Why the dollar still reigns supreme

Has de-dollarization started? Will the dollar continue to be the main currency in which countries hold their foreign exchange reserves and carry out international trade? Will it continue to be the main currency in which foreign exchange transactions are carried out and cross-border loans are given?

Further, questions are also being asked about the exorbitant privilege of the dollar. Recently, Uday Kotak, the chief executive officer of Kotak Mahindra Bank, termed the dollar “the biggest financial terrorist in the world”. He later said he had inadvertently used the words “financial terrorist” and what he meant was that a reserve currency, like the dollar, has disproportionate power.

Along with this, international investor and chair of Rockefeller International, Ruchir Sharma, recently wrote, in the Financial Times, that central banks now are revolting against the dollar.

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While some chinks seem to have appeared in the dollar’s armour, it is safe to say that there is still no alternative. In this piece, we will try and understand why that is the case. Nonetheless, before we do that, it is important to understand how the dollar came to be at the heart of the international financial and trading system.

Exorbitant privilege

By mid-1944, during the Second World War, it was more or less clear that the Allied forces were likely to defeat the forces led by the German dictator Adolf Hitler. At this point, countries came together to design a new financial system for the world.

The system that emerged placed the American dollar at the heart of it. This was an era when money was backed by gold. In this new system, the US stood ready to convert dollars presented by other countries into gold at the rate of $35 for one ounce (31.1 grams) of gold. It made the dollar the premier international currency of choice, as it was the only currency that could be converted into gold.

Along with this, in 1945, the US entered into a deal with Saudi Arabia, which had the largest discovered oil reserves at that point of time. In return for full American military support to the ruling clan of Al-Sauds, Saudi Arabia decided to price oil in dollars.

These two moves ensured that the dollar emerged as the premier international currency. Given that it was convertible into gold and the fact that most countries imported oil, the dollar became the main currency in which international trade was carried out. The only way to pay for oil-imports in dollars was to charge for exports in dollars. Once this happened, the countries started accumulating a good chunk of their foreign exchange reserves in dollars, making it the main reserve currency over a few decades.

On 15 August 1971, Richard Nixon, the former American president, decided that the link between gold and the dollar needed to be temporarily suspended. This temporary suspension eventually became permanent. Essentially, the dollars that countries held could no longer be converted into gold. They were basically pieces of paper (or digital entries). Even this change did not upset the dollar’s applecart. Also, oil continued to be priced in dollars. As former chairman of the US Federal Reserve Paul Volcker explained: “People were more willing to hold dollars that were not backed by gold than they ever were willing to hold dollars that were backed by gold.”

This gives the dollar an exorbitant privilege which continues to this day. Other countries need to earn these dollars in order to pay for commodities like oil. The US can simply print all the dollars it needs.

In fact, this exorbitant privilege was of help to the whole world when the US Federal Reserve printed a lot of dollars in the aftermath of the financial crisis of 2008, and, in the process, managed to rescue financial institutions across the world. On the flip side, when the Fed printed money in the aftermath of covid, it led to bubbles in stocks, real estate, bonds, cryptos, etc., all across the world.

The doubts

Over the last few months, some small and mid-sized American banks have gotten into trouble. This has led to questions about the stability of the American financial system and the dollar’s ability to continue to be at the heart of the global financial and trading system. This is a very weak reason.

The stronger reason is Russia’s attack on Ukraine. The US has used its exorbitant privilege to make things difficult for Russia. The access of 10 Russian banks to the Society for Worldwide Interbank Financial Telecommunication (Swift) network has been cut off.

As Robert D. Blackwell and Jennifer M. Harris write in War by Other Means: “The fact that Swift is domiciled in Belgium—as opposed to a country less sympathetic to US and European geopolitical interests—made it considerably easier to leverage this network.”

So, why is Swift so important? Globally, over 11,000 financial institutions use the system. While it doesn’t move money around the world, it provides messages on how to receive and make payments, making them faster and secure. Banning a country’s financial institutions from using Swift makes it very difficult for it to carry out international trade, given that a lot of it is invoiced in dollars.

This is not the first time that the US has made such a move. In the past, similar sanctions have been slapped on countries like Iran and Venezuela. So, the larger point here is that the risk of sanctions remains against any country which is inimical to American interests at any point of time.

It is perhaps this that led the Brazilian president, Luiz Inácio Lula da Silva, to recently say in China: “Every night, I ask myself why all countries have to base their trade on the dollar…Why can’t we do trade based on our own currencies?”

Even central bankers understand this and have accelerated their purchase of gold to diversify away from the dollar. As Sharma wrote in his piece: “Central banks are buying more tons of gold now than at any time since data begins in 1950.”

Nonetheless, despite the rhetoric, is the world really moving away from the dollar? The data doesn’t seem to suggest so.

The data

Let’s first take a look at the chart, which plots the percentage of foreign exchange reserves of countries in different currencies.

As of December 2022, more than 58% of the global foreign exchange reserves were in dollars. Now, if we want to build a case of the world moving away from the dollar, we can say that this proportion in 1999 stood at more than 70% and has come down since then. If we want to state the opposite, we can say that in 1995, 59% of foreign exchange reserves were in dollars and were at a similar 58% in December.

The nuanced proposition is that the world is moving away from the dollar, but at a very slow pace. At the same time, no other currency seems to be emerging as a challenge. Briefly, the euro threatened. But euro holdings as a proportion of global foreign exchange reserves peaked at 28% in September 2009. As of December 2022, they stood at 20.5%. Also, much of Europe’s economic position is weaker than that of America. So, is the case with Japan.

Other than foreign exchange reserves, data from the Bank for International Settlements tells us that close to half of the global trade is still invoiced in dollars. When it comes to cross border loans, half of the loans are in dollars. In the case of foreign exchange transactions, dollar is on one side in 88% of the transactions. So, clearly the dollar continues to be the premier international currency.

The chinks

This does not mean that there are no problems. There are. First, every time the US uses its exorbitant privilege through sanctions, it incentivizes countries to start looking for other options. As Blackwill and Harris write: “Each time the United States uses these sanctions, [it] may be hastening other countries’ search for alternatives to the dollar, which in turn would undercut the future effectiveness of sanctions.”

This seems to be happening now at a small level. First, central banks are buying a lot of gold to move away from the dollar. Second, as The Economist reports, in December, 16% of Russia’s exports were paid for in Chinese renminbi, from almost zero before the attack on Ukraine. Further, transactions on Cross-Border Interbank Payment System (CIPS), China’s alternative to the Swift, seem to be picking up. Also, many countries are working towards their own central bank digital currency and as Sharma puts it, they are testing how these currencies can be used to make payments for bilateral trades.

The US recognizes this risk. As the treasury secretary, Janet Yellen, recently told CNN: “When we use financial sanctions… over time it could undermine the hegemony of the dollar.” This also explains why countries continue to buy oil and gas from Russia without facing any sanctions. As The Economist explains: “Gazprombank, which processes these payments, remains a member of Swift.”

Another chink in the dollar’s armoury is the fact that Saudi Arabia seems to be looking to gradually move away from pricing oil in dollars. Also, the US is no longer dependent on Saudi oil like it was in the past, having become a net-oil exporter. So, in that sense, the security guarantee to the ruling clan of the Al-Sauds might not be as important as it was in the past.

The China challenge

The general thinking is that over a period of time the Chinese renminbi will challenge the hegemony of the dollar as the premier international currency. China has grown at a very fast pace and its GDP in 2021 (current dollar terms) stood at $17.7 trillion, against the US GDP of $23.3 trillion. Nonetheless, the Chinese economy continues to be largely a closed one. Capital cannot freely move in and out of China.

How does this matter? Countries need to invest the foreign exchange reserves they accumulate, in order to be able to earn a return on it. For that, money needs to be able to move freely in and out of China, as is the case with the US.

The US further satisfies this demand with different types of investment assets being available in the dollar—everything from stocks and startups to government bonds and private bonds. Plus, there is great liquidity in dollar-denominated assets, meaning investors can get in and get out of an investment very quickly. This explains why, as of December, only 2.7% of global foreign exchange reserves were in the renminbi.

Further, as the Reuters reports, renminbi’s “share of global payments is merely 2.5%, and tiny compared with US dollar’s 39.4% and euro’s 35.8%, according to SWIFT.”

China cannot let money move freely primarily because the Chinese growth model depends on the government channelizing massive domestic savings towards huge infrastructure projects. Allowing money to move freely runs the risk of Chinese domestic savings moving out of China.

Clearly, while the political rhetoric around the renminbi might be strong, it’s nowhere near becoming the premier international currency.

Countries have greater holdings of their foreign exchange reserves in the British pound and the Japanese yen. Also, if we look at countries with the largest foreign exchange reserves in the world, except for China, Russia, Hong Kong and perhaps Saudi Arabia, most countries are likely to prefer the US than China. So, clearly, there is a long way to go for China on this front.

Finally, as far as India is concerned, what should we prefer? A world in which the premier reserve currency is American or a world in which it’s Chinese? Now that is a no-brainer. ‘Hindi Cheeni Bhai Bhai’ is not something that works.

Vivek Kaul is the author of Bad Money.