What’s behind the U.S. dollar’s dominance, and what can end it?

The United States (U.S.) dollar has long been the dominant global reserve currency. And its continued supremacy is attributed to many factors — primarily to the size and stability of the U.S. treasury market. Recent data from the Wall Street Journal indicates that the treasury bond market has reached a staggering $27 trillion. This further solidifies the dollar’s position as the world’s most widely held currency.

Flight to safety

One of the primary reasons for the dollar’s enduring dominance is its reputation as a safe-haven currency. This perception is fueled by the U.S. economy’s relative insulation from global economic shocks and robust financial markets. For instance, foreign countries, such as Japan, China, and the United Kingdom, have significant investments in U.S. assets, including treasury bonds and stocks. According to the U.S. Treasury Department’s Treasury International Capital (TIC) data, as of the latest treasury report covering June 2023, foreign investors held approximately $26.9 trillion in U.S. securities, with the majority being treasury bonds. This is a substantial increase from 2022’s $14.3 trillion.

The dollar haven status was demonstrated clearly. For example, during the COVID-19 pandemic, the USDX showed strong hedging performance against the S&P 500 index, providing protection for investors. During the 2008 global financial crisis, the dollar’s value surged as investors sought safe-haven assets.

The US economy: Biggest game in town

The U.S. economy’s sheer size, with a $25.46 trillion GDP, also significantly maintains the dollar’s dominance. As the largest economy in the world, the U.S. is more stable and less susceptible to economic downturns than smaller economies.

This stability is evident in the dollar’s value, which tends to appreciate during economic uncertainty.

Liquidity, liquidity, liquidity

The depth and liquidity of the U.S. financial markets are another crucial factor in the dollar’s continuous reign.

As of March 2024, the combined market capitalization of companies listed on the New York Stock Exchange (NYSE) and the NASDAQ had reached $52.6 trillion. This makes them the world’s most prominent stock exchanges, with over 60 percent of the global market capitalization. Following them comes China’s financial markets at $11.5 trillion, Japan at $6.5 trillion, and India at $4.4 trillion. This liquidity attracts investors worldwide, further increasing the dollar’s global usage.

The Fed: The world’s interest rate trendsetter

The Federal Reserve’s dominant influence as the world’s primary interest rate trendsetter also contributes to the U.S. dollar’s stability. The Fed’s monetary policy decisions significantly impact global interest rates, influencing the value of the dollar and other currencies. This influence is particularly evident during economic uncertainty when the Fed’s actions can profoundly affect global financial markets.

The correlation between the Fed’s actions on interest rates and those of other global central banks is significant, especially in the recent global tightening of monetary policy to combat rising inflation. Central banks worldwide have been closely monitoring and adjusting their interest rates in response to the Fed’s actions and the broader economic landscape.

The Fed’s decision to raise interest rates has notably impacted other central banks, prompting many to follow suit in tightening monetary policy to address inflation concerns. The European Central Bank (ECB) and other major central banks have raised their interest rates in alignment with the Fed’s moves, reflecting a coordinated effort to combat inflation and stabilize prices globally

The U.S. dollar network effect

The U.S. dollar’s robust network effect is another key factor in its continued dominance. The dollar is the most widely held currency in the world, with a global share of over 60 percent of global central bank reserves. It also has involvement in nearly 90 percent of global foreign exchange transactions, according to the Bank of International Settlement.

This widespread usage creates a self-reinforcing cycle in which the dollar’s value is maintained due to its widespread acceptance and ease of conversion to other currencies.

Risks remain

The U.S. dollar’s dominance is not without its challenges and potential risks. Some of the key threats include:

Political, fiscal, and monetary policies

The U.S.’s expansive fiscal and monetary policies since the COVID-19 pandemic, the disruption of global supply chains, and the rising price of oil have led to growing inflationary pressures, measured by some research papers to have reached up to 8 percent. If it keeps repeating, it will erode confidence in the dollar and prompt other nations to seek alternatives.

On the other hand, political instability within the U.S., including partisan gridlock and social unrest, has diminished its global standing and undermined faith in its currency.

De-dollarization efforts

Many nations have pursued de-dollarization, seeking alternatives to the U.S. dollar for international transactions. This includes countries like Russia and China forging bilateral trade agreements and pursuing currency swaps to bypass the dollar.

China’s central bank has signed bilateral local currency swap agreements with 29 countries and regions, totaling about 4 trillion yuan ($550 billion). This creates a large pool of alternative liquidity outside the U.S. dollar system.

In 2014, Russia and China signed a three-year bilateral currency swap deal worth 150 billion yuan, which they later renewed in 2017. This allowed Russia to build up its yuan reserves and facilitated trade between the two countries. The trend also increased the ruble-yuan trade growth.

The volume of ruble-yuan trade has surged, increasing eighty-fold from February to October 2022. This shift toward direct ruble-yuan trade instead of using the dollar is due to the increasing use of sanctions by the U.S. on Russia since the Russia-Ukraine war broke out.

Emergence of digital currencies

The rise of digital currencies like Bitcoin and Ethereum offers a borderless and decentralized alternative to traditional currencies, potentially reducing the dollar’s role in international transactions.

The World Economic Forum reported that 33 percent of Nigerians, 21 percent of Vietnamese, 20 percent of Filipinos, and 16 percent of Turks and Peruvians either use or own cryptocurrency, highlighting the significant adoption of digital currencies worldwide.

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BRICS nations’ efforts

The decline of the U.S. dollar as the global reserve currency could lead to a power vacuum in the international financial system, creating uncertainty and volatility that could negatively impact the global economy.

If the BRICS nations develop their own currency systems, they might reduce their reliance on the U.S. dollar in international trade and finance. This could potentially create a new global reserve currency.

Weakening of the U.S. economy and loss of seigniorage

A diminished role for the dollar in international trade may reduce demand for U.S. exports, negatively impacting GDP growth and employment levels. Furthermore, the decline of the dollar’s dominance could result in the loss of seigniorage, the profit made by the issuer of a currency from the difference between its face value and its value in the market.

However, despite numerous risks — as the global economy continues to evolve and the world seemingly becomes multipolar again — the dollar will likely remain the dominant currency for the foreseeable future. This is supported by multiple pillars, with the dollar’s value and influence shaped by the complex interplay of these factors.

Amro Zakaria is a financial services industry strategist with over 23 years of experience in global markets. He sits on the advisory board and lectures at several universities as a guest speaker on topics related to the global economy, geopolitics, and future economic trends.

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