For almost a century, the US dollar has been the world’s reserve currency. This means that the central banks primarily conduct international transactions and settle international debts using the dollar.
However, some economists are pointing to signs of de-dollarization; that is, the effort by various countries to conduct international transactions using alternative currencies to the dollar.
De-dollarization could have a profound impact on the global economy, the international balance of power, and the day-to-day lives of ordinary people. For these reasons, is important to consider whether this economic trend is occurring and if so, how fast and why?
Why is the US dollar the world’s reserve currency?
The US dollar replaced the Great British pound as the world’s preferred reserve currency in 1931, amid the Great Depression. During both world wars, the US supplied the allies with the majority of their weapons and munitions. Most allies paid for the weapons with gold, meaning that by the end of the Second World War, the US possessed most of the world’s gold.
This was set in stone in 1944 when 44 countries agreed on the Bretton Wood system. The international delegation agreed to peg the world’s currencies to the dollar rather than to gold since the dollar was itself linked to gold. The US dollar was now the world’s official reserve currency.
Between 1971 and 1973, the Bretton Woods system dissolved due to US President Richard Nixon’s decision to suspend the dollar’s convertibility to gold. However, de-dollarization did not occur as a result.
The dollar remained the world’s reserve currency for several reasons, such as its perceived stability and the country’s hard and soft power.
is de-dollarization happening?
Some economists expect de-dollarization to occur as emerging economies in the Global South grow and seek to diversify the composition of their reserve currencies. In 2021, the International Monetary Fund (IMF) noted that “the US dollar’s share of global reserves has declined”.
There are economic, political, and strategic reasons some countries want to shift away from the dollar. Since the end of the Cold War, the US has been the world’s sole superpower, meaning that the world order has been multipolar. However, some states like China and Russia would prefer the world to be multipolar, wherein there would exist multiple poles of world power. De-dollarization would assist in the transition from unipolarity to multipolarity.
Another incentive for countries to diversify the composition of their reserve currencies, particularly those with poor bilateral relations with the US, is that the US can wield the preponderance of its currency as a geopolitical weapon. Sanctions imposed by Washington can be especially potent because of the centrality of the dollar in international finance. Even US allies like Saudi Arabia are wary of US sanctions since their human rights record could make them a target for Washington’s ire.
One approach to de-dollarization is Local Currency Trade (LCT), whereby states conduct trade with one another using their own currencies. The currencies are converted based on exchange rates. Earlier this year, China and Brazil announced that they would engage in LCT, as opposed to using the dollar.
The signs that de-dollarization is taking place are certainly there but this will not result in an overnight abandonment of the dollar as the world’s global reserve currency unless a very dramatic shift in geopolitics takes place.
Economist Stephen Yen predicts that it will take “many years” for the Chinese yuan to challenge the US dollar. Similarly, JP Morgan economists Meera Chandan and Octavia Popescu have assessed that “the US dollar will likely retain its dominance despite the ongoing attempts to replace it with an alternative reserve currency”.