Declining Dollar: Shifts in Global Power Dynamics [PREPARE #6]

Imagine being a small business owner who sells products online to customers worldwide. You accept payments in US dollars since it’s the most convenient and widely used currency for international transactions. You also keep some savings in US dollars, trusting that they will maintain their value and be easily exchangeable.

Now picture waking up one day to find that the U.S. dollar has lost its global appeal. An increasing number of countries are transitioning to other currencies or devising their own alternatives. As the demand for US dollars drops, so does their value. Your customers now request different currencies or ask for discounts. Your savings are dwindling and losing purchasing power, leaving you facing an unexpected financial crisis.

What led to this? Why is the U.S. dollar losing its dominance? And how can you safeguard yourself and your business? In this blog post, I will delve into the reasons and repercussions of the dollar’s decline and its impact on you and your future.

Revisiting the international role of the U.S. dollar (BIS Quarterly Review by Bafundi Maronoti)

The U.S. dollar has long been the world’s predominant currency, serving as the primary reserve currency and the most widely used medium for international trade and transactions. However, recent trends suggest that the dollar’s dominance may be waning.

A recent International Monetary Fund (IMF) report revealed that the percentage of US dollar reserves held by central banks dropped to 59 percent in 2021 from 71 percent in 1999. This decrease is partially due to the dollar’s diminishing role in the global economy as other currencies gain traction for international transactions.

In this article, we will explore how escalating geopolitical tensions between the U.S. and other nations may partly be due to the U.S. losing credibility as the global reserve currency’s issuer. We will examine the dollar’s significance in oil trade, how the U.S. has wielded its financial power to enforce economic sanctions, and how countries like China and Russia are challenging the dollar’s supremacy by seeking alternatives to reduce their reliance on the dollar-based system.

The Dollar’s Role in Oil Trade

The dollar’s position as the global reserve currency was solidified following World War II at the 1944 Bretton Woods Conference. Here, forty-four countries agreed to establish the International Monetary Fund (IMF) and the World Bank, and to peg their currencies to the dollar, which was then convertible to gold at a fixed rate. Although this system collapsed in 1971 when President Richard Nixon terminated the dollar’s convertibility to gold (“Nixon shock”), the dollar maintained its dominance due to its involvement in oil trade and widespread acceptance in global markets.

Before the collapse of the Bretton Woods system in 1971, the dollar’s strength hinged on its convertibility to gold at a fixed rate. After the collapse, however, the dollar’s dominance has relied partly on its role in the oil trade or the petrodollar system, which emerged in the 1970s as a result of US agreements with oil-producing countries to sell their oil in dollars and invest their surplus revenues in US assets. This arrangement generates high demand for dollars and enables the U.S. to borrow money at low interest rates.

Moreover, the U.S. has used its control over oil trade to advance its geopolitical interests. The U.S. has engaged in numerous conflicts related to oil, particularly when nations tried to trade oil using currencies other than the U.S. dollar. For example, in 1991, the U.S. led a coalition to liberate Kuwait from Iraq’s invasion, which was partly driven by Iraq’s resentment of Kuwait’s oil overproduction and its refusal to cancel Iraq’s war debts. In 2003, the U.S. invaded Iraq again, citing alleged connections to weapons of mass destruction and terrorism. However, some analysts argue that Iraq’s decision to switch from dollars to euros for oil exports may have also contributed to the conflict.

Currently, the U.S. is in an extended conflict with Iran over its nuclear program and oil exports, imposing sanctions on Iran to restrict its access to dollars and global markets. Since 2012, Iran has been trying to diversify its oil trade partners and currencies, using various methods such as bartering, local currencies, gold, and cryptocurrencies to bypass the sanctions. China, Iran’s largest oil customer, has increased its purchases of Iranian oil in recent years, surpassing levels prior to the sanctions. Furthermore, China has been advocating for the use of yuan in its oil trades with other countries as part of its broader strategy to challenge the dollar’s dominance in global finance. Some analysts suggest that Iran’s oil trade in non-USD currencies may be a factor in the ongoing US-Iran conflict.

The U.S.’s Financial Power and Economic Sanctions

The U.S. has also employed its financial power to impose economic sanctions on nations it considers rogue states or adversaries, such as Iran, North Korea, Russia, and Venezuela. By leveraging its access to the SWIFT transaction system, which facilitates international payments in dollars, the U.S. can block or freeze assets of targeted entities and pressure other countries to comply with its sanctions.

SWIFT, or the Society for Worldwide Interbank Financial Telecommunication, is a network connecting over 11,000 financial institutions across more than 200 countries and territories. It allows these institutions to securely and efficiently send and receive information about financial transactions. A majority of international transactions are denominated in dollars and necessitate access to SWIFT.

The U.S. has utilized its access to SWIFT as a potent tool to monitor and influence global financial flows and enforce its foreign policy interests. For example, in 2012, the U.S. urged SWIFT to disconnect Iran from its network as part of the sanctions imposed over Iran’s nuclear program. This action effectively severed Iran from the global financial system and severely impacted its economy. Likewise, in 2014, the U.S. imposed sanctions on several Russian banks and individuals in response to Russia’s annexation of Crimea and involvement in Ukraine. These sanctions limited their access to SWIFT and hindered their ability to conduct international business.

More recently, following Russia’s invasion of Ukraine in February 2022, the US and its allies imposed a new round of sanctions on Russia that were more extensive than those in 2014. Among these measures, the US announced that it would expel selected Russian banks from SWIFT, effectively cutting them off from the global financial system and impairing their ability to operate internationally. The US also imposed sanctions directly on Putin and Russian Foreign Minister Sergey Lavrov, as well as on relatives of members of Russia’s National Security Council and other key officials and businessmen. These sanctions aimed to impose swift and severe costs on Russia for its aggression and violation of Ukraine’s sovereignty.

China and Russia’s Challenge to the Dollar

China and Russia, among other nations, have been actively challenging the U.S. dollar’s dominance and seeking alternatives to reduce their reliance on the dollar-based system. These countries are diversifying their reserves into other currencies or assets, such as gold, euros, or renminbi, developing their own payment systems or platforms, and encouraging regional or bilateral trade agreements that circumvent the dollar.

As the world’s second-largest economy and the largest trading partner for numerous countries, China has been broadening the use of its currency, the renminbi (RMB), in international transactions. China has established currency swap agreements with over forty countries, enabling them to exchange their local currencies for RMB and vice versa. Additionally, China has launched a cross-border payment system (CIPS) as an alternative to SWIFT and a digital currency electronic payment (DCEP) system as a potential challenger to cryptocurrencies.

China’s efforts have achieved some success. SWIFT data reveals that the RMB ranked fifth among global payment currencies in 2022, with a 2.17 percent share. The RMB also represented 2.88 percent of global foreign exchange reserves by the second quarter of 2022, up from 1.08% when it was first included in the IMF’s special drawing rights basket in Q4 2016.

Russia has been reducing its exposure to the U.S. dollar and increasing its holdings of other currencies and assets, such as gold and yuan. In 2021, Russia’s central bank announced that it would offload all of its US dollar reserves, replacing them with euros and yuan. Russia has also been purchasing gold at a record pace, making it one of the world’s largest gold producers and holders.

Furthermore, Russia has been collaborating with China and other BRICS nations to develop a new international reserve currency based on a basket of BRICS member currencies. Russian President Vladimir Putin stated in June 2022 at the BRICS business forum that this initiative would help mitigate the risks of US sanctions and establish a more balanced and equitable international payment system.

The Future of the U.S. Dollar

Despite China and Russia’s efforts to challenge the dollar’s dominance, many experts believe it is unlikely that the greenback will be replaced as the leading reserve currency in the near future. The dollar still enjoys several advantages that make it difficult to displace from its position.

First, the dollar benefits from network effects: the more people use it, the more valuable it becomes. The dollar is widely accepted and trusted worldwide as a medium of exchange, a unit of account, and a store of value. The dollar is also supported by a large and liquid financial market offering a variety of instruments for investors and borrowers.

Second, the dollar benefits from inertia: people tend to stick with what they know and are accustomed to. The dollar has been the world’s reserve currency for decades, and many countries have built their economic and financial systems around it. Changing these systems would involve significant costs and risks that many countries might be unwilling or unable to bear.

Third, the dollar benefits from a lack of viable alternatives: no other currency can match its scale, scope, and stability. The euro faces structural problems such as weak growth, high debt, and political fragmentation. The yuan encounters obstacles like capital controls, market distortions, and political interference. The ruble, on the other hand, is too small and volatile to be a serious contender.

The future of the dollar’s dominance depends on several factors, including the relative economic performance and policy choices of the U.S. and its rivals, the evolution of global trade and financial patterns, and the emergence of new technologies and innovations that could disrupt the existing system. The U.S. also faces challenges that could undermine its credibility as a debtor nation, such as rising public debt and political polarization.

In recent years, the U.S. public debt has reached unprecedented levels, particularly after the massive fiscal stimulus to combat the coronavirus pandemic. According to the Congressional Budget Office, the U.S. public debt is projected to exceed 100 percent of GDP in 2021 and reach 202 percent of GDP by 2051. This raises concerns about the sustainability and affordability of US borrowing, especially if interest rates rise or foreign demand for US assets declines.

Additionally, the U.S. political system has become more polarized and dysfunctional, as evidenced by repeated battles over raising the debt ceiling, a legal limit on how much the U.S. government can borrow. Initially intended to streamline congressional approval of borrowing, the debt ceiling has become a source of political brinkmanship and uncertainty, threatening to trigger a default on U.S. obligations. A default would have catastrophic consequences for the U.S. and global economy, as it would undermine confidence in the dollar and disrupt financial markets.

In conclusion, the U.S. dollar’s dominance is increasingly threatened by a combination of factors: soaring public debt levels, the potential for further stimulus despite inflation risks in the face of economic slowdowns or shocks, and the resulting debt-inflation feedback loop that could erode U.S. credibility and lead to higher interest rates. Furthermore, the prevailing economic theories and policy tools employed by the U.S. today may only exacerbate this crisis, raising questions about their effectiveness in addressing the challenges that lie ahead.

Over the next five installments of this blog series, we will delve deeper into the complexities of this situation and explore how current monetary and fiscal policies may inadvertently contribute to the weakening of the dollar’s dominance, and the potential implications this holds for the global economy.

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