The US dollar’s future role in the global economy is under scrutiny.
Policymakers in emerging markets are increasingly voicing dissatisfaction with the high profile and pivotal role that the USD plays in trade and finance, due to a combination of geopolitical and macroeconomic concerns.
In particular, Russia and China appear to be leading the charge in pushing alternatives to the dollar. Russia has been forced into finding alternatives having been effectively kicked out the dollar system after the West imposed sanctions following Russia’s invasion of Ukraine.
This has also given impetus to Beijing’s renminbi (RMB) internationalization agenda. For example, China has been developing an alternative clearing system (CIPS) to the US (CHIPS), alongside an alternative to the SWIFT messaging system which facilities cross-border banking settlement (and which Russia has been barred from). Other countries have followed suit, although with varying degrees of enthusiasm.
There are reports of India exchanging rupees and UAE dirhams for Russian oil. Similarly, Turkey agreed to pay for 25% of its Russian oil imports in ruble. In May, ASEAN members agreed to increase trade in local currencies. The trend in trade invoicing is not just limited to emerging markets (EMs), with Australia and France also agreeing to trade deals with China denominated in yuan.
A broader de-dollarization agenda has also been a focal point within the BRICS group, where several initiatives have been tabled. These have included not just using members’ currencies in trade transactions more frequently, but also a BRICS alternative to the IMF’s SDR, and even introducing a gold-backed currency. So far only the use of local currency in trade has found support, but most members appear onboard with reducing their reliance on the dollar at least rhetorically.
The growing economic weight of emerging markets – which we expect to rise from around 44% of the world economy to 56% by 2050 – raises the potential for EM policymakers to have more sway on global trade and financial flows. Already, EMs account for around 44% and 39% of global exports and imports (Chart 1). Thus, their potential to lead a de-dollarization trend in global trade invoicing and broader financial flows is large.
Chart 1. Emerging markets’ growing role in global trade
Source: IMF, Haver, abrdn, August 2023.
Are FX reserves a sign of what’s to come?
FX reserves could potentially reflect a reduced desire to hold dollar assets. The US dollar’s share of official foreign exchange reserves has been on a gradual downward trend, falling over 10pp over the past 20 years (Chart 2). Notably, much of this shift has been driven by a rotation into other developing market (DM) currencies, such as the euro, British pound, Canadian dollar, and Aussie dollar. The Chinese RMB has also increased its share, but from a very low base.
However, there are limitations to looking at reserve holdings in this narrow sense and extrapolating that to reduced dollar exposures overall. The rise of sovereign wealth funds and state banks managing foreign assets have obscured the true extent of countries’ holdings and, as such, FX reserves are likely downplaying overall exposure to the dollar.
FX reserve holdings also reflect the exchange rate regime being operated, with more flexible systems requiring smaller reserves as intervention becomes less common. For example, China’s official reserves have been relatively flat since 2016 at close to $3tn, reflecting a more flexible exchange rate system combined with capital account restrictions on domestic entities which has reduced the need to hold substantial USD FX reserves. Reserves as a share of total foreign assets have declined from around 70% in 2011 to 35% by 2022, reflecting this shift.
Chart 2. Dollar’s share on a gradual downtrend
Source: IMF, abrdn, August 2023.
Similar trends can be seen in other large accumulators of foreign assets (Chart 3). And in countries like Norway, Singapore and Australia, reserves make up less than 5% of total foreign assets.
Moreover, actions taken by US policymakers in the depths of the pandemic, namely the Fed providing an increasing number of dollar swap lines and creating the FIMA repo facility, have arguably strengthened the role of the dollar in the international monetary system, even if official sector FX holdings have moderated.
Chart 3. The shifting composition of foreign assets
Source: Haver, abrdn, May 2023.
The dollar is still dominant in financial markets
The dollar is still the dominant currency in foreign exchange and international funding. Indeed, the dollar’s share of overthe-counter FX transactions has remained remarkably stable (Chart 4). While the share of cross-border bank loans and international debt has actually risen by around 10pp to 50% over the last 10 years.
Chart 4. Dollar still dominant in financial markets
Source: BIS, abrdn, August 2023.
The US also dominates equity markets. For example, the US accounts for 62% of the MSCI All Country Index and around a similar share of the MSCI World Index. As such, it is likely that dollar-based assets still make up a significant share of foreign assets, despite FX reserves showing some divergence away from the dollar (primarily towards other DM currencies).
Indeed, the factors that strengthen the dollar’s position, namely capital market openness, institutional quality, and its established use as a currency of transaction are hard to replicate and overturn. Even with the creation of the euro - which meets many of these criteria - the dollar has maintained a dominant role globally.
FX transactions naturally lend themselves to triangulation which reinforces a deep single vehicle currency market. Similar to the international use of English within business and academia, it is often easier to transact via the USD rather than attempting bilateral exchange between country pairs. The greater ability to hedge in dollar markets, combined with the prevalence of multinational enterprises within the global supply chain, are further factors which may slow a move towards greater diversity in trade invoicing.
The rise of the renminbi faces major hurdles
China’s rapid economic ascent and pivotal role within global trade set up the RMB as the pretender to the USD throne.
The PBOC’s internationalization efforts have delivered a more market-determined exchange rate (even if it remains somewhat interventionist at times) and central bank swap lines have been set up. As noted above, there has also been some success at encouraging trade to be priced in RMB. But despite all this, true internationalization remains a distant prospect.
First, the RMB is starting from a low base. It’s share in official FX reserves is only around 3%, compared to almost 60% for the USD. Survey research by the Official Monetary and Financial Institutions Forum (OMFIF) found that reserve managers are in no rush to expand their RMB holdings, anticipating that China’s share of global reserves would grow to just 6% over the next 10 years.
Secondly, China is showing no sign of running current account deficits – which would spur greater holdings of Chinese assets – nor fully liberalizing its capital account. It is true that foreign investors now have relatively free access (while the capital account remains much tighter for domestic entities), but fear that capital controls could be imposed suddenly are likely still a restraining factor. More fundamentally, there is little-to-no sign that China’s high saving structure is about to change, or that trade deficits will be condoned in the near future.
Finally, the opacity of CCP policy making and weaker institutional safeguards, combined with (and potentially amplified by) geopolitical tensions damage the element of trust that helps create a global reserve currency. Indeed, China’s attempt to insulate itself from sanction risk may backfire: exposure to the dollar system may raise the odds of ‘good’ behavior (China has been at the forefront of developing a central bank digital currency (CBDC) and this could potentially offer a route to by-pass the dollar-based system. In theory, an importer using digital currency could transfer the required payment, negating the need for settlement through banks which requires instructions to be sent through a system such as SWIFT. It is however unclear how this would operate in practice, how an e-RMB would fit within the international system, and over what time scale this could actually be introduced.at least in the eyes of investors), therefore freeing oneself from the prospect of sanctions may not in fact reduce risk premia demanded.
China has been at the forefront of developing a CBDC and this could potentially offer a route to by-pass the dollar-based system. In theory, an importer using digital currency could transfer the required payment, negating the need for settlement through banks which requires instructions to be sent through a system such as SWIFT. It is however unclear how this would operate in practice, how an e-RMB would fit within the international system, and over what time scale this could actually be introduced.
Multi-currency future a possibility, but unlikely in the near-term
We think it is likely the dollar will remain as the prominent currency in global trade and finance as it stands. However, it is possible that greater diversification could occur within trade invoicing, where local currencies or dominant regional currencies are increasingly used.
Over the longer term, this rise in local currency trade could reduce the dollar’s broader role in the global financial system. But major hurdles remain to reduce dollar hegemony.
We appear to be a long way from CBDCs providing a route to by-passing the dollar-based system and there are questions around EMs willingness to undertake the reforms to develop institutional quality and capital market depth which would increase their ability to absorb capital flows through more traditional channels. Nevertheless, were progress to be made on these fronts it could usher in something more akin to a multi-currency system.
US actions could lead to a self-inflicted demise of the dollar. A technical default – triggered by a failure to renegotiate the US debt ceiling – or a significant degradation of US institutions could weaken the dollar’s position and open the door for other currencies to gain a more dominant position.
But there appears a high bar for this to threaten the dollar’s position. The shine has not come off the dollar despite a global financial crisis, several debt ceiling stand-offs, political and social upheaval, and a resurgence of inflation. Indeed, the US dollar on a trade-weighted basis is close to its early-2000s peak (Chart 5). Those wondering each night why the dollar is so widely used, are likely to be asking themselves that question for many more nights to come.
Chart 5. Dollar close to its strongest in two decades
Source: Haver, abrdn, August 2023.