How dollar hegemony is gradually receding

Dollar’s uneasy reign, lasting over a century, is increasingly under threat. But this will not surprise anyone since most are sceptical about the “exorbitant privilege,” that the greenback continues to enjoy; a phrase used in 1960s by then French Finance Minister Valery Giscard d’Estaing. The Russia-Ukraine war and the ongoing disruption in the forex market due to the US Federal Reserve actions appear set to act as catalysts to accelerate the move towards reduced dollar hegemony.

A peek into history reveals the shaky foundation on which dollar’s dominance was built. The greenback rose to power in the years following World War I, displacing the mighty British pound. While the UK suffered large losses in the war, the US was a late entrant and was the main supplier of weapons and goods to the allies. US trade as well as economy grew rapidly, as a result. Also, countries facing financial resource crunch after the War turned to the US for funds, purchasing US bonds and sending gold to the US, paving the way for the dollar’s position as a reserve currency.

The famous Bretton-Woods Agreement in 1944 sealed this position with 44 countries agreeing to peg their currencies to the dollar, which in turn was backed by the large gold reserves accumulated during the War. But this Agreement was nullified by US President Nixon in 1971, when he unilaterally suspended the convertibility of dollar into gold, due to the problems facing the US economy then, and the gold reserves held by the US proving inadequate to cover the dollars held in reserves of other countries.

There is, therefore, no compulsion for any country to peg its currency to the dollar any more. Of concern is the fact that the US is making the most of its position as the owner of the predominant reserve currency by resorting to unbridled note printing, while failing to exhibit the responsibility this position entails. It continues to take monetary decisions with the sole purpose of helping the US economy, unmindful of the massive disruptions caused by its actions to other economies.

With the dollar dependence doing more harm than good, countries are beginning to reduce their dollar exposure.

$ holding in forex reserves

The IMF’s Official Foreign Exchange Reserves statistics highlight the manner in which countries are reducing dollar denominated assets in their official forex reserves. The share of the dollar in global allocated forex reserves declined to 58.8 per cent in March 2022; the lowest since 1995.

Countries have been pruning their dollar holdings in line with the reducing clout of the US in global trade. The share of dollar reserves was 71 per cent in 2000 when the US was the largest trading nation accounting for a 12.1 per cent share of global exports. China accounted for 3.9 per cent of global trade then, but it has overtaken the US in the last two decades, with 14.7 per cent share of global exports in 2020. The US’ share has whittled down to 8.1 per cent in this period.

The peak dollar holding in official forex reserves (in recent times) was just after the Nixon shock, in September 1971, when 85 per cent of global forex reserves was held in dollars. But Nixon’s action marked the beginning of the diversification away from dollar.

What’s the alternative to the dollar? The euro was touted to be the challenger in early 2000. But the economic woes of the countries in the European Union have made its position rather wobbly. Despite this, the share of euro in official reserves has increased from 16 per cent in 2000 to 20 per cent this year.

The other challenger to the dollar is, of course, the yuan. But many countries would be wary of backing the Chinese currency, given Beijing’s frictions with almost every other nation. The increase in the share of yuan to 2.8 per cent of official reserves appears to be entirely due to the Chinese government’s purchases.

Time for a reset

While the diversification has begun, countries are still saddled with large dollar reserves. This is largely due to the humongous amount of notes, amounting to trillions of dollars, printed by the US Fed since 2008, flowing in to all countries.

One of the routes channelling the flow is overseas borrowing in dollars. The ultra-low interest rates in the US since 2008 have resulted in sharp increase in dollar-denominated loans. According to the Bank for International Settlement, around $13.4 trillion had been borrowed in dollars by non-bank entities till the end of 2021 of which one-third was by emerging market economies. The other means through which dollar reserves have increased is foreign investment flows in dollars into assets across the globe. With more than half of global investable funds originating from the US, dollars have been flowing into equity, debt commodity and other markets across countries, creating asset price bubbles.

But the raging inflation and the threat of recession in the US along with rising yields of US treasury securities mean that continuing to accumulate dollar reserves is akin to building a pile of highly combustible substance that can blow up anytime.

We are, however, in a Catch-22 situation since foreign investment inflows or foreign loans cannot be turned away immediately. Reducing the dependence on these can be done only over the long term, by encouraging domestic investors and domestic lenders to substitute foreign funds and increasing overseas borrowing in rupee.

But trade in dollars can be reduced if bilateral agreements are signed to settle in domestic countries, as was done with Russia and with Iran. The world could also be moving towards a scenario of multiple groups of nations with common currencies, akin to the European Union. India could be part of one such grouping, thus doing away with the dollar peg.

Kenneth Rogoff, writing in The Guardian, says that China is on the verge of stopping pegging the yuan to a basket of currencies and instead will shift to a system where the exchange rate will move freely, largely influenced by inflation. That is another way to unshackle from the dollar.

According to a recent IMF Blog report, countries are diversifying into currencies of smaller economies which are less volatile and show better growth such as Australian and Canadian dollars, Swedish krona and South Korean won.

The diversification from dollar has therefore begun. It’s to be seen how fast this progresses.

COMMENT NOW