Dollar dominance – will we ever break the buck?

The world has changed. Many believe the American primacy that dominated the 20th century could be coming to a close. The world is becoming multipolar and so is the gravity of global trade.

Surely the dollar-based economic system has to adjust to this new reality? Well, not necessarily…

We currently have a huge asymmetry between several continental-sized powers driving global economics and trade – China, India, the US, Europe – and the financial ‘plumbing’ that connects them remaining resoundingly dollar centred.

And that’s despite talk of change from many places over many years.

Saudi Arabia and China have been talking about invoicing oil in a currency other than US dollars for a number of years. While Brazil’s government has been increasingly vocal about uncoupling its trade with China from the dollar.

Some would argue that such bilateral deals could be motivated by trying to avoid US sanctions or attempting to do business with countries like Russia, which are locked out of the dollar system.

The UAE dirham has been used this way to settle some oil transactions with Russia. But ironically, the dirham has been pegged to the US dollar for 25 years and is basically a proxy for it in all but name.

Why the dollar’s attractive

The fact is that these anti-dollar moves have been present for well over 50 years without seeing any traction. The principal issue with giving up the dollar has always been: where would oil producing nations invest their earnings?

The attractiveness of the US dollar is its network effects – it’s convertibility, transferability (without capital controls) and store of value.

Other currencies like the yuan or rupee frankly fail on these measures, and simply aren’t a viable alternative for those countries wishing to maintain the value of their national wealth.

Are central banks moving away from the US dollar?

The other global force that drives demand for US dollars is central banks, particularly those in nations with historic current account surpluses and export-led economies.

These nations – such as Japan, China and Canada – have steadily accumulated US dollars since the 1990s to insulate themselves against economic shocks and volatile shifts in demand for their exports. They’ve held dollars primarily in US government bonds – the most liquid global assets and the easiest to sell during a crisis. Here at Coutts, we hold them as diversifiers in our client portfolios for those very reasons.

But a decade of low interest rates caused local managers of national reserves to seek out marginally higher returns by storing different currencies. As a result, we’ve seen a declining trend in the share of these central bank reserves held as dollars – as shown by the green line in the chart below. It’s perhaps telling, though, that this hasn’t impacted the overall value of the US dollar – shown by the blue line.

We’ve also seen other currencies creeping into these national reserves. Analysis by The Centre for Economic Policy Research shows that, at the end of 2021, a number of other, ‘non-traditional’ currencies were being held by central banks. They include the Australian, Canadian and Singapore dollars, the Chinese renminbi and the Korean won.

Just the dollar by another name

But crucially, far from diversifying away from the US dollar, these currencies are once again simply proxies for it. They are all fully integrated into a system of links between each central bank and the US Federal Reserve which remains firmly dollar based.

The dollar is therefore still the global reserve currency of choice and the only currency for conducting international commerce, despite the diminished demand for it by central banks.

It might make up less of their reserves, but it still underpins the system that connects them all. We even have situations like Poland and Hungary trading with each other in dollars rather than the euro.

For another currency to usurp the dollar, it would need to be freely transferable without capital controls, universally accepted and fully integrated into the central bank system. And without those huge requirements being met, there’s simply no incentive to diversify away from dollars.