The Current Status of the Dollar and Challenges to Dollar Supremacy
Traditionally, a country’s economic dominance has been a key factor in determining the strength of its reserve currency. At present, the dollar remains the principle currency of international commerce—roughly 60 percent of foreign exchange reserves are in dollars, and approximately half of all cross-border loans and international debt securities are dollar-denominated. The market for U.S. government securities remains the deepest and most liquid in the world, and during the 2008 recession and the more recent economic shocks associated with COVID-19 in 2020 the dollar served as a safe haven asset for international investors. Foreign governments hold over a third of outstanding U.S. government securities, a proportion much greater than in other developed economies. Nevertheless, the U.S. economy’s ever-shrinking proportion of global output and disruptions to the financial system are prompting fundamental questions about the dollar’s staying power as the global reserve currency. The U.S.’s share of global GDP fell from 40 percent in 1960 to 24 percent in 2019, and over the same period, China’s output increased from 4 percent to 16 percent.
Today, the dollar has three main rivals: the EU’s euro, Japan’s yen, and China’s renminbi. Accounting for 21.2 percent of official foreign exchange reserves, the euro is arguably the second-most important currency in the world. The euro has several attributes that make it an attractive alternative to the dollar. For example, the euro’s Economic and Monetary Union (EMU) has a large internal economy and is central to global trade. Europe’s deep and liquid financial markets, as well as the policy predictability afforded by the European Central Bank (ECB), make the euro a compelling international medium of exchange. Yet, the euro faces structural weaknesses that complicate its ability to challenge the dollar. The eurozone’s unique institutional structure as a monetary area without a corresponding fiscal union undermines the supervisory and regulatory power of the ECB. The yen, which constitutes six percent of official foreign exchange reserves and is the world’s third-largest reserve currency after the euro and the dollar, faces similarly substantial barriers to internationalization. These barriers include onerous regulatory requirements, uneven liberalization of domestic financial markets, and ongoing economic stagnation. In addition, raw materials—which today still tend to be invoiced in dollars—constitute a significant share of Japan’s imports. For these reasons, barring significant unforeseen geopolitical or technological developments, neither the euro nor the yen is likely to challenge dollar hegemony anytime soon. The same cannot be said for the renminbi.
According to most metrics used to evaluate a currency’s international importance, China’s renminbi remains well behind the dollar, euro, and yen. At the end of 2020, only 2.2 percent of official foreign exchange reserves were held in renminbi, lower than not only the dollar, euro, and yen, but also the pound sterling. Yet, the renminbi is viewed as the dollar’s greatest long-term threat because of China’s record of robust economic growth since the 1980s, its rapid integration into the global economy, and its centrality in international trade. (China is now a larger trade partner than the U.S. in 128 countries.) As evidenced by the creation of CIPS, the launching of the digital renminbi, and previous attempts to internationalize the renminbi, China’s efforts to undermine the dollar are also more aggressive and explicit than those of other countries. The IMF’s decision to include the renminbi in its basket of Special Drawing Rights (SDR) currencies in 2016 suggests that these efforts are beginning to bear fruit. (The SDR is an international reserve asset that the IMF distributes to supplement member nations’ existing reserves; its value is determined by five currencies—the dollar, the euro, the yen, the renminbi, and the pound.)
The renminbi still faces several economic and political challenges to widespread international adoption as a global trade, investment, and reserve currency. Currently, China assertively controls its capital account, meaning that there are strict conditions and some outright restrictions placed on flows of foreign capital into and out of the country. A country’s capital account (sometimes referred to as “financial account”) consists of the financial flows generated from foreign direct investment, portfolio investment, cross-border loans (and other investments), and the country’s use of foreign reserves as it relates to the country’s currency exchange rate. In China’s case, the central bank also intervenes to control the renminbi’s exchange rate, buying or selling renminbi to keep its exchange rate below what its free-floating market value would be. (This, in turn, makes Chinese exports cheaper and more attractive.) These factors contribute to investors’ hesitation to trade in renminbi and limit its ability to become an international currency. A lack of market-determined interest and exchange rates, mature and liquid financial markets, and predictable legal frameworks continue to undermine the renminbi’s ability to become a more attractive investment vehicle than the dollar.
China also faces the challenge of an uncertain future in Hong Kong. Hong Kong serves as the main channel through which foreign investment enters the Chinese market, with two-thirds of overall foreign direct investment capital flows moving into and out of China through Hong Kong. Hong Kong is the world’s largest offshore renminbi center, providing clearing, settlement (over 70 percent of global renminbi transactions are settled in Hong Kong), financing, and asset management services in renminbi. China’s introduction of its National Security Law in June 2020, and the subsequent protests, have created an uncertain future. Under the National Security Law, individuals and companies can be legally tried in mainland China, a move that vastly expands the CCP’s influence. In response to the law’s passing, international companies are considering moving operations from Hong Kong, with the American Chamber of Commerce finding that over 40 percent of international companies, led by financial firms, are now considering moving operations out of Hong Kong. A diminishing role for Hong Kong as an international financial center would significantly set back China’s efforts to internationalize the renminbi and globalize its economy.
Formidable as these challenges may be, China’s, Russia’s, and the EU’s sustained attempts to seek alternatives to the dollar are slowly making headway, and the introduction of central bank digital currencies (CBDC’s) could significantly bolster their efforts. Additionally, questions over the ability of centralized systems such as SWIFT to keep up with technological advancements have emerged. In 2016, a string of cyberattacks targeted banks by subverting their SWIFT accounts. The most successful attack resulted in the theft of $81 million from the Bangladesh Central Bank. Despite new cybersecurity measures adopted in 2018, fraud and cybercrime through SWIFT have continually risen steadily since 2016, with four out of five SWIFT members reporting at least one incident of fraud since 2016. Security concerns over existing systems and the potential for digital currencies to both increase transaction speed and lower costs (by cutting out the need for intermediaries) are driving interest in expediting their adoption. A widespread transition to the use of digital currencies could diminish dependence on the current dollar-dominated global infrastructure, even without a country directly overtaking the U.S. economically. For China, the recent pilot launch of a digital renminbi could expedite capital account liberalization and financial market development, while providing a vehicle to trade directly in renminbi and circumvent international intermediaries such as SWIFT. Russia and the EU are both exploring launching digital currencies of their own, creating novel opportunities to move away from dollar reliance. While the existing CBDC infrastructure is in its infancy, concurrent and sustained efforts over time from China, Russia, and the EU hold the potential to erode the influence of the dollar in the long run.
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What could you foresee as being the most significant impacts from a diminishing role for the dollar, and what opportunities or risks does that create for your organization / sector?