Russia’s war of extermination in Ukraine has been met with far-reaching sanctions. These have included the freezing of the Russian central bank’s access to its substantial dollar and euro reserves. But financial measures to apply diplomatic pressure on Moscow have yielded a surprising countermeasure: Vladimir Putin now insists that countries must pay Russia in rubles for their purchases of oil and gas. At the same time, the Saudi prince MBS is in talks with Beijing to price some of its oil sales to China in renminbi. Russian entities which have been locked out of the SWIFT system might move towards the Chinese-led Cross-Border Interbank Payment System (CIPS) and find some rupee-ruble bilateral currency swap arrangement with India. More tellingly, as per the IMF, the dollar share of foreign currency reserves in central banks around the world fell from 71% in 1999 to 59% at the end of 2021.
Many analysts like Zoltan Polszar of Credit Suisse have wondered aloud if this might signal the beginning of the end of the US dollar’s role as the world’s reserve currency and international traders’ preferred unit of invoicing. While obituaries to the dollar are never in short supply after a major financial crisis or world-historical event, how accurate are they? And what follows the dollar: the digital renminbi, the euro, a multipolar currency order, or a market in cryptocurrency?
Ever since the Bretton Woods institutions were set up in 1944, the dollar’s ubiquity has undergirded American power and prestige. This was further accelerated by the fall of the Berlin Wall, after which the United States used (or misused, depending on your persuasion) the power of the dollar to sanction 10,000 entities affecting 50 countries with more than 27% of world GDP for crimes ranging from torture to the illicit use of cryptocurrency. As early as the 1960s, Valéry Giscard d’Estaing, then the French Minister of Finance, dubbed it the dollar’s privilège exorbitant (‘exorbitant privilege’). The United States, for example, can never suffer a balance-of-payments crisis as long as it can purchase its imports in its own currency. Also, despite a deeply negative net international investment position and large accumulated current account deficits, the US income balance is positive, with earned income higher than interest expenses by as much as 1.7-1.9%.
Indeed, for all prognostications of doom, the US dollar appreciated in recent weeks relative to most currencies. This despite high global and American inflation, and without the kinds of extreme capital controls and double-digit interest rate policy being pursued by the Russian central bank since February. Most international investors still consider US Treasuries a financial safe haven and value the unrivalled depth and liquidity of America’s capital markets, open to the rest of the world. Network externalities and sheer inertia ensure that the dollar liquidity status quo is largely self-reinforcing. As recently as 2019, 88% of all forex transactions were invoiced in US dollars, making it the global vehicle currency of choice and one for which forex dealers most readily find counterparties. The dollar has a convertibility that the renminbi and the ruble cannot ever aspire to because of the political imperative in an autocracy of a tight control over the domestic financial system. Its other putative rival, the cryptocurrency market, bled almost $2 trillion in value this May. Even much-vaunted ‘stablecoins’ collapsed overnight.
What explains the dollar’s resilience? For starters, the lack of credible alternatives. No other currency offers a similar investor-friendly market infrastructure with comparable liquidity in safe, risk-free assets. Consider the euro, which makes up 20.64% of global forex reserves and is the unit of account for the invoicing of 32% of global payments (not much below the dollar’s 40%). The eurozone runs an external surplus and does not need inflows from reserve managers, and the novel EURObonds issued in the aftermath of Covid are equivalent to only 5% of the stock of US Treasuries in the hands of the public. Also, negative interest rates imply an effective on central bank holdings of euro reserves. German 10-year bonds- the benchmark for continental European bonds- have a negative yield of 0.46%. The market for government bonds traded in euro is fragmented by country of issuance, as opposed to the large and homogeneous US Treasury market.
Even less convincing is the challenge posed by the renminbi (yuan). Despite efforts at internationalisation that began in the 1990s, it remains a half-baked global currency, illiquid and unconvertible outside designated offshore markets. Higher transaction costs have implied that the renminbi is used in only about a quarter of China’s own international trade, which remains largely dollar-denominated. China’s vast and increasing network of international loans and investments is entirely dollar-denominated, as are the listings of its blue-chip firms such as Alibaba, Baidu, and Tencent on the New York Stock Exchange. The Shanghai and Shenzhen stock exchanges allow licensed foreign institutions to trade in A-shares under the QFII and the RQFII programmes, but equivalent listings of non-Chinese blue-chip firms in renminbi is- as yet-inconceivable. Also, China, like Japan in earlier decades, fears ‘excessive’ internationalisation of its national currency as it could undermine its ability to encourage export-oriented manufacturing by maintaining a ‘competitive’ exchange rate. Even at a time when there are political insurance benefits to reserve diversification, foreign exchange holdings in renminbi in 2021 were a meagre 2.79% as opposed to 20.64% for the euro, 5.57% for the Japanese yen, and 4.78% for British pound sterling. The volatility-adjusted returns on renminbi assets are just not as competitive as those of transparent, open economies with liberal democracies such as Japan, the EU, and the UK (all of whom are staunch US allies with similar policy positions) where monetary policy decisions are not subject to the caprice of an opaque, unaccountable politburo. The dollar retains an overwhelming share of 58.81%.
Moreover, borrowing in dollars provides emerging-market banks and firms access to larger and more liquid global credit markets. Thus, firms in emerging markets endogenously take on currency mismatches so that lenders’ investment positions are hedged against local-currency exchange rate risk. Replacing the dollar with renminbi or ruble or even IMF Special Drawing Rights in this scenario would only make the costs of default risk far too prohibitive to allow ease of transactions. Countries which choose to exit the dollar bloc will end up restricting their ability to reassure foreign investors, which could adversely impact their growth strategies. It would also reduce their central banks’ effective, non-fluctuating reserve currency collateral. Even China’s policy of sterilised foreign exchange intervention necessitates a reserve accumulation commitment to support the inflow of private foreign capital. Thus, the United States’ greatest systemic competitor ended up with $3.2 trillion in dollar-denominated foreign currency reserves in November 2021, with nowhere else to park such humongous amounts of money and effectively hedging the US dollar against erosion risk.
To be sure, economic and political mismanagement caused by the extreme polarisation of US domestic politics might one day undermine US Treasuries’ risk-free status. Markets would then adopt a less favourable view of US government creditworthiness and seigniorage claims. The need for a multipolar financial order with more central banks creating liquidity and international financial centres offering pools of it might arise. But for now, seizures of Russian foreign exchange reserves will reinforce the dollar’s dominance rather than weakening it. By raising the costs of misbehaviour, the threat of US sanctions lowers the risk outlook for all private investors and not just US-based ones.
As long as these factors remain in place, the greenback will remain the only show in town.