International Finance
Economy Magazine

Dollar’s kingship under threat?

IFM_ Dollar's kingship
As of 2023, central banks hold about 60% of their foreign exchange reserves in Dollars

In May 2023, Zimbabwe announced its plan to issue gold-backed digital currency for ‘investment purposes,’ with the Reserve Bank of Zimbabwe dumping the US Dollar.

Then in April 2023, Bangladesh became the 19th nation to settle trade with India in Indian rupees.

Iran too has abandoned the US currency for making trade payments with China and Russia. Saudi Arabia, a key OPEC member, will start accepting PetroYuan instead of PetroDollar.

Brazil President Lula da Silva recently called for the BRICS to come up with its own currency to settle cross-border trade between the member nations. His government has already signed a deal to trade in local currency with China.

Russia is now using Yuan in its international trade, after being hit with sanctions for invading Ukraine in 2022. Moscow and Beijing are also eyeing the launch of a joint BRICS currency to challenge the Dollar hegemony.

While Brazil and Argentina have discussed the creation of a common currency for their bilateral trades, UAE and India have started talks to use rupees to trade non-oil commodities. Expect more such news to arrive in the coming days, as the process of dedollarisation gathers steam.

What is dedollarisation?

As of 2023, central banks hold about 60% of their foreign exchange reserves in Dollars. The US currency started displacing the pound sterling as the international reserve currency in the 1920s after the Second World War. The 1944 Bretton Woods Agreement established the post-war international monetary system, thus enabling the Dollar to ascend as the world’s primary reserve currency for international trade.

The US also exercises significant control over the SWIFT financial transfers network (network which powers international money and security transfers), along with the overall global financial network, with the ability to impose sanctions on entities/individuals.

According to the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) survey, the share of reserves held in US Dollars by central banks fell from 71% in 1999 to 59% in 2021.

However, the fact remains that these foreign currency reserves facilitate overseas trade transactions, stabilise exchange rates and bolster financial confidence. About half of the international trade is invoiced in Dollars. Imports of energy, food and medicine can be a pain point for emerging and poor markets, in case the US Federal Reserve tightens its monetary policy, cause in that case, the Dollar will get stronger, resulting in costlier imports.

Why a sudden urge for dedollarisation?

The answer lies in the US’ economic response against COVID, where the Fed created Dollars at an unprecedented rate to rescue the economy, thereby resulting in global imbalances and economic instability.

Also, currencies with substantial exposure to the Dollar face increased vulnerability to currency fluctuations, thus putting countries at a higher risk of a financial crisis.

According to the American Institute for Economic Research, the economic disruption faced by Iran and Russia, after being disconnected from the international Dollar-trading systems, prompted smaller nations to look for alternatives.

Knowing in detail

In May 2023, US treasury secretary Janet Yellen accepted the fact that the imposition of sanctions against countries hostile to US’ geopolitical interests, also comes with the risk of jeopardising the hegemony of the Dollar.

The Ukraine war has been the biggest example of the targeted country (Russia), successfully finding alternative payment arrangements for bypassing sanctions. Ruble-Yuan trade has increased eighty-fold. Moscow is now working together with Iran to launch a gold-backed cryptocurrency.

Yellen used the Iran example, to state that when US sanctions are imposed against countries, the local populations there face hardships. In the words of the US treasury secretary, “Our sanctions on Iran have created a real economic crisis in that country, and Iran is greatly suffering economically because of the sanctions… Has that forced a change in behaviour? The answer is much less than we would ideally like.”

Russia is now going back to the Soviet Union days, by rearranging the bilateral arrangements, which would facilitate trade in the Ruble and the currencies of other countries. Beijing will conduct trade with Brazil in the local currencies of the two countries. The move is not based on sanctions, but a straight message from China about its intention to challenge US’ economic hegemony.

Between 2022 and 2026, as much as 30% of the loans given by the BRICS Bank to its member countries will be in local currencies. Since Russia and China are prominent members of BRICS, expect the alliance to lead the dedollarisation campaign in the coming days.

Understanding US and Dollar hegemony

“With the Dollar as the reserve currency, the US does not have to worry about any balance of payments problems, unlike other countries. It can settle its payments by issuing IOUs to other countries which they would hold, since these IOUs in the shape of Dollars are a safe form of holding wealth. For this reason, it can manage to, and does, stimulate the world economy,” says a report from NEWSClick.

For this very reason, the business of American banks increases significantly, as the Dollar is the principal medium of circulation in global trade. Also, the Dollar enables the imposition of income and demand compression on the primary commodity-producing countries of the ‘Third World’ to ensure a growing supply of primary commodities to meet metropolitan demand without any price rises in their prices.

“The US Dollar has been the official currency for international trades and the king of Currency for ages. The Dollar is enjoying a powerful status in the world, which gives it the power to dominate other economies. The desire to create a new currency will help reduce the dependence on the US Dollar and the US economy which in return could help mitigate the impact of economic and political changes in the US on their own economies. It may provide benefits such as reduced exchange rate risk, lower transaction costs, interest rate changes and increased trade among BRICS nations,” said Mahavir Lunawat, Managing Director of leading mid-market investment bank Pantomath Capital Advisors, while interacting with the International Finance.

When there is an excess demand for primary commodities in the ‘Third World’, its price rises in terms of the local currency, thus creating expectations of a depreciation of its exchange rate vis-à-vis Dollar, and triggering a flight of finance from that particular ‘Third World’ economy, resulting in currency depreciation, forcing the nation to raise its interest rate and adopt cost-cutting measures.

Decoding the 2022 scenario

Both 2021 and 2022 were about the rising inflation in the United States and the Fed’s rate hike spree to tackle the crisis. As economies reopened after two-year COVID hiatus, disruptions in the supply chain and the fuel market (due to the Ukraine war) increased food and raw material costs, thereby raising the consumer price levels within the US.

An increasing inflation cuts down a currency’s buying power. The Federal Reserve raised the interest rate on bank-to-bank lending, seven times in 2022 and the phenomenon is still going on. The target is to bring down the inflation at a yearly 2% ratio, by restricting the borrowing demand, which will ease price pressures as well. A country’s interest rate is the return on investment for that nation’s currency. As the Fed kept on increasing the interest rate, the Dollar’s value increased as well.

This has now made the American Dollar attractive to global investors. These individuals are selling other currencies to purchase Dollars, thus further strengthening the currency and adding more to its hegemony.

As a result of a stronger Dollar, importing goods became relatively cheaper for the US as fewer Dollars were needed to pay the same price in other currencies. However, for other countries, importing food, energy and medicine became a pain point, as their respective currencies depreciated against the Dollar, thereby making the whole process an expensive one.

Fed tightening rates have affected the overall competitiveness of US exports as well. As the Dollar remained strong throughout 2022, the affordability of American products declined as well.

Will Yuan be the challenger of Dollar?

China has now got cosy with Russia, which got delinked from the international payment platforms (based on USD) for attacking Ukraine. In 2022, the share of Russian imports paid for in Yuan rose from 4% to 23%. In February 2023, the Chinese currency overtook the Dollar as the most traded currency on the Moscow exchange for the first time in its history.

China has been pushing for Yuan’s internationalisation and the Ukraine war has given the move an impetus. Although the Dollar remains globally dominant, the Xi Jinping government has successfully convinced Argentina and Brazil to pay in Yuan for Chinese imports. Bangladesh approved a payment in Yuan worth USD 318 million to settle part of a Russian loan for its nuclear power plant development.

In March 2023, a Chinese company used Yuan to buy 65,000 tons of liquefied natural gas (LNG) from French multinational TotalEnergies, registering the first instance where the Chinese currency was being used in an international LNG transaction. The world’s second-largest economy has also developed an alternative to Swift as well as a digital currency, called the e-CNY.

“However, replacing the Dollar would be hard! As of 2022, the Dollar accounts for 59.79% of total foreign reserves. In comparison, the Euro accounts for 19.66%, while the Chinese renminbi accounts for just 2.76% of global reserves. Other countries have a lot of catching up to do. The Dollar’s dominance of global trade and capital flows dates back at least 80 years,” Lunawat remarked.

“While it may not be a direct setback for the United States, as the Dollar will likely continue to be a dominant currency in global trade, it may lose influence in some segments of the global economy. It reflects a growing trend of countries seeking to reduce exposure to potential risks associated with relying solely on the Dollar. To conclude we can say that Chinese dialogue is successful in attracting trading partners and motivating them to look beyond the US Dollar,” he added further.

The move has roadblocks as well

While the Dollar’s share in global Central Bank reserves recently dropped to less than 60% from roughly 70%, twenty years ago, Euro’s share went up from 18% to just under 20%. CNY’s share stands at less than 3%.

China is known for its capital controls. It allows foreign central banks’ investments in renminbi to be liquidated and repatriated. However, inward investment in China cannot be easily reversed. Despite CNY becoming a major instrument of trade savings and credit financing in Russia, China still hasn’t offered Moscow long-term financing, thus resulting in an underdeveloped credit market. Capital controls still remain a key challenge for Yuan’s internalisation efforts, especially when it comes to imagining the currency as an effective means of savings and deposits.

Then you have India, which due to its border tensions with China, is not reportedly okay with its domestic business entities settling foreign trade in Chinese currency. India’s biggest cement producer UltraTech used CNY for a cargo of Russian coal in 2022, thus raising eyebrows from the government level, as New Delhi asked banks and traders to use UAE dirhams instead of the Chinese currency. India also has memberships in SCO, RIC and BRICS, three prominent regional groupings, which are supposed to be the flag bearer of dedollarisation in the coming days. Given the fact that the Indian Rupee has now been used by 19 countries to settle their trade payments, expect New Delhi to challenge China’s efforts of making the Yuan a prominent international currency.

“India too has been trying to move away from the Dollar. Recently 18 countries have been given permission to trade in Indian Rupees. However, the process is complex, critical and with a long gestation period. There are several challenges in establishing a new currency, including economic stability, political coordination, and establishing credibility and acceptance in the global market. The success of such an initiative would depend on various factors, including the commitment and cooperation among the BRICS nations and the acceptance of the new currency by the international community,” Lunawat added further.

“India has an edge. The biggest edge that India has over China is trust. The transparency, stability, and reliability of democratic institutions will drive other countries to use the INR without any hesitation. In April 2023, India successfully concluded an agreement with 18 countries to trade in Rupee which includes stalwarts like the UK, Germany, Singapore, Saudi Arabia, UAE, Oman, Qatar & Bahrain. India being the world’s most populous country with the largest working population and with ability & willingness to spend is the biggest market for anyone. Apart from FDI, India receives more than $100 Billion every year in remittances from abroad. India seems to be crossing early-starting China and hence will surely win the race,” he remarked.

“An international currency is one widely used to invoice international trade in goods and services (a unit of account); to settle payments in trade and financial transactions (a medium of exchange); and to denominate financial assets and serve as reserves for foreign central banks (a store of value). These functions are strongly interrelated. The biggest challenge for the Chinese currency Yuan going international is the lack of trust and confidence in the currency,” Lunawat said.

He also noted that China maintains strict capital controls to manage its economy and prevent excessive capital outflows, something which doesn’t augur well for the Yuan’s free flow.

“Full convertibility of the Yuan is necessary for it to become a widely accepted international currency. China has been gradually liberalizing its currency, but there are still restrictions on capital account transactions,” the senior banker noted.

As per Lunwat, the widespread adoption of a currency requires transparency in economic policies, regulatory frameworks, and adherence to the rule of law. China’s legal and governance systems are areas of concern for international investors and businesses.

“To attract global investors and facilitate international transactions, the Yuan needs deep and liquid financial markets. China has been working on developing its bond and equity markets, but further improvements are necessary to enhance market depth and liquidity,” he stated.

“Geopolitical tensions and trade disputes can influence the international acceptance and adoption of the Yuan. Political stability and trust in China’s economic policies are important factors for international investors and businesses considering the Yuan as an alternative. Overall, while the Yuan has made progress in internationalization, addressing these challenges will be crucial for its wider acceptance and potential as a global currency,” the senior banker concluded.

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