War in Ukraine Accelerates Stealth Erosion of Dollar Dominance
The author is a professor of economics and political science at the University of California at Berkeley.
The decision by the United States and its allies to freeze Russia’s foreign exchange reserves has sparked intense debate over the future of the international monetary system.
This debate is vigorous because the stakes are high and it’s been at least 75 years, and World War II, since similar decisions were made — and after that the system changed. The debate is confusing, however, because it overlooks what really happened in the global monetary system.
Despite repeated references to the “dominance of the dollar”, the share of the dollar in identified global foreign exchange reserves has tended to decline over the past 20 years, falling from just over 70% at the turn of the century to just 59% at the third quarter of 2021.
This trend is not the result of currency or interest rate changes affecting the value of different reserve assets. Nor does it reflect the aversion to the dollar on the part of a handful of banks accumulating large reserve balances. Rather, it is the result of an effort by many central banks to diversify away from the US currency.
Now comes the surprise. Diversification is not into the euro, the pound sterling and the yen, the other long-standing components of the IMF’s basket of special drawing rights, a multi-currency reserve asset. The collective reserve share of these currencies has remained virtually unchanged for two decades.
Moreover, only a quarter of the transfer was to the Chinese renminbi, which was added to the SDR in 2016. At least three quarters was to the currencies of small economies such as Canada, Australia, Sweden, South Korea and Singapore, as disorganized for IMF which I co-wrote shows.
What explains the rise of these currencies? First, their markets have become more liquid. Historically, only a handful of countries had deep and liquid markets open to the rest of the world. Traders were only able to find counterparties in a handful of currencies. In practice, it was mainly the dollar but also the euro, the pound sterling and the yen. These were units used as vehicles for international transactions and therefore held by central banks as reserves.
But the costs of trading in subsidiary currencies have come down with the advent of electronic trading platforms and new technologies for automated market making and liquidity management. We see this in the bid-ask spreads on the subsidiary currencies, which are now as low – sometimes even lower – than on the euro, the yen and the pound.
Second, central banks have become more active in the search for yield. Reserve wallets are larger, which raises the stakes.
Third, and in a related vein, low bond yields from major reserve-issuing countries have intensified the search for alternatives. Non-traditional reserve currencies regularly offer attractive volatility-adjusted returns relative to their traditional counterparts.
Thus, we are already seeing a move towards a more multipolar international monetary system – but not the tripolar system dominated by the dollar, the euro and the renminbi anticipated by many observers.
Recent events should accelerate diversification. In the case of Russia, of course, all the issuers of substantial reserves, with the exception of China, actively participated in the freezing of reserves. Russia’s long-standing movement towards reserve currencies other than SDRs has therefore not provided it with a safe haven.
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However, now that the sword of a reserve freeze has been drawn, one can also envision a scenario in which the United States freezes a country’s reserves but other governments do not follow. In this case, further diversification of reserves by the target country could have insurance benefits.
What about faster diversification into the renminbi? Anyone considering moving reserves in this direction will need to consider the possibility that China may be subject to secondary sanctions. Moreover, Putin’s actions are a reminder that authoritarian strongmen can act capriciously when there are few national checks and balances to hold them back. The fact that President Xi Jinping has shown a reluctance to interfere in the operations of the People’s Bank of China is no guarantee that he will maintain this position in the future. It is no coincidence that every major issuer of reserve currency in history has had a Republican or Democratic form of government, with checks on executive power.
Russian reserve managers have no choice but to turn to the PBoC as long as it continues to grant them access. But for other central banks, an ironic result of the US decision to weaponize the dollar may actually be to slow international adoption of the renminbi.