The end of the dollar? Why multipolarization will marginalize, not vanquish, dollar hegemony
09 April 2023
by Zachary Cefaratti
The transition of the global economy to a more multipolar currency system has corollaries with the ongoing energy transition, but it does not portend any imminent or existential treat to the dollars value, or its role as the dominant reserve currency.
The world is familiar with the three energy transitions, from biomass to coal, from coal to oil, and now from oil to sustainable sources of energy. There are several similarities to transitions of global reserve/settlement currencies in that such transitions span over many decades, that they do not imply a complete replacement of the former, and that the ongoing transitions of both are to more multi-polar systems rather than replacement of one dominant currency/fuel by another. Oil is not being replaced by one single energy source, it is co-existing in an energy mix that increasingly includes sustainable sources such as solar, wind, geothermal, hydro and several others. Oil will remain a central energy source along these various sources of renewables for the foreseeable future just as the dollar will remain dominant in a more multi-polar system with several other currencies.
Recent headlines have caused many to fret about the decline, or even an imminent collapse, of the US Dollar. Specific concerns have focused on headlines relating to alternatives to the US Dollar being used as settlement currencies, such as alternatives to the US Dollar for settling oil trades. It is important to differentiate between the various roles of the US dollar outside of the United States and to study each of them independently, as these concepts while interrelated are often conflated to make incorrect conclusions about the consequences of multipolarization.
The dollars role outside the US: Settlement, financing and reserves
The different roles that the dollar plays are often conflated into one, in which people refer to status of the dollar as the ‘global reserve currency’, however the dollar performs multiple roles in the world and it is important to differentiate them before analyzing the potential demise of the dollar. It is also important to remember the three fundamental functions of currency: a unit of account, a means of payment and a store of value.
The dollars role as a settlement currency refers to its use to finalize, or “settle,” international transactions between parties. When two parties from different countries engage in a trade or financial transaction, they may choose to settle the transaction in a specific third currency rather than their respective domestic currencies. This is done to simplify the transaction process, reduce currency conversion costs, and minimize exchange rate risks. The US dollar has been popular as a settlement currency for countries even when trade between those countries does not involve the United States, such as for trading of oil, however the world has been long moving towards a more multipolar system where parties agree to settle transactions in one of their own currencies. The function of a settlement currency takes advantage of two functions of a currency — its function as a unit of account, and as a means of payment — but not necessarily as a store of value. As countries exchange rates in local currency become more stable, their institutions become more efficient and the risks and complexities of dealing in their currencies are reduced, the need to use a third currency for settlement is reduced.
The dollar is also a popular financing currency, and is used as the currency for denominating many financial transactions such as bonds, loans and acquisitions particularly in emerging markets. This is usually done to reduce borrowing costs, attract international investors or reduce foreign exchange risk when the underlying activity is principally correlated to dollar prices — however there has been a growing trend for financing to occur in local currency in emerging markets, particularly for domestic currency activities as the institutions in those nations have become more robust, and to manage the risk of adverse FX movements or negative impacts of US monetary policy in those countries. Furthermore, multi-lateral institutions such as the IMF and World Bank have favored the US Dollar for financings they sponsor, however the IMF also denominates loans in SDRs which are linked to a basket of currencies. The dollars function as a unit of account is the primary currency function at play when it is used as a financing currency, with the secondary being its role as a means of settlement.
The dollars has long been the dominant reserve currency as well, with a large portion of global reserve assets (upwards of 60% according to the IMF) being held in US Dollars. The dollars role as a reserve currency takes advantage of its function primarily as a store of value. It is the role of the dollar as a reserve currency that is relevant to most arguments.
Why do countries hold foreign reserves?
A reserve currency is a foreign currency held in significant quantities by central banks and other financial institutions as part of their foreign exchange reserves.
Countries hold foreign reserves for various reasons, principally including:
- Currency stability and pegs: Holding foreign exchange reserves, particularly in stable reserve currencies, helps countries maintain the value and stability of their own currency. Central banks can use their foreign exchange reserves to intervene in the currency markets to support their domestic currency or manage its exchange rate, particularly during times of economic stress or volatility. Maintaining stable exchange rates is critical for countries engaging in international trade, and many countries with strong exports and heavy reliance on international trading peg their currencies — with the US dollar being by far the most common peg. In order to maintain the peg, countries must hold significant reserves of US dollars. A number of currencies are currently pegged to the dollar including the Hong Kong Dollar, The Saudi Riyal, the Qatari Riyal, the UAE Dirham, and numerous others. Exporter countries, typically large oil exporters, use pegs and exchange rate management to prevent their currency from appreciating against their trading partners so that their goods don’t become uncompetitive, often referred to as ‘Dutch disease’, which would otherwise crowd out development of other sectors of the local economy. Kuwait has notably used a basket of currencies rather than the US Dollar for its peg, but this has generally been regarded as inefficient and has created numerous complications for Kuwait including in relation to monetary policy transmission.
- External debt management: Countries often have external debt obligations denominated in reserve currencies. Holding reserves in those same currencies helps countries meet their debt service obligations and reduces the risk of currency mismatches, which can lead to financial instability. When a foreign currency is a popular financing currency, it is important to hold reserves of that currency.
- Confidence and credibility: Holding a substantial amount of foreign exchange reserves, particularly in widely accepted and stable reserve currencies, can signal a country’s economic strength and boost investor confidence. This can help attract foreign investment and enhance a country’s creditworthiness in the eyes of international investors and credit rating agencies.
- Liquidity and safety: Reserve currencies are typically characterized by deep and liquid financial markets, which means that assets denominated in these currencies can be easily bought or sold without causing significant price changes. This liquidity is essential for central banks, as they may need to liquidate their reserve assets quickly during times of economic stress or to intervene in currency markets.
Countries hold other reserve assets, such as gold, for similar reasons to holding reserve currencies. The currency reserves held by countries are often accumulated naturally by trading and investment that is not converted to local currency, rather than purchased on the open market.
Important characteristics of a reserve currency
For a currency to be suitable as a reserve currency, it must have certain characteristics. The characteristics of the US Dollar have made it the clear choice as a global reserve currency, where others have faltered. It is often said of the others “China is a prison, Europe is a Museum and Japan is a nursing home”. It also also often quipped that “bitcoin is an experiment”. The optimal characteristics of a reserve currency include:
- Supply — In order to be suitable as a reserve currency, there should be an expanding supply of that currency outside of the first country. Therefore, the first country must be willing and continue to supply its currency to other countries by running a persistent current account deficit. This is referred to as the Triffen Dilemma. However, running persistent current account deficits can lead to long-term domestic economic imbalances, such as high levels of debt, inflationary pressures, and potential loss of confidence in the currency. Over time, these imbalances may undermine the stability and value of the reserve currency itself. The US has run persistent current account deficits, providing much supply of US dollars internationally making it not only suitable as a choice for a reserve currency, but also causing much of the reserve accumulation to occur naturally. Chinas role as a global exporter/manufacturer has made its currency unsuitable, and has caused China to instead be a significant accumulator of reserves — mostly the dollar. Japans domestic focus has also made it unsuitable in this regard. Indeed, there is no suitable currency in terms of supply dynamics besides the USD to act as a global reserve currency today.
- Open capital account and limited exchange rate intervention — an open capital account is critical for a global reserve currency, as this allows that currency to be freely exchanged and liquid. Countries with capital controls or which engage in significant exchange rate intervention, such as China and to a lesser extent Japan, are unsuitable to provide a global reserve currency as this creates signifiant risk to the availability and value of reserves held in their currencies.
- Stable and predictable institutions — when considering holding reserves in the currency of another nation, the reserve holder must be confident in the institutions underpinning the foreign currency are strong and predictable. The US has a well established and relatively predictable legal system, and its institutions such as the Federal Reserve have strong credibility. Chinas institutions are considered to be much more unpredictable and unreliable, especially for foreigners. Europe also lacks institutionalization at the federal level, with limited fiscal integration between its member countries, frequent economic divergence between its members, an incomplete banking union and recurrent sovereign debt crises.
- Political position — the political positions of a reserve currency issuer affects its attractiveness as a suitable reserve currency, and while the US has long been the dominant global political power, its global hegemony has decreased and political risks have been the largest challenge to its position as a reserve currency issuer. It is often criticized for abusing its position as the issuer of the worlds reserve, settlement and financing currency through imposition of sanctions and using the dollar clearing system as a mechanism for sometimes draconian enforcements of those sanctions. The US is also accused of abusing its power through the extrajudicial imposition of regulation and reporting requirements in combatting money laundering, terrorist financing and tax evasion which some worry may be driven my ulterior motives and political agendas. This has challenged the sovereignty of other countries including non-rivals, and the US has been accused of weaponizing the US dollar. The ascent of China as a political power in parallel with the US weaponization of the dollar has helped Chinas position, but it remains far from being a contender as a reserve currency issuer. The lack of unity in international politics for Europe, as well as the lack of Japanese importance as a global political power limit the role of their currencies gaining prominence via this channel. An interesting discussion on the weaponization of the dollar took place at AIM Summit last year https://youtu.be/dQR0KQ73vXY between Nouriel Roubini, Mohamed el Erian, Bill Browder and Dani Burger.
- Other factors which are self explanatory include the size and strength of an economy, network effects, and widespread use.
All said, given the important characteristics of a global reserve currency, the US dollar is unlikely to lose its position as the issuer of the dominant global reserve currency for the foreseeable future, if ever — however the world is moving to a more multipolar system where countries do hold a variety of currencies in their reserve accounts. Countries incentives to hold foreign reserves are not diminishing, and the relative attractiveness of dollar alternatives has not improved remarkably. Furthermore, rival countries such as Russia and potentially China are likely to continue to seek to reduce their concentration of reserves held in US dollars, opting for alternative reserve assets including gold as well as multi-currency options with the dollar remaining a central reserve currency (as long as trade continues)- which is not a new trend. Neither is the formation of fixed exchange trading blocks, or the extreme example of ‘optimal currency areas’.
Why recent headlines don’t change much
The move to a more multi-polar system has been going on for decades. The introduction of the Euro was a major historical change, but it did not replace the dollar as the preferred reserve currency. Current tensions with Russia and China will not bring a sudden collapse in the US dollar. Other announcements which have sparked concern, such as countries using alternative currencies for oil trades, form fixed exchange or alternatively denominated trading blocks or to denominate financing transactions are likely to be of limited observable consequence, as those focus on the role of a settlement currency or as a financing currency rather than a reserve currency. And even if Saudi Arabia does choose to settle some oil trades in RMB, it does not affect Saudis reserve management strategy. Saudi Arabia will continue to hold the bulk of its assets in USD reserves and denominated assets, and as long as its currency remains pegged to the US Dollar even if it denominated oil trades in RMB it would likely exchange to its local currency, in effect buying a proxy for the US Dollar. Therefore, the dollars replacement as a settlement currency does not affect the strength of the dollar or its demand, but could affect the ability of the US to use the dollar as a political tool given its disintermediation from settlement.
It is the dollars status as a global reserve currency and its attractiveness for third countries (as well as their citizens and companies) to use dollar denominated assets as a store of value that influences how the dollars role as a reserve currency affects its relative value.
Also remember the old FX traders adage, no currency actually floats — they all sink at different rates. Any time the dollar does depreciate significantly, it means the currencies of other countries appreciate relative to the dollar. Many countries still rely heavily on the US as a major trading partner, and when their goods become too expensive due to FX appreciation, those countries often engage in FX intervention to suppress the value of their currency relative to the dollar — principally by accumulating dollar reserves.
Given the glacial pace at which the multi polarization of the global reserve, financial and settlement currency system will develop, there will be no observable effect in this transition on the dollars value, and I would generally not factor this into any investment strategy considering the much more dominant forces at play. I do feel that politicians and diplomats in the US have overplayed and abused the dollar as a tool of foreign policy — they should remember Teddy Roosevelt’s adage to “speak softly and carry a big stick”.
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