Mao Zedong was no monetary theorist, but his reflections on power help explain why the dominant role of the US dollar will persist. ‘Power grows through the barrel of a gun’, he said. One could add that currency power does too.
Throughout history, the top global currency has tended to be that of the dominant military power. Sterling ruled when Britain had an empire ‘on which the sun never set’, as did the silver Denarius and gold Aureus when Rome had its time. Currency power is a derivative of national power – and guns count.
But it would be wrong to think that the dominance of the dollar will give way to the renminbi, for instance, simply because China is accumulating power relative to the US.
The distribution of global currency power changes very, very slowly because of what economists call ‘network effects.’ The more widely the dollar is used – the bigger its network – the more entrenched it becomes and the more costly it is for anyone to operate without it.
The dollar is to international finance what the English language is to international communication. That status is reinforced by the reliability of the US legal system, the depth and liquidity of its capital markets, and its global cultural appeal.
Another decisive factor that keeps the dollar on top is its ready convertibility into other currencies, which makes it exceptionally easy to use internationally. While capital controls were a key part of the post-war Bretton Woods system which lasted until the 1970s, it is an unshakeable norm of the current international monetary system that each of the currencies that countries rely on as a store of value are fully convertible. The yen, the euro, sterling, and their smaller colleagues like the Australian and Canadian dollars are also free of any capital controls restricting their use.
These factors help explain why the dollar accounts for some 60 per cent of global foreign exchange reserves while the US only contributes around a quarter of global GDP; and why the dollar is bought or sold in nearly 90 per cent of global foreign exchange transactions.
True, the dollar has lost some of its shine in recent years: 20 years ago, the dollar accounted for 67 per cent of world foreign exchange reserves. But it is worth noting that the currencies the dollar has lost ground to – mainly the Canadian and Australian dollars, and the yen – are generally both convertible and printed by US allies.
The non-convertible renminbi, meanwhile, remains basically irrelevant as a global store of value, accounting for only 2 per cent of global foreign exchange reserves.
Short of a world war three with the US on the losing side, is there anything that could upend the dollar’s role? In the very long run, the growth of central bank digital currencies might conceivably erode its status. Nearer term, though, two risks stand out.
The first is an excess global supply of dollars on a scale that might just make the rest of the world lose faith in them.
Persistent external deficits in recent decades have left the US with substantial foreign liabilities. In the late 1980s the US was still a net creditor to the rest of the world. Now, though, what it owes foreign lenders outstrips what it is owed by foreign debtors by approximately $20 trillion, or around 70 per cent of US GDP. If there are so many dollars floating around that their worth becomes questionable, it could have negative consequences. But even this might be a greater risk to the level of the dollar – its exchange rate – rather than its status.
Another risk for the dollar might be its increasingly frequent use as a weapon the US deploys against countries it wants to punish.
Freezing Russian foreign exchange reserves in February 2022 is certainly the most aggressive weaponization of the dollar to date, following similar (but much smaller) assaults on the central banks of Libya, Iran, Venezuela and Afghanistan.
The theory is that the dollar’s use as a foreign policy tool and over-use of sanctions like these could make more countries worry about losing access to their dollars, encouraging a tilt away from the dollar to other alternatives.
That might be an easy switch if i) there were decent alternatives to the dollar, and ii) investing in those alternative currencies was a reasonable way of minimizing sanctions risk. The first is true, but the second is not: US sanctions on Russia’s central bank were joined by virtually every country that prints a reserve currency.
That said, the renminbi is making a bit of progress – if not as a store of value, then at least as a means of exchange. Chinese data show that by mid-2024, 27 per cent of China’s total trade in goods was settled in renminbi, up from 17 per cent in early 2022. This means that China is using its own currency to settle just over $50 billion more each month than it did in early 2022.