Is the Dollar's dominance ending?

The questions were asked by Hanna Voss.

Ms. Liu, maybe start with a small overview of what De-dollarization is and why it has gained attention in recent years especially.

Zongyuan Zoe Liu: Sure. I think we can understand De-dollarization both in terms of a single country's own domestic economy as well as in the global financial system or a global context. So in the domestic case, De-dollarization means certain countries that do not print the US dollar but have a dollarized economy. They are non-US countries that use the US dollar as their own domestically circulated currency as means of exchange or unit of accounting due to their own conditions, sometimes this is associated with financial and monetary difficulties and then as their domestic conditions improve, the economies become less dollarized. However, what we are more concerned about in terms of De-dollarization is in the global context or the so-called dollarization of the global financial or economic system. This is related to the status of the US dollar as the dominant currency in the global economic and financial system, and its dominance can be evaluated through different areas, including international trade, currency traffic, international finance, development finance, equity markets, and its role as a safe haven currency in times of crisis.

As we saw after Russia's invasion of Ukraine when the value of many currencies decreased, while the value of the dollar increased. When in time did this dollar dominance begin, and when did it become so pervasive?

The exact time when the US dollar became the dominant currency in the international economic and financial system is a subject of debate because the dominant currency status means the dollar is the world’s reserve currency, primary currency for trade invoicing and commodity pricing, leading currency in international finance and development finance, and the go-to safe haven currency. It is widely held that the dollar became the global reserve currency in the aftermath of WWII at the 1944 Bretton Woods Conference. However, scholars like Barry Eichengreen and Marc Flandreau argued that the dollar replaced the sterling and became the leading reserve currency in the mid-1920s but the 1933-dollar devaluation led to the sterling regained its position as the leading reserve currency. In terms of the use of the US dollar in commodity pricing and trading, especially in the global oil market, this can be dated to 1975 when Saudi Arabia and the United States reached an agreement on oil sales exclusively using U.S. dollars. Saudi Arabia also urged the OPEC to do the same, and by the end of 1975 all OPEC members agreed to price their oil in dollars. The agreement at that time also came with U.S. security protection, hence a dollar-oil-security nexus. OPEC’s decision to price oil exclusively in US dollar marked a significant moment in establishing the dollar's dominance in the global economic system.

Nowadays, what would you say are the key drivers behind the trend of De-dollarization that we're observing globally? Or let’s start with: do you actually observe that trend?

There is a distinction between De-dollarization and the increasing use of local currencies. De-dollarization refers to a systematic reduction in the use of the US dollar in global finance and trade and in reducing the US dollar in central bank reserves. Currently, we are witnessing a rise in the use of other currencies, such as the Chinese renminbi, in international trade and investment. However, this does not necessarily equate to global De-dollarization. The US dollar still dominates in international finance, commodity pricing, and other crucial areas. It's important to note that while there is a trend toward the increased use of alternative currencies, particularly the renminbi, this is not the same as global De-dollarization or dethroning the US dollar at the moment. However, history suggests that there is no guarantee that the dollar's dominant status will last indefinitely.

So, a more frequent use of local currencies does not automatically lead to a systematic De-dollarization?

Exactly, there's a distinction between the two. Using local currencies more frequently in international trade does not necessarily equate to a systematic De-dollarization. The international financial system is massive and can accommodate multiple currencies, including regional and global ones. While there is a trend toward increased use of local currencies, especially in regional trade, it doesn't imply a complete displacement of the US dollar. Even China, despite being the world's largest trading nation, still extensively employs the US dollar in its import and export activities. This is particularly evident in the context of oil transactions, where China continues to rely on the US dollar. So the dollar remains dominant in key areas of global finance. Furthermore, many economies are still dollarized economies and their key exports, such as commodities, remain priced in dollars.

What can you say are the geopolitical developments driving this trend, especially in countries like Russia, Iran, and others?

The current acceleration in De-dollarization is primarily due to geopolitical developments and sanctions. Countries like Russia, Iran, and others have actively sought alternatives to the US dollar due to their concerns about being subject to sanctions or losing access to the dollar-based financial system. Geopolitical tensions have played a significant role in driving this trend. However, there are also valid economic reasons for using local currencies in international trade, particularly when countries are trading extensively with each other. The economic reasons include reducing transaction fees and exchange rate risk. Additionally, countries would also prefer to raise capital in local currencies if they can to minimize asset-liability mismatch, which is another economic reason to use local currencies rather than the US dollar. The economic and geopolitical factors are intertwined in the De-dollarization process.

Apart from individual countries and their use of their own currency, there are these groupings like BRICS. Recently, it was decided that six more countries, including Saudi Arabia, the United Arab Emirates and Iran, will become members. What does that mean for the international financial market and the dominance of the dollar?

The expansion of BRICS with additions of major energy exporters such as Saudi Arabia, the UAE, and Iran, improves the nominal importance of the BRICS as an energy and financial partnership. Countries like Iran, Russia, and China have strong incentives to develop alternative currency system due to their concerns about sanctions and being cut off from the dollar-based system. This expansion also increases the potential for the promotion of the use of non-dollar currencies in energy pricing, trading, and settlement. BRICS expansion with adding new energy powerhouses could contribute to the development of alternative energy trading markets, both oil and natural gas. For example, China’s renminbi oil futures trading launched in 2018 has developed rapidly. The Chinese government is also very much interested in promoting the use of renminbi in natural gas trading.

However, the importance of expansion is “nominal” in that BRICS members do not all have the same degree of interest and capacity in promoting de-dollarization. India, for example, currently is becoming a closer partner of the West and tends to have a different strategic agenda than China on important issues, including security, trade, and finance. Given that BRICS is a consensus-based group, it is unlikely that the expanded group will aim to dethrone the dollar. That said, they do have shared interests in promoting the use of local currencies in trade and development finance. The addition of Saudi Arabia will also give additional momentum to the New Development Bank, of which the UAE is already a member.

What are potential benefits for a country actively pursuing De-dollarization?

There are several. First, using its own currency can reduce transaction costs in international trade and mitigate exchange rate risks. This can benefit a country's trade and economy. Second, it can enhance a country's financial autonomy, as it doesn't have to rely on the US-dominated financial infrastructure and regulations. It allows for greater control over its own financial system. Finally, there is an element of prestige and sovereignty in having one's currency play a more significant role in international affairs.

Let's assume, even on a small scale, that some form of De-dollarization occurs. What are the implications for a country's monetary policies and central banks? How might central banks adapt to this changing financial landscape?

The scenario you described, where De-dollarization takes place, would indeed have significant implications for monetary policies and central banks globally. Currently, the Federal Reserve serves as, in a sense, the world's central bank. When the Federal Reserve makes decisions, such as raising interest rates, it has far-reaching consequences worldwide. For example, in coping with the 2007-2008 global financial crisis, the Fed’s quantitative easing and later tapering have had direct impacts on economies around the globe. In the past, many emerging market crises were linked to dollar strength and U.S. interest rate hikes. Stronger dollar and rising U.S. interest rates force developing countries to tighten their monetary policies to defend their own currencies and defend against inflation pressures. U.S. interest rate increase also pushes up the costs of borrowing in US dollar and the cost of servicing dollar-denominated debt.

We often see central banks like the European Central Bank (ECB), Bank of Japan, and Bank of England closely aligning their policies with the Federal Reserve. However, if De-dollarization were to progress significantly, the relevance of the Federal Reserve could diminish. In this scenario, central banks in various countries might need to reassess their strategies and policies.

Additionally, the ability of the US government to borrow at favorable rates could be compromised, affecting not only the United States but also the global financial system. From a geopolitical perspective, the US dollar's status as a tool for imposing sanctions could also be diminished, influencing how countries navigate international relations.

And at what point, theoretically, could we really speak of systematic De-dollarization?

The most dramatic scenario that could signify systematic De-dollarization would be the end of the dollar-based international financial system. This would involve the systematic depreciation of the US dollar against major currency baskets and a significant loss of confidence in the US financial system. In such a scenario, other currencies and alternative financial systems would become more dominant. However, it's essential to note that such a scenario is unlikely as long as the US financial system remains large and deep, the US Treasury bonds continue to serve as the global risk-free benchmark, the US economy remains competitive, US market remains appealing, and international investors remain having confidence in the US economy. A more gradual shift is currently underway, with the rise of alternative financial infrastructure and instruments, but again, this is not a systematic de-dollarization or attempt to dethrone the dollar.

Some critics argue that the United States has weaponized the use of the US dollar by imposing sanctions on countries and entities, effectively cutting off their access to the dollar-based financial system. How does this factor into the De-dollarization trend, and what are the implications?

The use of the US Dollar as a weapon through sanctions has indeed played a significant role in driving the De-dollarization trend in terms of the rise of alternative financial infrastructure led by countries that are more prone to sanctions. When the United States imposes sanctions on a country or entity, it often restricts their access to the dollar-based financial system. This can include freezing assets held in US banks, limiting their ability to move assets through the dollar-based financial system around the world or conduct international trade in dollars, and blocking their access to international finance.

In response to this, countries subject to sanctions have actively sought alternatives to the US Dollar, both to bypass sanctions and to reduce their dependence on the US-dominated financial infrastructure. This has led to increased efforts to use local currencies, explore digital currencies, develop and promote alternative to SWIFT-CHIPS (such as Russia’s SPFS and China’s CIPS), and strengthen economic ties with countries that are less reliant on the dollar.

What might be the implications of that?

The implications are twofold. First, it can undermine the effectiveness of US sanctions, as countries find ways to work around them. Second, it accelerates the trend of De-dollarization in terms of more countries seeking to join the alternative system to hedge against potential sanctions, as more countries seek to insulate themselves from the potential use of the US Dollar as a weapon in international politics. This underscores the importance of considering the geopolitical dimensions of De-dollarization in addition to economic factors.

Former US Treasury Secretary Jack Lew has also highlighted that the more sanctions are used, the more countries are incentivized to explore alternatives to the US dollar. This underscores the idea that the use of the US dollar as a weapon in economic statecraft can contribute to the acceleration of De-dollarization. It's a complex and evolving phenomenon that requires careful consideration by policymakers and market participants.

What role do digital currencies, such as central bank digital currencies (CBDCs) and cryptocurrencies, play in the context of De-dollarization?

When we consider the landscape of digital currencies, it's crucial to differentiate between cryptocurrencies and central bank digital currencies. CBDCs, like China's digital yuan, represent an attempt to create a digital alternative to cash-based fiat currencies such as the US dollar. However, they are still integrated into their respective local currency systems, such as the renminbi. Cryptocurrencies, like Bitcoin and Ethereum on the other hand, operate in a realm of their own and are subject to speculation and government regulation. They are not tied to any specific national currency, which introduces unique challenges and opportunities. One key challenge in the world of cryptocurrencies is interoperability — the ability to seamlessly convert one cryptocurrency into another and to conduct cross-platform transactions. Currently, this remains a significant hurdle, so they are not yet capable of challenging the US dollar's dominance in international finance.

Are there any historical examples of successful De-dollarization that countries or regions have pursued, and if so, what can we learn from them?

Historically, there have not been examples of successful De-dollarization efforts, but there have been successful regional currency swap agreements driven by unique circumstances. The first of such is the Chiang Mai Initiative launched by the ASEAN Plus Three countries in May 2000 in the aftermath of the Asian Financial Crisis of 1997-1998.

However, it's important to note that regional developments do not override the dollar’s dominant currency status in the international system. Lessons from these examples suggest that systematic De-dollarization can be challenging and requires careful coordination of monetary and fiscal policies, as well as efforts to build trust in the local currency and confidence in the respective economies.

But is there not also a danger that we underestimate the consequences of De-dollarization as long as we deem it unrealistic and place too much trust in the dollar?

De-dollarization is a multifaceted process with implications for global finance. While there is a trend toward the increased use of local currencies and alternative forms of digital currency in international trade, the US dollar's dominance remains significant in areas like international finance, commodity pricing, and as a safe haven currency. This trend is a reminder that the global financial system is not static, and countries and regions are exploring alternatives to reduce their dependence on the US Dollar.

However, it's crucial to be cautious about assuming that the dollar's dominance is in immediate jeopardy. The exact timeline and extent of De-dollarization are subjects of debate, with some experts suggesting that it would require a significant and unlikely event to dethrone the US dollar. Nonetheless, while the dollar's dominance endures, we should certainly not take it for granted, yes.

While we may not be observing a systematic De-dollarization at this moment, the trend of countries diversifying their currency use in international trade and finance is real. The US dollar's role may evolve gradually, and it's essential for policymakers, businesses, and investors to monitor these developments and adapt to potential changes in the global financial landscape. The dollar's dominance, while enduring, is not immutable, and its future role may depend on various economic and geopolitical factors. The most significant threat to the dollar’s dominance, however, comes from within the U.S. economy and U.S. domestic politics.