Sonu Varghese, VP, Global Macro Strategist
There’s always been talk about the U.S. dollar (USD) losing its dominant currency status in the world, but lately, the chatter seems to have increased. Russia’s invasion of Ukraine added to concerns after the U.S. imposed severe and expansive sanctions on Russia and Russian officials – enabled by the fact that U.S. Treasury has jurisdiction over any transaction that involves the flow of USD. Rising tensions between the U.S. and countries like China and Saudi Arabia has also raised concerns that these countries could price oil sales in Chinese yuan, denting the USD’s dominance in the global oil trade, never mind the fact that these talks have been going on for several years now. We have also had some questions about the potential impact of the conflict in Gaza. However, the dollar actually tends to strengthen during periods of elevated uncertainty, so we see little direct concern for the USD from the conflict, even if its scope were to expand.
The reality is this: The USD’s dominant role is not going to end any time soon, especially since there’s no good alternative. Let’s walk through three reasons why, using some great data from a recent Federal Reserve report.
#1. The World Has Confidence in the U.S., and Thereby the U.S. Dollar
This confidence doesn’t come out of nowhere. As the Fed report notes, a key function of a currency is:
“A store of value which can be saved and retrieved in the future without significant loss of purchasing power.”
The U.S. has the world’s deepest and most liquid financial markets, thanks to the following:
- The size of the U.S. economy
- The strength of the U.S. economy
- Open trade and capital flows, with fewer restrictions than a lot of other countries
- Strong rule of law, and property rights, with a history of enforcing them
Which is why, despite the U.S. making up just about 25% of the world economy, about 60% of global foreign currency reserves are denominated in USD. This has fallen from about 71% in 2000 but is still far ahead of other currencies, including the euro (21%), yen (6%), British pound (5%), and Chinese renminbi (2%). And the decline has been taken by various other currencies, as opposed to a single other one.
#2. Network Effects: The USD Is Dominant in Trade Invoicing and International Finance
The USD is the world’s most popular medium of exchange when it comes to trade, even trade not involving the U.S. Outside of Europe, where the euro is naturally dominant, more than 70% of exports are invoiced in U.S. dollars. That’s not likely to change anytime soon, especially with so many countries and companies involved.
It shouldn’t be a surprise that the popularity of the USD as a medium of exchange means it almost automatically becomes the dominant currency in international banking. Think of all the USD flowing across global banks as companies/customers make payments to each other. Close to 60% of international foreign currency banking claims – i.e., bank deposits denoted in foreign currency – and loans are in USD. That’s been fairly stable since 2000 and has actually increased over the last decade. The euro is second, but makes up just about 20%.
Similarly, foreigners like to borrow in dollars as well, and even more so over the last decade. Of the total amount borrowed in foreign currency, dollar-based borrowing accounts for 62% of it. That’s up from 56% in 2012.
Network effects can be extremely hard to dislodge. It won’t be easy to convince people across the world that they have to move their assets from the USD to another currency, let alone make the switch without any risk.
#3. Most important reason: The U.S. Is Willing to Maintain Massive Trade Deficits
Here are a couple of statistics (as of Q4 2022):
- The rest of the world held about $7.4 trillion in U.S. Treasury securities
- The rest of the world held about $1 trillion in USD banknotes, which is about 46% of all USD banknotes out there
These are all “liabilities” of the U.S. government – i.e., loans to the U.S. government. But the real question is why do foreigners hold so much of these in the first place?
Part of the answer lies in the two reasons discussed above, but here’s another big one. Foreigners sell a lot of stuff to Americans, about $3.3 trillion worth in 2022 alone. And they get USD in return for all that.
In an ideal world, foreigners would turn around and use those dollars to purchase stuff made in the U.S., and trade would be “balanced.”
But they don’t. Instead, they bought about $2.1 trillion worth of goods from the U.S. last year.
Which means there was an extra $1.2 trillion that foreigners had. What do they do with it?
The U.S. Is Willing to Supply the Rest of the World with Treasuries & Banknotes
U.S. dollars can only buy goods and financial assets in the U.S. Foreigners could buy something in Europe or China, but they’d have to convert the USD to euros/yuan first and then someone else is left holding USD, and then they have to figure out what to do with those USD.
Instead, foreigners turn around and buy the safest, most liquid security in the world: U.S. Treasuries. Some of them also simply hold USD in cash (or deposits in their local bank). As I noted above, these are liabilities of the U.S. government that the U.S. is more than willing to issue. No other country, including the Eurozone, looks remotely capable, or willing, to do that anytime soon.
Which is why there are so many dollars and Treasuries held by the rest of the world.
Could that change, as countries decide to trade in their own currencies instead of the USD? Sure, but there’s a problem.
Take Saudi Arabia and China for example. The former could sell oil to China in yuan, but then the Saudis have to figure out what to do with those yuan. They’d have to buy assets in China – but there aren’t too many of them, especially Chinese government bonds.
China has capital controls as well. which means it may not be easy for the Saudis to pull their money out of China in the future, especially during crisis when the Chinese want to limit outflows. Capital controls are how the Chinese control their currency, and it’s hard to see them letting go of that lever anytime soon.
In sharp contrast, the Fed is willing to act as the global central bank, supplying dollar liquidity to the rest of the world when there’s a crisis.
The Global Economic Model Is unlikely to Shift
The Chinese could decide they don’t want extra dollars. So instead of selling all the extra stuff they produce to Americans, they could sell it to Europe, the rest of Asia, and Africa. But the thing is, those countries don’t want too many of those goods either – because consumption is not as big a part of their economies (like the U.S.).
Now, the Chinese could decide not to produce as much but that is not a recipe for economic success.
Ideally, their own citizens would buy all the extra stuff they produce. But here’s the problem: Chinese households don’t earn enough to buy all those extra goods, and they save a lot more than Americans. They have to, since there’s nothing like Social Security or Medicare there. China then channels these savings into investment, that leads to a lot of buildings, infrastructure, and industrial production. Which is what drives their economy.
The Chinese government could “fix this” but that involves a significant shift in how their economy works – essentially redistributing national income away from government and businesses to households, which would be a massive political project that’s unlikely to happen anytime soon.
It’s not just the Chinese. It’s the Germans too, along with countries like Taiwan and South Korea, all of whom rely on exports to drive their economies.
A shift away from the economic model that these countries rely on, to a model that is consumption led, is very difficult. As the previous chart shows, it’s actually gotten worse over the last few years, as US trade deficits grew even more.
In fact, it would be better for U.S. manufacturers if other countries do switch their economic model, because that would mean they could buy more stuff that’s made in the U.S. And trade would be more balanced.
In any case, there’s no practical alternative to the U.S. dollar right now, and its dominance is likely to remain in place. To the degree that things change, it would likely be a long slow process, not a sudden change due to a particular conflict or political decision. The global economy is a complex system in which the dollar is deeply embedded. But that’s been an economic strength, as the dollar continues to play an important role facilitating trade, providing liquidity, and supporting economic stability.