The Bank for International Settlements – BIS, a “bank for central banks” that “fosters international monetary and financial cooperation” – reports that the dollar accounts for nearly 90% of transactions in a daily foreign exchange market of $7 trillion. The BIS also reports that this share of dollar’s forex trades has been stable over the past 20 years.
Those are important facts to keep in mind in order to make sense of a widespread pessimism that the dollar is losing ground to potential competitors.
The BIS numbers are showing that the dollar is the world currency, unmatched in its roles of a universally accepted unit of account and means of payment.
And those are two out of three key roles of money.
The dollar, however, has much more competition when it comes to its role as a store of value – the third essential role of money. That is measured by the share of dollar-denominated assets held by central banks in their foreign exchange reserves. On average, the dollar component in global reserves has fluctuated in the range of 75% to 59% during most of the post-WWII period.
The dollar could do better as a store of value
Those fluctuations are caused by central banks’ views of assets real purchasing power, prudential concerns, liquidity and the role particular reserve components play in the management of monetary policy.
That broad spectrum of factors has led to occasional bouts of pessimism about the dollar’s position as the world’s key currency.
Chief among those concerns have been periods of accelerating U.S. inflation, and, more recently, the use of the dollar as an instrument of geopolitical warfare.
America’s high inflation cycles have always been sensitive issues for global holdings of dollar-denominated assets. But things got a definitive turn for the worse with the huge U.S. monetary mismanagement that caused the Great Recession, followed by more than a decade of further policy mistakes with unrestrained credit expansion.
The world financial markets are now bracing for tremors as the U.S. Federal Reserve tries to shrink its $9 trillion balance sheet to manage a soaring inflation rate – and an inevitably long and deep economic recession.
Sadly, that process also coincides with Washington’s decision to confront Russia and China on fundamental issues of world order by using the dollar as the main vector for destructive economic and financial operations, and for American extraterritorial judicial overreach.
Most remarkably, a new dimension has just been added to an increasingly dangerous big power confrontation by “freezing” hundreds of billions of dollars of Russia’s reserve assets held in the global financial system.
Such an arbitrary asset confiscation has put the world economy in uncharted territory.
And how will all that play out transcends the realm of economic analysis, based on assets’ real purchasing power, liquidity and monetary control.
Weaponizing the dollar is a bad idea
The only reasonable conclusion at this point is that prudential issues will be of paramount importance in future asset diversification decisions.
The dollar, therefore, could take a knock as a reserve asset, but nothing for the foreseeable future can replace the greenback as a key global transactions currency in a fully dollarized world economy and a dollar-dominated international financial system.
People expecting that a shift to yuan-based China-Saudi Arabia energy trades will mark a decisive step in dislodging the dollar as a key world currency should think twice.
Yes, the announcement effect and a symbolism of such a change – if it were to take place – might cause a blip on trading screens, but a $45 billion (the amount of China-Saudi annual oil trades) event would hardly register in trillions of dollars of daily forex turnover.
A similar drop-in-a-bucket effect could be expected for an almost identical dollar amount of Russia-China energy trades that are already being transacted in rubles and yuans.
Apart from that, the yuan has a very long way to go from its current 2.8% share of world currency reserves to present a credible alternative as a reserve asset and a global transactions currency.
For that to happen, China needs to develop open, broad and deep globally traded yuan asset markets. That is a long and delicate process where China will not run the risk of destabilizing its economy by losing control of the monetary policy.
The U.S., for its part, has to reconsider its ill-judged policy of weaponizing the dollar. Washington’s diplomacy has better leverage to support peace and prosperity.
The greenback is also providing huge economic benefits. The U.S. has a unique privilege of acquiring real assets from the rest of the world in exchange for digital dollar credits -- or pieces of paper it can print at a zero marginal cost and issue at its own discretion.
But above all, the world economy needs a world currency. By establishing the dollar as a key currency, Washington offered the world an instrument to conduct global commerce and finance. That is an extraordinary piece of high ground in the history of the world.