Will Dollar Dominance Diminish?

By Laura Catterson, Hottinger Investment Management

The US dollar dominates global trade. It accounts for over 60% of the world’s currency reserves and in 2019, was involved in 88% of all transactions.[i] The Euro follows at over 20% and 32% respectively.[ii] This gives the US extraordinary power over anyone who imports or exports anything, anywhere. Commodities such as oil, gold & coffee are all priced in dollars regardless of where they come from. This clout has long frustrated America’s rivals – the centrality of the US dollar in the global payments system cements the potency of US trade sanctions and thus America’s dominance. Even amid the chaos of the coronavirus outbreak and collapsing global financial markets in late March, international investors sought refuge in the dollar. As it stands, any alternative has to overcome too many hurdles to make a viable play for the greenback’s current reign, and thus, the real test for the dollar’s endurance rests on Washington’s ability to weather potential storms and produce economic policies that enable the country, over time, to manage its national debt and curb its structural fiscal deficit.[iii]

The dollar came to dominate trade after World War II. Whilst countries were trying to rebuild, the US economy was strong resulting in a stable and plentiful dollar. In 1944 a conference of 44 nations decided to peg their currencies to the US dollar while the dollar itself was pegged to gold. As global trade grew so did the use of the dollar to conduct the world’s business. Even after the US abandoned the gold standard in 1971, the dollar remained the world’s currency of choice due to its liquidity and the efficiency of the US banking system.

Figure 1: World Allocated Reserves by Currency for 2020 Q1

Sceptics of the dollars continued stature point to the “rise of the rest”. The European Union has continued to further promote the Euro in international transactions and, although hit hard by the current crisis, it has grown its reserve currency status over the past 21 years sitting second only to the dollar. One factor that could further its advance is the European Commission’s plan to fortify its recovery budget for COVID-19 bailouts by issuing debt that will be repaid in EU-wide taxes. Some argue this could become the basis of a true fiscal union prompting more people to hold Euros.[iv] However, this proposal has been met with fierce resistance from some EU capitals, highly suspicious of granting Brussels with fresh resources. The euro-zone crisis has also cast significant doubt on the currency’s long-term dominance with the Italian budget deficit near 10% of GDP[v], France; 11.4%[vi] and Germany; 7.25%.[vii]

Former United States treasury secretary, Henry Paulson, argues that the Chinese renminbi (RMB) has the greatest potential to assume a role rivalling that of the dollar [iv] China’s size, prospects for future growth, integration into the global economy and accelerated efforts to internationalize the RMB all favor an expanded role for the Chinese currency. Yet, by themselves, these conditions are insufficient. Beijing has major hurdles to overcome before the RMB can emerge as a global currency let alone dethrone the dollar. China needs to make more progress in moving to a market-driven economy, improve corporate governance, and develop efficient, well-regulated financial markets that earn the respect of international investors. However, they show no inclination to abandon capital controls and make the Yuan fully convertible which only further delays the RMB’s potential advance.

When it comes to the primacy of the dollar, the main risk stems from Washington itself. The dollar’s status reflects the soundness of the American political and economic system. To safeguard the dollar’s position, the US economy must remain a model of success. That, in turn, requires a political system capable of implementing policies that will allow more Americans to flourish and achieve economic prosperity. It also requires a political system capable of maintaining the country’s fiscal health. No country has remained on top without long term fiscal prudence thus it is vital the US responds positively to today’s economic challenges.  US foreign policy is also of huge significance in maintaining the dollar’s edge. Policy choices abroad affect US credibility and, to a large extent, determine its ability to shape global outcomes. Washington must therefore be mindful that unilateral sanctions – made possible by the primacy of the dollar – are not free of cost. Weaponizing the dollar in this way can energize allies and foes to develop reserve currencies. Fortunately for the US, Iran, Russia and Venezuela have attempted to work around the dollar’s key role but with limited success.[viii] Major economies appear unwilling and unable to join forces in an attempt to dominate the dollar however, the US should not be complacent.

Above all, the United States must preserve the conditions that created the dollar’s supremacy in the first place. A thriving economy rooted in sound macroeconomic and fiscal policies; a transparent, open political system; and economic, political, and security leadership abroad. In short, sustaining the dollar’s status will depend almost entirely on the United States’ ability to adapt its post-COVID-19 economy so that it remains a model of success. Taking initiative to adjust and update global rules and norms that govern trade, investment, and competition in technology will also be key. With success in these areas, the dollar’s reign will remain unchallenged.

[i] https://data.imf.org/regular.aspx?key=41175

[ii] https://www.tradersmagazine.com/am/88-of-all-2019-forex-transactions-are-in-us-dollars/

[iii] https://www.foreignaffairs.com/articles/2020-05-19/future-dollar

Figure 1: https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

[iv] https://www.ft.com/content/68e5f028-a1a1-11ea-94c2-0526869b56b0

[v] https://www.reuters.com/article/us-health-coronavirus-italy-budget-exclu/exclusive-italy-sees-2020-budget-deficit-near-10-of-gdp-source-idUSKBN21Y2U9

[vi] https://www.reuters.com/article/health-coronavirus-france-deficit/french-budget-deficit-seen-at-114-in-2020-minister-says-idUSFWN2DG0W8

[vii] https://uk.reuters.com/article/us-health-coronavirus-germany-budget/germanys-debt-plans-create-budget-deficit-of-7-25-this-year-sources-idUKKBN23M14E

[viii] https://www.brookings.edu/wp-content/uploads/2019/09/DollarInGlobalFinance.final_.9.20.pdf