The Challenges to the Dollar

The dollar’s position as the premier global currency has long seemed secure. The dollar accounts for about 60% of the foreign exchange reserves of central banks and similar proportions of international debt and loans. But recent developments raise the possibility of a transition to a stratified world economy in which the use of other currencies for regional trade and finance becomes more common.

Such a statement may seem to be inconsistent with the Federal Reserve’s activities to stabilize global financial markets. As it did during the global financial crisis of 2008-09, the Fed has activated currency swap lines with other central banks, including those of the Eurozone, Great Britain, Japan, Canada and Switzerland, as well as the monetary authorities of South Korea, Mexico, and Singapore. Those central banks that do not have swap agreements can borrow dollars from the Fed via its new foreign and international monetary authorities (FIMA) facility. Under this program, central banks that need dollars for their domestic financial institutions exchange U.S. Treasury securities for dollars through a repurchase agreement. These moves accompany the Fed’s extensive range of activities to support the U.S. economy, which include cutting the federal funds rate to zero, purchasing large amounts of Treasury, mortgage backed and corporate securities, and lending to corporations and state and municipal governments.

But other governments are uneasy with the U.S. government’s use of the dollar’s position in international finance to enforce compliance with its foreign policy goals. International transactions in dollars are cleared through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking network and the Clearing House Interbank Payments System (CHIPS). The U.S. has denied foreign banks access to these systems when they wanted to penalize the banks for dealing with governments or companies that the U.S. seeks to punish. This practice has become more common under the Trump administration, which has used the sanctions to strike at Iran, North Korea, Russia, Venezuela, and others.

European leaders have made clear that they find this use of the dollar’s international role no longer acceptable. When the U.S. abandoned the agreements on nuclear weapons with Iran, European banks were forced to choose between defying the U.S. or their own governments, which encouraged them to continue their ties with Iran. In response, Britain, France, and Germany have founded a clearing house, Instex, to serve as an alternative system, and several other European Union members will join it. Moreover, if the Europeans proceed with the issuance of a common EU bond, there will be an alternative safe asset to U.S. Treasury bonds that will foster the use of the euro in foreign exchange reserves.

China is also moving to encourage the international acceptance of its currency as an alternative to the dollar. The Chinese bond market is the world’s second largest, and the foreign appetite for Chinese bonds has increased. Foreigners bought $60 billion of Chinese government bonds last year, and now hold 8.8% of these bonds. Some of these bonds will be held by central banks diversifying the composition of their foreign currency reserves.

China’s Belt and Road Initiatives have expanded its economic presence in emerging markets, which also leads to a wider usage of its currency. Chinese investments in infrastructure and other projects in these countries increase the usage of the renminbi, as will the trade that follows.  The number of banks processing payments in renminbi has grown greatly in recent years, and most of these banks are based in Asia, Africa and the Middle East.

There are obstacles to the wider use of both the euro and the renminbi. While Germany’s Chancellor Angela Merkel has voiced support of a common European bond, the heads of other European governments have expressed their concerns.  China continues to maintain capital controls, although it has allowed foreigners to invest in the bond market through Hong Kong. But the imposition of a new security law for Hong Kong raises concerns about China’s willingness to allow financial concerns to affect its political goals.

The euro was once more widely seen as a viable alternative to the dollar. Hiro Ito and Cesar Rodriguez of Portland State University in their recent research paper, “Clamoring for Greenbacks: Explaining the Resurgence of the U.S. Dollar in International Debt”, examine the determinants of the currency composition of international debt securities. In their analysis they undertake a counterfactual analysis to examine what would have happened to the shares of the dollar and the euro in the composition of these securities if the global financial crisis had not occurred. They report that the predicted share of the euro in international debt would have been higher than it actually has been, while the share of the dollar would be lower.

When Ito and Rodriguez wrote their paper, they forecast that the dollar would continue to be the dominant international currency. But the Trump administration has damaged the international standing of the U.S., and this will have long-term consequences. Benjamin J. Cohen of UC-Santa Barbara has pointed out that “…there is palpable resentment over Trump’s indiscriminate use of financial sanctions to punish countries…” More generally, the U.S. government has sought to limit the county’s international interactions.

Harold James of Princeton wrote about the dominance of the dollar after the global financial crisis in his book, The Creation and Destruction of Value: the Globalization Cycle, which was published in 2009. At that time he foresaw the central role of the dollar as continuing because of the “political and military might of the U.S.”, as well as its economic potential. But he also stated that:

“Such concentrations of power can be self-sustaining when they attract not only the capital resources, but also the human resources (primarily through skilled immigration) that allow exceptional productivity growth to continue.”

James warned that if a country closes itself off from exchanges with other nations, its relative decline can be hastened. He pointed out that:

“Since the isolationist impulse is a major strand in the American political tradition, it is impossible to close off this possibility; in fact, its likelihood increases as the economic and political situation deteriorates.”

The pandemic has the potential of serving as an inflection point, which follows a period of confrontations with other countries over trade. The fumbled response of the U.S. to the pandemic will encourage the governments of Europe and China to extend their influence in the financial sphere.  A world with several dominant currencies need not be inferior to one with a single hegemonic currency. But it will come about in large part as a result of the self-inflected damage that the Trump administration has perpetrated on the international standing of the U.S.