An interesting debate has emerged in the last few weeks among financial analysts: are we nearing the end of King Dollar, the dominance of the US currency in global payments and reserves? Some argue that the recent sharp depreciation of the US dollar is cyclical in nature and does not portend the dollar losing its role as the currency of choice for international traders, investors, and reserve managers. Others see storm clouds on the horizon and predict that the dollar’s decades-long position as the main global reserve currency is in jeopardy.
Nouriel Roubini, Eswar Prasad, and Mohamed A. El-Erian see present worries about a rapid decline of the dollar’s safe haven status as over-exaggeration. However, Roubini concedes that while the dollar’s position is safe for now, it could encounter significant challenges in the years and decades ahead.
Others are less sanguine. According to Ray Dalio, founder of hedge fund giant Bridgewater Associates, efforts to counter the economic fall-out of the COVID-19 pandemic created massive amounts of dollar liquidity. These monetary injections are in danger of debasing the dollar, even raising the specter of a currency crisis as government debt is monetized by the Federal Reserve.
Steven Barrow, head of G-10 strategy at Standard Bank, similarly worries that the combination of the COVID-19 pandemic and rising political risks ahead of America’s November election could generate the perfect storm of economic and political uncertainty to crash the US dollar – a danger more often associated with emerging-market currencies.
Both sides of the debate offer interesting insights into the future of the US dollar, and with it, the International Monetary System (IMS). I agree with those who see recent declines of the US dollar as mainly cyclical in nature. The Bloomberg Dollar Spot Index has dropped roughly ten percent from its peak in late March; a large move, but not out of the ordinary.
Therefore, the US dollar’s predominance looks quite unassailable in the short term. However, the risks mentioned by the latter two analysts are real and must be evaluated to understand longer term trends. Such an analysis shows that there is a distinct possibility of America losing its monetary monopoly.
Three longer-term trends are key. First, since the 1960s US trading partners and investors have fretted about the United States abusing its “exorbitant privilege” and debasing the dollar in a flurry of spending. These worries reached a climax during the 1970s but then gradually subsided, only to reappear during more recent economic crises, especially the Global Financial Crisis of 2008.
The COVID-19 pandemic has once more stirred these worries. Since the outbreak of the pandemic trillions of dollars in fiscal spending supported by massive monetary injections have raised the possibility that the U.S. will go too far. As Dalio remarks, “There is so much debt production and debt monetization.”
Massive government stimulus could increasingly rely on central bank monetization, especially if longer term interest rates start to rise. Since fiscal stimulus and monetary injections are of an unprecedented size, fear of future U.S. inflation and a loss of trust in the American currency are justified.
However, we have seen this movie before. The advent of the Federal Reserve’s Quantitative Easing after the 2008 Financial Crisis was similarly unprecedented and caused corresponding worries about future inflation and currency debasement.
These worries were reflected in March 2009 when Zhou Xiaochuan, then the Governor of the People’s Bank of China, called for an end to the dollar's reign as the global reserve currency and urged the G-20 to find a replacement. His remarks underlined Beijing's concerns about its dependence on the US dollar, including large dollar reserves now amounting to just above $3 trillion.
While this first trend provides cause for worry, a second one gives international monetary actors further incentive to try to find a replacement for the dollar. The Trump Administration has driven the weaponization of the dollar via trade, financial, and technology sanctions to a new extreme. For the first time, Chinese policy makers are now actively debating a doomsday scenario: being cut off from the international dollar clearing system that forms the backbone of the IMS.
One reason for heightened concern is the Hong Kong Autonomy Act. Among its tools are sanctions levied on top of Chinese and Hong Kong officials that threaten to block them and any bank doing business with them from the dollar payments system. Hong Kong Chief Executive Carrie Lam had to reportedly close some of her credit card accounts as a result.
While implementation of the Act does not mention Hong Kong’s ongoing access to the US dollars payments system, such a threat is a possibility and has been reportedly considered by White House officials. Sanctioning Hong Kong or large Chinese banks from accessing the international dollar system would cause global financial chaos. Such sanctions may prove to be a trump card that is too potent to play.
Nonetheless, the simple consideration of such moves in Washington, even if highly unlikely, have stirred considerable anxiety in Beijing. The risk remains real that China could be cut off from the international payments system based on SWIFT, the Society for Worldwide Interbank Financial Telecommunication. Being barred from a central node in the globe’s financial plumbing could inflict enormous pain on China’s economy, threatening both social and political stability.
This situation creates the third and perhaps most important trend. The dominance of the US dollar has not just been due to limited capital controls, a system of flexible exchange rates, and deep, liquid bond markets in the United States. The US dollar’s monopoly is also due to the fact that there is simply no clear alternative. The dollar dominates since any country vying for America’s position would have to take into account the downsides of the exorbitant privilege: an overvalued currency and the associated large current-account deficits that are needed to meet the global demand for safe assets, such as government bonds.
Neither the European Union, Japan, nor China have been willing to pay this price, since strong exports remain central to their economic models. But the weaponization of the US dollar is changing this calculus, especially for Beijing. The promotion of a new international payment and settlement system to replace the current US dollar-denominated one has become a life and death issue.
For the first time in history, China cannot continue to depend on the dollar’s monopoly without facing massive risks to its economic wellbeing. Internationalizing the Renminbi (RMB) has moved from a desirable to an essential policy.
And the timing for China is quite fortuitous, though not the best. Already American strategic rivals and allies alike are trying to diversify away from dollar assets that can be sanctioned or seized. American geopolitical hegemony is on the wane, and the public-health failures and related economic vulnerabilities due to the COVID-19 pandemic are further contributing to economic weaknesses that are more pronounced than in other industrialized countries. These factors make the dollar relatively less attractive.
Finally, China’s experimentation with a blockchain enabled digital payments system, the DC/EP, could provide the technological means for a major breakthrough in the IMS that suits Beijing’s priorities: massive amounts of real time data on currency movements that enable much more effective (and less intrusive) ways to monitor, channel, and, ultimately, control capital flows.
Consequently, while the present pressures on the US dollar are mainly of a cyclical nature, deeper underlying trends paint a more troubling image. Matters could converge in coming years to create a viable alternative to the US dollar for the first time in 80 years. In turn, this could shake the IMS, ushering in a new era of multi-currency competition characterized as much by geopolitics as by who is able to effectively and broadly deploy the best new financial and currency technologies.