The mighty US dollar has held a central role in the world’s monetary system since the Bretton Woods Agreement in 1944 defined all other currencies in relation to the American greenback. But with the rise of China as a global superpower and growing tensions between the West and the East, together with BRICS, some commentators are questioning the hegemony of the US dollar.
Before delving into whether the US dollar’s position as the world’s reserve currency is under immediate threat, let’s consider why it has achieved this “supreme” currency status. When the Bretton Woods system came into place, the US dollar was the currency with the most purchasing power, underpinned by the US’s ownership of 70% of the world’s gold bullion reserves.
When the US ended the direct convertibility of dollars to gold in the 1970s, the dollar retained its position based on the influence of the US economy, the power of its military and the strength of its institutions. The dollar is trusted because governments, organisations and people have faith in the rule of law, separation of powers, the free flow of capital, and the sanctity of property rights in the US.
The world’s economic engine
As importantly, the US has been the world’s economic powerhouse since early in the 20th century. By 1990, the US accounted for 30% of world GDP and 40% of output among G7 countries. Today, even with the rise of China, the US still accounts for around 30% of global output. And it has easily outclassed other G7 countries, with 58% of this group’s GDP.
Underpinning this performance is a diverse economy, powered by industrial capacity and technological innovation as well as enviable access to natural resources. The dollar’s reserve status has helped to amplify these virtues, putting the US in the driving seat of the world economy. Since 1973, the dollar has gained a cumulative +-2% against its developed-market peers in the dollar index.
The US dollar’s status as the world’s reserve currency is overwhelmingly positive for the American economy. Not surprisingly, the US’s geopolitical rivals recognise that this gives the US enormous sway over their own economies. One frequent complaint is that the US can effectively export dollars to the rest of the world and import goods during times of high inflation—effectively exporting inflation to its trading partners.
The weaponised dollar
Many of the US’s global competitors also understand that the US can weaponise the dollar to punish states that act contrary to its interests—consider the example of China’s possible invasion of Taiwan. Given that the US can freeze or even seize dollar reserves of countries that don’t toe the line, as it has done recently with Russia, nations that have reason to fear American sanctions are understandably interested in alternatives.
Alternatives to the dollar are coming to the fore, but at a snail’s pace. With China becoming more assertive on the world stage, it is positioning the yuan as an alternative for international finance, trade and lending. Usage of the yuan for trade finance contracts has tripled since 2019, and China has also created the CIPS platform as an alternative to SWIFT.
Yet today, Chinese currency accounts for only about 1.7% of cross-border payments worldwide, compared to 50% for the dollar. The local currency’s share of China’s own cross-border payments and receipts did, however, rise to a record high 48% in March this year from nearly zero in 2010. The dollar’s share declined to 47% from 83% over the same timeframe.
While some countries are transacting in yuan, heavily sanctioned Russia is the only one that has made a major shift, more out of necessity than choice. Yuan’s usage in Russian export payments shot up 32-fold last year and it has become Russia’s most traded currency. Bangladesh, for example, is also paying Russia in yuan for a nuclear plant, but it remains to be seen whether any counterpart would be prepared to keep and invest the money in yuan.
For now, China’s financial offering still cannot compete with the US. China’s capital markets are shallow compared to the US, there are forex controls, and the currency is subject to substantial manipulation. The yuan won’t displace the dollar unless China allows greater freedom of inward and outward investment. These movements have been avoided to ensure stability and control of the domestic Chinese economy.
If not yuan, why not an alternative to fiat currency?
The yuan is clearly not the answer to dollar hegemony, then. There was a time that some commentators thought the euro would challenge the dollar. But the fragility of the eurozone, its slow economic growth and a lack of quality euro-denominated assets that international investors and central banks can use as a store of value mean that the euro isn’t a compelling alternative to the US dollar.
What about Bitcoin or gold? Bitcoin’s pricing is still too volatile, meaning that you can’t price goods like oil or wheat in this crypto. It’s also not yet as quick and easy to pay as it is with good old-fashioned money. Gold may have a place as an inflation hedge and store of value, but it’s not portable or divisible enough for modern trade.
That brings us back to the dollar. There are some economists who suggest that the dollar might be headed for long-term decline in value and that the US’ ever-rising debt could one day cause a fiscal crisis. The US dollar’s share of global reserves is gradually falling as a new multipolar global order starts to rise.
But any change to the dollar’s status may take decades or even centuries. The dollar’s gravitational pull remains irresistible because of the network effect and the amount of value sunk into that currency. Between 50%-67% of global trade is invoiced in US dollars and it accounts for 60% of all central bank reserves. These are facts that cannot be changed without enormous risk to the global economy.
Investors trust the US dollar with their insurance, pension, and savings because they trust in the rule of law, the transparency of information and the openness of the US markets. When push comes to shove, most global investors, traders, and financial institutions will trust the US dollar rather than the currency of an authoritarian state such as China, where rule of law is weak, markets are opaque and closed, and investor protection is non-existent.
