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The Dollar’s Demise May Come Gradually, But Not Suddenly

Thought Leader: Niall Ferguson
April 23, 2023
Source: Bloomberg
Written by: Niall Ferguson

“Every night,” the president mused, “I ask myself why every country needs to trade in the dollar. … Who decided it was the dollar after the disappearance of the gold standard? … Today, countries have to chase after dollars to export, when they could be exporting in their own currencies.”

The president in question was Luiz Inácio Lula da Silva of Brazil, and the venue was the New Development Bank in Shanghai on April 13. There was a great deal of interest in this latest news about Lula when I visited Sao Paulo last week. To me, however, the striking thing was how un-new it was. Lula’s words immediately brought to my mind the musings of another president more than half a century ago:

The convention whereby the dollar is given a transcendent value as an international currency no longer rests on its initial base. … The fact that many states accept dollars … in order to make up for the deficits of [the] American balance of payments, has enabled the United States to be indebted to foreign countries free of charge. Indeed, what they owe those countries, they pay … in dollars that they themselves can issue as they wish. … This unilateral facility attributed to America has helped spread the idea that the dollar is an impartial, international [means] of exchange, whereas it is a means of credit appropriated to one state.

The speaker then was President Charles de Gaulle of France, and the date was Feb. 4, 1965. It was de Gaulle’s broadside against the dollar that prompted his finance minister, Valéry Giscard d’Estaing, to coin the memorable phrase “exorbitant privilege,” which encapsulated the French complaint.

Being fed up with the dominance of the mighty dollar is, in other words, old hat. Indeed, it is such a recurrent theme of financial journalism that one can identify cycles in the use of the phrase “exorbitant privilege.” Recent peaks, according to Google, were in 2007, 2011 and 2014. The Google “Ngram” for “de-dollarization” follows a similar path.

I first wrote an article on the subject nearly two decades ago, in June 2004. I was then an occasional contributor to The New Republic and my theme was the grave challenge to dollar dominance posed by the creation of a single European currency.

“For the United States,” I wrote portentously, “the question is: How long can [the] dollar standard last? As long as the dollar is ascendant, the United States can continue to run huge trade deficits and budget deficits, without having to worry about serious economic fallout. But if the dollar were to lose its status as the world’s reserve currency, and suffer a more precipitous slide, that could have grave consequences. Unfortunately for Americans, the sheer magnitude of the imbalances, along with the emergence of suitable alternative — the Euro — have made this a distinct possibility.”

Fortunately for me, a man is not under oath when writing such stuff.

Readers will therefore understand why my initial response is one of skepticism to any new claims that the demise of the dollar is imminent. But here they come again — not just Lula but a cluster of widely respected economic commentators. According to Peter C. Earle of the American Institute for Economic Research, “the dollar’s fate as the lingua franca of world commerce over the long haul may already be sealed.”

For Earle, it is American overuse of financial sanctions that is to blame. The more the US exploits its power to shut adversaries’ economies out of the dollar payments system, the more other countries want to reduce their exposure to that risk. Hence recent agreements between China and Brazil, China and France, and India and Malaysia, to settle trades in one another’s currencies.

“Prepare for a multipolar currency world” was Gillian Tett’s message in a recent Financial Times piece. Earlier this month, while Chinese president Xi Jinping was in Moscow, Russian President Vladimir Putin pledged to adopt the renminbi for “payments between Russia and countries of Asia, Africa and Latin America” to reduce Russian exposure to “toxic” dollar-denominated assets.

Because of such trends, according to Stephen Jen of Eurizon SLJ Capital, the dollar has already “suffered a stunning collapse.” “The USD is losing its market share as a reserve currency at a much faster rate than is commonly believed,” Jen wrote in a recent research note quoted at length by Robin Wrigglesworth in the FT. “The main driver of the collapse in USD’s reserve status in 2022 may have reflected a panicked reaction to property rights being jeopardized” by the freezing of Russia’s foreign currency reserves following its invasion of Ukraine.  “What we witnessed in 2022 was sort of a ‘defund-the-global-police’ moment.”

That’s a nice line, but so was the eurotrashing of the dollar 19 years ago. So, let’s take a closer look at the data. It’s true that, conventionally measured, the dollar now accounts for a smaller share of international reserves than it did in 1999 — down from just above 70% then to 59%. However, as Brad Setser of the Council on Foreign Relations has pointed out, if you take the X-axis back to 1995, you can see that the dollar share of international reserves is higher today than it was back then.

The Dominant Dollar

Global foreign exchange reserves

Source: International Monetary Fund; Brad Setser

In any case, the principal shift that has occurred since the 1990s is that the euro has become the world’s second-favorite reserve currency (which would have been a smarter but more boring and therefore less publishable thing for me to have predicted in 2004). The same goes for international debt issuance, international loans, foreign exchange turnover and global payments through Swift: In each domain (especially the last) the euro has clearly established itself as numero dos.

The fact that the euro area countries joined the US in imposing financial sanctions on Russia greatly weakens the argument that it is American overuse of sanctions that is undermining dollar dominance. As Setser notes, the invasion of Ukraine and subsequent sanctions don’t seem to have had a discernible effect on reserve allocation, even when you take into account the various sovereign wealth funds, which also accumulate foreign currency assets. The Chinese have actually increased their holdings of so-called “agency” bonds issued by US government entities such as the Federal Housing Administration and the Government National Mortgage Association.

The clinching data point was provided last week by Brent Donnelly of Spectra Markets, who used Bank for International Settlements statistics to show that, when it comes to major currencies’ shares of global transactions, the dollar’s privilege is still exorbitant. Every three years since 1989, the BIS has put the dollar’s share at between 80% and 90%. There has been no downward trend.

It is not hard to explain why the Chinese renminbi remains such a small share of international reserves: “capital controls” are the only two words you need to say to end the discussion. As Michael Nicoletos recently argued, without capital controls, a very large amount of Chinese capital would leave the country in search of diversification and more secure property rights. The Bank of England made this point in a seldom-cited but excellent paper a decade ago. The counterfactual of a convertible renminbi is one of a significantly depreciated currency.

Former Treasury Secretary Larry Summers had a good line about all this back in 2019. “You cannot replace something with nothing,” he said. What other currency is preferable to the dollar as a reserve and trade currency “when Europe’s a museum, Japan’s a nursing home, China’s a jail, and Bitcoin’s an experiment”?

If you are structurally long the dollar (as I am) and like that sort of thing (as I do), I can also recommend reassuring takes from my Bloomberg Opinion colleagues Tyler Cowen and John Authers. Foreigners just love our green-colored pieces of cloth with their rugged founders’ faces and their quaint masonic iconography, argues the former. “De-dollarization isn’t happening at all,” says the latter, because “the dollar is the cleanest dirty shirt.”

It is a cliché to say that we live in an ever-changing world. But if something doesn’t change for half a century — the dollar is the dominant currency and some foreign leaders resent that — why do economists and financial journalists keep predicting the demise of the dollar every six or seven years?

Of course, there are many things in history that stayed the same for 50 years and then suddenly changed. That is precisely what makes history hard to predict. It’s why people love to quote the exchange from Hemingway’s The Sun Also Rises:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

But there is no basis for thinking that reserve currencies lose their status in anything resembling these ways. The transition from sterling dominance to dollar dominance was all gradual, even if it was punctuated by occasional sterling crises. Those happened roughly once a decade from 1931 until, well, last year. And despite all the crises, sterling still accounts for about 5% of global reserves. This is a tortoise race.

So what we need to look for are signs that another such gradual change could be getting underway. Just as the creation of the euro in the 1990s paved the way for a new silver medalist in the reserve-currency race, so — if you look closely — there are meaningful signs that the Chinese currency is gathering enough momentum to be a meaningful contender for bronze in, say, 2043, passing the yen and the pound.

In an important new paper, the Berkeley economic historian Barry Eichengreen and co-authors have called it “the renminbi’s unconventional route to reserve currency status.” Their argument is that China does not need full financial liberalization, including an open capital account, to increase the international use of its currency.

First, the rapid growth of central bank swap lines engenders “confidence that RMB can be obtained from the Chinese central bank.” Second, the proliferation of offshore renminbi markets “reassures central bank reserve managers and other investors that they can convert RMB into dollars at stable and predictable rates.”

The scale of both these developments is startling. Since around 2009, the People’s Bank of China, the country’s central bank, has negotiated bilateral currency swap agreements totaling 3.7 trillion renminbi ($550 billion) with at least 39 central banks. Since 2010, when renminbi trading in Hong Kong was first authorized, offshore markets have sprung up in 24 other cities around the world. By July 2021, 1.25 trillion renminbi ($200 billion) was deposited in offshore accounts — an order of magnitude smaller than offshore dollar deposits, but not nothing.

At the same time, as another excellent new paper by Horn et al. shows, China has established itself as an international lender of last resort, launching “a new global system for cross-border rescue lending to countries in debt distress.”

In recent years, more than $170 billion in liquidity support has been extended to more than 20 countries, including repeated rollovers of swaps coming due. Chinese state-owned banks and enterprises have given out an additional $70 billion in rescue loans for balance-of-payments support. All told, China’s bailouts are equivalent to more than 20% of total International Monetary Fund lending over the past decade.

The authors sum their story up as “Bailouts on the Belt and Road,” noting that recipients of funds tend to be Belt and Road Initiative borrowers and that the interest rates they pay are relatively high compared with Western loans to countries in similar circumstances.

The serious study of history is all about pattern recognition. Both sets of authors spot the same pattern. “The RMB today,” write Eichengreen et al., “is not unlike the dollar in the 1950s and 1960s. Convertibility of RMB into dollars today is limited by capital account restrictions, while convertibility of dollars into gold was restricted by US monetary law under Bretton Woods. The 1950s and 1960s were the decades of the Bretton Woods System, when the dollar had to be backed by gold but was not convertible into the metal in the US. The offshore gold market in London then and the offshore RMB market today are products of a similar phenomenon, namely the imperfect convertibility of an international currency (the dollar then, the RMB now) into the ultimate reserve asset (gold then, the dollar now).”

Horn et al. also see “historical parallels to the era when the US started its rise as a global financial power, especially in the 1930s and after World War 2, when it used the US Ex-Im Bank, the US Exchange Stabilization Fund and the Fed to provide rescue funds to countries with large liabilities to US banks and exporters. Over time, these ad hoc activities by the US developed into a tested system of global crisis management, a path that China may possibly pursue as well.”

It had not fully struck me until I read these papers that the US dollar rose to global dominance before financial liberalization, which happened in the 1980s and 1990s. And part of its rise took the form of acting as an international lender of last resort.

Another reason the dollar slowly displaced sterling was that American financial technology raced ahead of British. Something similar is also happening today: China has pioneered online payment platforms on a far larger scale than anything we have in the West. As my Stanford colleague Darrell Duffie points out, China’s much-vaunted central bank digital currency (e-CNY) is not the thing to watch. It’s still Alipay, which handles three orders of magnitude more transactions than e-CNY and already has a large international presence, including 2.2 million users in the US.

Meanwhile, the US government is running significantly higher deficits than the ones I wrote about in 2004. And, unlike two decades ago, the Federal Reserve has been monetizing a large part of the deficits. Back then, the Fed balance sheet was 6% of GDP. Now, after successive rounds of quantitative easing and other interventions, it is up to 35%. The 2021-23 surge of US inflation cannot be explained without reference to major errors of fiscal and monetary policy. If the US intends to preserve its global monetary dominance, it is concealing that intention very well.

One striking consequence of these developments has been a significant surge in the dollar price of gold, which has risen more than 50% in the past five years, at a time when US Treasuries have fallen by 8%. John Maynard Keynes famously called the gold standard a “barbarous relic,” but there is nothing barbarous about a non-interest-bearing asset that outperforms an interest-bearing one. Data from the World Gold Council are revealing on this score. According to the most recent figures, the euro area holds 30% of total world official gold holdings, the US 23%, whereas Russia and China together hold just 12%.

However, the top buyers of gold between 2002 and 2023 were Russia (1,876 metric tons) and China (1,525 tons), with Turkey, India and Kazakhstan some way behind. The top sellers over the same period were the euro area (minus 1,726 tons) and Switzerland (minus 1,158 tons), with the English-speaking countries (minus 87 tons) far behind.

All That Glitters

Additions to gold reserves in metric tons

Source: World Gold Council

Yet this is not to suggest that gold is another, more ancient rival to the dollar. It is far from clear that accumulating gold will solve the Russian — and Chinese — problem of vulnerability to US sanctions. It is just a good illustration of how slowly the global monetary system changes.

The year before de Gaulle’s diatribe against the dollar was when my favorite James Bond film was released. Goldfinger remains a wonderful cinematic achievement, from the villain’s first victim — the actress Shirley Eaton, clad only in gold paint — to the exquisite exchange between Bond and Gert Frobe as a laser beam inches towards Sean Connery’s groin:

007: Do you expect me to talk?

Goldfinger: No, Mr. Bond. I expect you to die!

But, aside from the almost unmitigated sexism, one aspect of Goldfinger has dated absurdly. It’s the moment when the man from the Bank of England explains why Goldfinger’s suspicious accumulation of gold is a problem requiring 007’s attention:

We here at the Bank of England are the official depository for gold bullion. Just as Fort Knox, Kentucky, is for the United States. We know the amounts we each hold and the amounts deposited in other banks. We can estimate what is being held for industrial purposes. Thus, both governments can establish the true value of the dollar and the pound.

Those days were over within seven years, when President Richard Nixon broke the link between gold and the dollar that had been the anchor of the Bretton Woods System. Since then, the currencies of the world have fluctuated against one another and against gold, sometimes quite violently, sometimes barely noticeably.

Hardly a Currency Crisis

Source: Bank for International Settlements

Just look at the trade-weighted real effective exchange rate of the dollar since the “Nixon shock.” There’s a 32% plunge from July 1971 to October 1978. Then there’s a 49% rally to March 1985. Another 36% plunge to August 1992. Then up 33% to February 2002. Back down 26% to July 2011. And all the way up 53% to October 2022.

You can say what you like about the dollar, but it sure is bouncy. And it is precisely this lack of rigidity that explains the persistence of the post-1971 monetary system. Unlike the gold standard, the dollar system has an elastic anchor — a fiat dollar, the supply of which is primarily determined by domestic economic considerations.

Other currencies are very welcome to compete: the euro, the renminbi — and (who knows?) maybe the future “BRICS currency” imagined by Lula in Shanghai. But do not expect “de-dollarization” to follow the Hemingway two-stage model. The world changes its monetary anchor only one way. Gradually.

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