The Stark Realities of De-dollarisation

The Stark Realities of De-dollarisation

De-dollarisation, the process of reducing dependence on the US dollar, is gaining attention, but challenges remain for alternative currencies

The world is alive, with the sound of…de-dollarisation? Indeed, type in the word ‘de-dollarisation’ on Google search – in just 0.34 seconds, as many as 625,000 results flash on your screen – a plethora of those being recent news articles perpetrating the idea of a global economic system that does not depend on the U.S. dollar. The reality, however, is that the term – and the concept – is not new at all.

The term was first coined in 1960 by Robert Triffin, a Belgian-American economist best known for his critique of the Bretton Woods system of fixed-currency exchange rates. Triffin argued that the U.S. dollar’s role as the world’s reserve currency was unsustainable, as it would eventually lead to a decline in the value of the dollar – unless the United States was willing to run ever-growing deficits, a concept known to the world as the Triffin dilemma.

This paradox primarily arises as a conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. He pointed out that the country whose currency was being considered the global reserve currency – the currency the world wished to hold – must be willing to supply the world with an extra supply of its currency to fulfil the demand for these foreign exchange reserves, thereby almost certainly leading to a humongous trade deficit.

Indeed, the United States’ total debt-to-GDP ratio stands in the 120%-region according to the 2021 value published by the World Bank – among the highest in the world.

The Stockholm Syndrome of Global Finance

It is prudent to remember, however, that global central banks to this day put rainy-day funds in dollars in case they need to prop up exchange rates during economic crises – i.e. safe haven hoarding. If a currency weakens too far against the dollar, oil and other commodities traded in the U.S. currency become expensive, raising living costs and fuelling inflation. A majority of the most widely traded global currencies, from the Hong Kong dollar to the Panama balboa, are all pegged against the dollar for similar reasons.

There is a reason why the U.S. dollar has, for long, remained the backbone of the global economy and will possibly continue to do so – and the answer is trust. But why exactly this trust in the United States? An editorial from BusinessLine ventures a guess:

“The answer perhaps lies in its soft power built on its values and the institutions that uphold those values. Britain was a brutal coloniser but there was a time when everyone wanted to be like Britain. Now everyone wants to be like America which, too, has been brutal in its pursuit of commerce but much nicer in many other ways than Britain ever was. In a way this is like the Stockholm Syndrome of global finance.”

Slipping reserve status?

In an attempt to break this hegemony, several countries, including those in the Middle East, the BRICS nations, namely Brazil, Russia, India, China and South Africa and even a South America-centric approach from Argentina and Brazil have for long considered a move away from the dollar. There are several melodies to this tune – but sadly, no consensus. Consider the BRICS currency chorus, for example.

As China became the world’s second largest economy, its ambition to position the Yuan as a reserve currency, a challenger to the King Dollar, became glaringly apparent. Quite a few countries, especially those indebted to Chinese loans and participants in the Belt & Road Initiative, echoed similar sentiments. India too, seeks to de-dollarise, but is silent on the Yuan as a challenger. It rather favours a combined BRICS currency. This lack of consensus is exactly why the dollar remains unchallenged.

Yet, according to one of the biggest U.S. banks, JP Morgan, slight signs of de-dollarisation have recently started unfolding in the global economy. The dollar’s share of central banks’ foreign reserves in the final quarter of 2022 hit a two-decade low – a gradual slowdown that now sees it at a level similar to 1995. The strains of steep U.S. interest rate rises and sanctions freezing Russia out of the global banking system following its 2022 invasion of Ukraine have thus been seen as impetus for a fresh push by the BRICS nations to challenge the dollar’s hegemony.

The almighty dollar has for long had a lock on commodity trading, allowing Washington to hinder market access for producer nations from Russia to Venezuela and Iran. But de-globalisation is (possibly) forcing a shift. India is purchasing Russian oil in UAE dirham and roubles. China switched to the yuan to buy some $88 billion worth of Russian oil, coal and metals. Chinese national oil company CNOOC and France’s Total Energies completed their first yuan-settled LNG trade in March.

What ensued was thus the dollar’s share of official FX reserves falling to a 20-year low of 58% in the fourth quarter of 2022, according to International Monetary Fund data. What happened in 2022 was a very sharp plummeting in the dollar share in real-terms. This was a reaction to the freezing of half of Russia’s $640 billion in gold and FX reserves. This had sparked a re-think in countries such as Saudi Arabia, China, India and Turkey about diversifying to other currencies.

A Reality Check

China’s yuan (CNY) now accounts for a record but still small 7% of FX trading volume, while the euro’s slice has shrunk 8 percentage points over the last decade of ultra-low interest rates to 31%. Trade invoicing has not seen much change, with the dollar and euro maintaining a steady 40-50% share over recent decades, although the U.S. share of global exports is now estimated at a record low 9% compared to record high 13% for China.

While progress in internationalising the yuan has been limited, JP Morgan added, it was unlikely to change much given the country’s capital controls. The CNY is 2.3% of SWIFT payments, JPMorgan’s analysts said, versus 43% for the dollar and 32% for the euro.

A few weeks ago, BRICS foreign ministers gathered in Cape Town, South Africa along with representatives from other countries such as Saudi Arabia, the United Arab Emirates and Kazakhstan. Most of the talk was about creating a new world order, a BRICS currency and de-dollarisation.

Though the BRICS coalition could be substantial, given the group has 42% of the world’s population, economically, it delivers just 23% of total global output and only 18% of trade. According to the Society for Worldwide Interbank Financial Transactions, the dollar is used for 42% of global currency transactions.  The euro’s share is 32% but it doesn’t have anything like the same influence outside Europe and parts of North Africa. The Chinese yuan contributes about 2%, as its non-domestic usage does not extend significantly even within Asia, or outside of trade-linked finance.

The challenge is that while some BRICS countries are resource-rich, most are transaction-volume poor. None, either alone or combined, can magic up an alternative currency. Substantive progress on nuts-and-bolts commerce among the group has to come first. The dollar’s dominance might be irksome but there is no alternative that is anywhere near critical mass. Rage against the dollar machine all you want — but it isn’t listening.

The Paradox of the Yuan as a reserve currency

Making the Chinese yuan a reserve currency instead of the U.S. dollar would have both advantages and disadvantages for China. However, it is important to note that this response is based on information up until September 2021, and the situation may have evolved since then.

  • Economic Impact: While having the yuan as a reserve currency would increase its international prestige and reduce dependence on the U.S. dollar, it could also lead to a current account deficit for China. This is because a reserve currency status typically leads to an appreciation of the currency.

An appreciating yuan would make Chinese exports more expensive and less competitive, potentially reducing the demand for Chinese goods and services from other countries. Consequently, China could experience a decrease in exports, leading to a current account deficit.

  • Trade Imbalances: China has relied heavily on exports to fuel its economic growth. The country has maintained a significant trade surplus for many years, which has been instrumental in supporting its domestic industries and employment.

If the yuan were to become a reserve currency and appreciate significantly, it could potentially disrupt China’s export-oriented model. A stronger currency would make Chinese exports more expensive, leading to a decline in demand and a potential trade deficit.

  • Political Considerations: China’s government tightly controls its currency exchange rate to maintain stability and support its export-driven economy. Allowing the yuan to become a reserve currency would require greater flexibility in exchange rate management. This could be politically undesirable for China as it might reduce the government’s control over its currency and create uncertainty in the economy. China’s leaders prefer to maintain stability and a controlled environment, and relinquishing control over the currency could be seen as a potential risk to their political goals.

It is worth noting that China has been taking steps to internationalise the yuan and increase its prominence in global trade. The country has been promoting the use of the yuan in international transactions, signing currency swap agreements with other countries, and expanding its influence in international financial institutions. These efforts reflect China’s desire to gradually increase the yuan’s role in the global financial system while managing the potential risks and challenges that come with it.

The BRICS trust deficit

  • Economic and financial integration: The BRICS countries need to increase their economic and financial integration in order to create a BRICS currency that is widely accepted and used. This would require them to harmonise their economic policies, create a common financial system, and develop a common currency basket.
  • Political will: The BRICS countries need to have the political will to create a BRICS currency. This would require them to overcome their differences and work together in a coordinated manner.
  • Trust: The BRICS countries need to build trust in their economies and financial systems in order to convince businesses and investors to use a BRICS currency. This would require them to implement sound economic policies and to maintain financial stability.

Finally, would countries like India accept the replacement of a US Dollar hegemony by a Chinese hegemony? Will China allow its currency to float freely, risk a trade deficit, and lose its profound advantage of massive exports to the world using its undervalued currency? Let’s not forget that the term de-dollarisation was coined almost 63 years ago.

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