The future of the U.S. dollar

There has been a long-term trend toward currency diversification in global financial transactions and trade, but it is still not likely that the U.S. dollar will lose its dominance any time soon.

There has been speculation lately that the U.S. dollar is on the verge of a major decline and might even lose its status as the world’s major reserve currency. “De-dollarization,” or the movement away from using the U.S. dollar as the primary currency of exchange in global trade and investment, has become a hot topic in financial publications. It appears to stem from news that China is beginning to use the yuan in commodity trades with a handful of trading partners, and BRICS might be exploring the potential for a common currency. Other reason for change could be the developments of cryptocurrencies and digital central bank alternatives. Extrapolating these trends, the argument is that demand for dollars will fall, sending its value steeply lower.

A long-term trend toward diversification of currencies in global financial transactions and trade may develop, but it’s a big leap from dollar dominance to de-dollarization. The dollar remains close to a 10-year high versus currencies of countries with which the U.S. trades. It also remains the primary currency used for trade and financial transactions in the global economy. The size of the recent non-dollar transactions that have raised alarm are very small.

There are few signs that major foreign holders are poised to suddenly shift away from U.S. dollars and there are few other currencies that could take its place as a reserve currency. A gradual move to a global economy with a less-dominant dollar is possible over time, but it is unlikely that the dollar will lose its reserve currency status any time soon.

During the past decade, the dollar has been propelled higher by relatively high U.S. interest rates compared to other major countries, strong capital inflows, and its status as a safe haven in times of turmoil. The dollar’s gains have been broad-based, with similar appreciation versus emerging market and major developed market currencies.

Coming out of the long stretch of lackluster growth in the aftermath of the financial crisis of 2008-2009, the dollar was largely range-bound against major currencies, but it began to move higher in 2015 as U.S. interest rates moved up. Higher interest rates boosted returns to dollar-based investors. At that time, central banks in Europe and Japan were keeping policy rates at zero or in negative territory, while U.S. rates were positive. The combination of stronger economic recovery and higher yields helped push the dollar higher.

International investment flows indicate that demand for U.S. dollars extends beyond U.S. Treasury securities. With a resilient economy, the U.S. saw the largest inflow of foreign direct investment, long-term investment in businesses and property, of any major economy in 2023. It’s also worth noting that much of the rise in investment flows in the U.S. over the past few years has gone into equities.

Dollar demand for transactional purposes has remained steady over the years. It still accounts for more than 80% of financial market transactions. The dollar’s position as the world’s major reserve currency is periodically a source of concern among investors, even though its position hasn’t changed much in decades. The dollar’s share of global reserves has declined gradually over the past 20 years as central banks diversified their holdings, mostly into the euro since its introduction in 1999. Allocations of reserves to other currencies, such as the British pound and Canadian dollar, have gained modestly as well. Overall, however, the dollar still represents about 60% of global reserves, a modest decline from 67% 20 years ago.

A reserve currency needs to be freely convertible and have deep and liquid bond markets to be considered safe for foreign central banks to hold. Central banks need to know that their money is easily and readily available when needed, particularly in times of stress. The U.S., with a large, open, and liquid market for Treasury securities, fits that role. That’s why when the covid crisis hit the global economy, the U.S. Federal Reserve expanded its swap lines with foreign central banks to enable access to dollars for countries that were struggling to access dollars for trade and debt payments.

While other major countries’ markets have these qualities, the size and openness of the U.S. market is difficult to match. Europe’s bond markets are more fragmented than the U.S. market although a movement toward euro-denominated sovereign debt issuance would provide a stronger base for it as an attractive alternative. Japan’s bond market is closely controlled by its central bank, which owns the bulk of its government debt. China has capital controls, and its currency isn’t even freely convertible. Giving up capital controls would mean that the government would relinquish control over investment flows and leave the currency susceptible to decline if domestic investors moved their money elsewhere.

Short-term, there is room for a moderate cyclical decline in the dollar. The main driver is likely to be a greater convergence of interest rates in the major economies as the U.S. Federal Reserve has come to the end of its rate hiking cycle while other central banks continue to tighten policy.

Longer-term, movement to a multi-currency global economy is possible and could have benefits, particularly for emerging-market countries where moves in the dollar can have big effects on economic growth. However, it would require some major structural changes in many regions such as reducing barriers to trade and investment, along with strengthening protections for investors. These changes take time and political will.

Investors can likely benefit over the long run from global diversification. Diversification works best when economic cycles diverge, which may happen later this year if U.S. economic growth slows relative to expansions in other countries. With U.S. interest rates likely having peaked, returns in global bond markets may improve.

Overall, a further easing in the dollar’s strength over the course of 2024 could be an opportunity for investors to diversify globally, but a major structural change in the world currency order is unlikely short-term.

Longer-term, as geopolitical structures transform, there is a chance that China will play a more dominant role, or that the BRICS countries will expand and develop their own alternative to the U.S. dollar. This would tie into a continued de-globalization and polarization between a U.S. led bloc and a China led bloc. As money does not have any feelings, it will gravitate towards transparency, openness, liquidity, convertibility, and speed. At this point, the U.S. dollar is the better choice. Should China and others start developing towards these key openness elements, money will come their way. Longer term, it is likely that China will play an increasingly important role in the global currency markets and as a major reserve currency, either independently, or within the BRICS umbrella.

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