What the End of Dollar Dominance Could Mean for the Global Economy

Even when the US is not involved in a trade, the exchange of currency involves the greenback. All commodities (ranging from oil to coffee) and metals (like gold and silver) are quoted in the US dollar in the global financial markets. Due to these reasons, around 50% of the roughly $2.04 trillion worth of dollars in circulation was held by foreign entities (in circulation outside the US), according to the Federal Reserve’s estimate released in the first quarter of 2021.

So, why did the greenback become the world’s most prominent currency, why is its power flailing now and what could this mean for the global economy?

All Hail the Power of the USD

The US emerged as the leading superpower after World War II. At this time, the country controlled around 75% of the world’s gold supply and the US dollar become the only currency to be backed by the yellow metal. Meanwhile, with depleted gold reserves, other nations were unable to follow the gold standard and 44 countries came together to sign the Bretton Woods Agreement, pegging their currencies to the US dollar. The agreement, inked in 1944, made the US dollar the new gold.

Although the Bretton Woods system failed, the US dollar didn’t lose its power. By the 1970s, the US no longer had enough gold to back all the dollars issued and the gold convertibility for the greenback was ended by President Richard Nixon. Several economists predicted the end of the dollar dominance following this move. But that didn’t happen. In fact, the US dollar gained momentum as the world’s currency for trading and as a store of value. The strength of the US economy supported the greenback’s position as the global currency.

How the US Dollar’s Demise May Impact Us

Countries recognise that the dollar dominance puts the US in a position of power, giving it an “exorbitant privilege,” a term that was coined in the 1960s by France’s then Finance Minister Valéry Giscard d’Estaing to bring this issue to the limelight.

Fundamentally Mismatched

Although the greenback has held its position as the king of currencies, the US economy’s global output has shrunk over the past couple of decades. America’s economic growth is projected to slow. S&P Global forecasts a slowdown to 2.4% in 2022 and 1.6% in 2023, while the OECD projects a deceleration to 2.5% in 2022 and 1.2% in 2023. Despite this, the sentiment for the US dollar is largely positive, as reflected by Acuity’s Sentiment Widget.

Global Trade

With around 90% of global trade invoiced in dollars, exporters and importers in the US are protected from exchange rate risk. In strong contrast, traders from all other countries are exposed to dual forex risk and higher costs. Let’s say, China wishes to export goods to Australia. To pay for the goods, the Australian importer coverts Australian dollars to US dollars (bears forex risk + the cost of conversion). The Chinese exporter receives the payment in US dollars and needs to covert the amount into the yuan (again bears forex risk + the cost of conversion). This is double the risk and double the cost of converting Australian dollars directly to yuan. If the US dollar’s dominance is replaced by another currency, this situation will not be any different.

Trickle Down of Economic Issues

Supported by the Fed’s aggressive monetary tightening, the US dollar index, which tracks the greenback’s performance against a basket of major currencies, rose to about a 20-year high in July. This adversely affects all financial markets and all nations around the world. Owing to the dollar dominance, America’s inflation problem has seeped into the economies of even those countries that approached the pandemic-led crisis with much more prudent policies. The end of the dollar dominance can help countries shield themselves from the consequences of America’s policymaking.

Global Debt

Countries hold US dollar reserves to pay external debts, keep their exports competitively priced, and protect themselves from a liquidity crisis. This puts America in a position of undue advantage, as the country can service its trillions of dollars of debt at very favourable interest rates. The end of the dollar dominance will have an equalising impact.

In fact, central banks around the world have started moving towards this objective, albeit with baby steps. The US dollar’s share of forex reserves held by global central banks declined steeply to 59% in the fourth quarter of 2021.

Although China’s emergence as the world’s second largest economy did get the IMF to award the yuan the status of reserve currency in 2015, the Chinese currency failed to the gain the confidence of global central banks.

Political Power

The US has leverage against all other countries because it holds their reserves. This was highlighted by the move to freeze around $630 billion of foreign reserves held by Russia’s central bank in response to the invasion of Ukraine. This weaponizing of the US dollar has caused significant worry, motivating central banks around the world to consider alternatives.

Countries have been toying with the idea of putting an end to the dollar dominance for years. In 2009, China and Russia had suggested a global currency that was not controlled by a single nation. Although cryptocurrencies seem to fit the bill, governments need a more stable option as well as one that can operate under a well-defined regulatory framework. Till then, the US dollar is likely to remain the unrivalled king of currencies.