance?

A March 2022 IMF working paper titled “The Stealth Erosion of Dollar Dominance” was instrumental in reigniting this debate on a global level. The three researchers involved in the study – Arslanalp, Eichengreen and Simpson-Bell – stressed on active diversifiers and the rise of non-traditional currency reserves in order to monitor the depletion of the dollar’s strength.

In general, though the declining strength of the dollar in global trade is a fact well-documented, “the currency’s dominance has been resilient in the face of a declining US share of global GDP (as well).” The following figure marks clearly the decline in the share of the US dollar in global foreign exchange reserves since 1999 from over 70% to a little under 60% currently.

Interestingly, the fall in the dollar hasn’t necessarily been accompanied by the growth of other traditional safe-haven currencies like the euro or the Japanese yen either; it has instead been congruent with the rise of non-traditional reserve currencies (the researchers noted 46 “active diversifiers” in the study).

Dollar disruptions

Business Insider reports, “The move by the US and its allies to freeze Russia’s central bank out of much of its foreign currency reserves has raised concerns that countries could start moving away from using the dollar, due to worries about the power the currency grants the US. (…) Major investors are taking the risks to the dollar seriously.”

The relatively small global trade share of the US; when compared to the widespread prevalence of the dollar in the global payments ecosystem poses a major point of pressure. Furthermore, the country’s deteriorating net foreign asset position seems to be exacerbated with rising foreign debts from the import-heavy economy, with geopolitical disruptions such as Russia’s invasion of Ukraine only set to add to existing pressures.

Goldman, in their note, observed the reluctance of institutional investors to hold the British Pound post the huge volume of debt racked up during WWII. The situation with the US dollar, they opine, seems to be moving that way now – “if a reserve currency issuers’ debt is allowed to grow relative to GDP, eventually foreigners may grow reluctant to hold more of it.”

A fragmented global system could be rather damaging for the dollar, according to Gopinath. The increased use of other currencies in world trade would further cause global central banks to diversify their foreign reserve portfolios – at the expense of the dollar.

Goldman further believes the direction of the dollar’s future is in the hands of the Washington and the Federal Reserve: “…policies that allow unsustainable current account deficits to persist, lead to the accumulation of large external debts, and/or result in high US inflation, could contribute to substitution into other reserve currencies….”

This being said, given the deep entrenchment of the dollar and that there are no set alternatives to replace it the way the dollar replaced the pound, the position of the greenback as the global reserve currency – holding about 60% of global reserves – is safe for the foreseeable future.

It might be one to keep an eye on for the future, though.

Find the IMF Working Paper at:https://www.imf.org/en/Publications/WP/Issues/2022/03/24/The-Stealth-Erosion-of-Dollar-Dominance-Active-Diversifiers-and-the-Rise-of-Nontraditional-515150

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