The de-dollarisation debate

There are reasons to be bearish on the greenback, but it is unlikely to lose the reserve currency status

Of late, one of the hot topics under discussion among commentators is the issue of the US dollar (USD) being the reserve currency of the world and the huge advantage and privilege that this reserve status bestows on the US. While the US accounts for about 25 per cent of global gross domestic product (GDP), its true economic power is far greater, driven by global dependence on the USD.

This topic has come up for debate recently as there is anecdotal evidence of countries trying to break away from the USD. There are reports of China and Saudi Arabia agreeing to settle their bilateral oil trade in renminbi (RMB). India is also being forced to settle its purchase of Russian oil in either rupees or dirhams. There are murmurs of Brazil and China also agreeing to settle their bilateral commodity exposures in non-dollar currencies, while Russia and China are using the renminbi to settle their bilateral transactions.

While the world has for long resented the extravagant privilege granted to the US, and its control over the global financial architecture, why are these discussions gathering pace and being taken far more seriously today? The obvious answer is the weaponisation of the USD and the use of trade and currency sanctions to cripple the Russian economy. Few were expecting the US to freeze Russian foreign exchange assets and cripple Russia’s ability to settle trades in the currency. Through its lack of access to USD, Russia has been frozen out of the global financial system, unable to access capital from any Western financial institution. The inability to buy Russian oil in USD has also forced many countries, which are still buying the oil, to find alternative methods to settle this trade.

Many countries, especially rivals of the US are uncomfortable with their dependence on the USD and the power this gives America. 

There are active discussions ongoing among many as to how to reduce this USD dependence, leading to many experiments to settle trade and transactions in non-USD currencies.

To understand the context, one must first understand how omnipresent the USD is today in trade, foreign exchange, international finance and foreign exchange (FX) reserve management.

The USD accounts for approximately 90 per cent of all FX transactions. That means that the dollar was on one side or the other in nine out of 10 global foreign exchange transactions. The dollar also accounts for 85 per cent of all currency forward and swap markets. Almost half of all cross-border loans and international debt securities are also denominated in USD.( source: JPMorgan). This number is despite the fact that non-US entities are the borrower/issuer in 88 per cent of all international debt issuance. It is undeniable that dollar capital markets are the largest and most liquid. For anyone wishing to raise capital in size, they will ultimately have to tap the US capital markets.

The dollar is also used for about 50 per cent of all trade invoicing despite the US only accounting for about 12 per cent of global trade.

The dollar remains the currency of choice for managing FX, comprising 60 per cent of global FX reserves.

While this number has come down from 66 per cent in 2015, the shift away from the USD has largely been to smaller currencies like the Aussie/Canadian dollar, only 2-3 per cent has moved into the Chinese renminbi, most of which has been driven by Russia.

While many countries want to diversify their FX reserves away from the USD due to the freezing of Russian FX reserves, there are no easy choices.

Firstly, even if Russia had its reserves in euro instead of the dollar, it would not have helped, as even the EU joined the sanctions. In fact, more euros were frozen than USD for Russia given its larger trade exposure with the EU. Given the extreme set of circumstances required to provoke a freezing of reserves, it is highly likely that the entire Western powers will be coordinated in doing so. 

Gold may be an option to diversify your reserves, but most central banks do not have more than 10 per cent in the asset class (except Russia and Turkey).It provides no yield, and if all major central banks tried to boost their gold holdings, it would have a serious price impact.

As for cryptos, given its extreme volatility, most central banks do not have the stomach to include them in their reserves. Central bank digital currencies do not solve the diversification problem as they still have the same counterparty risk as holding the currency of the issuing central bank.

If one were to look at the top 20 countries ranked by quantum of FX reserves, it becomes very clear that except for China/Hong Kong, the rest are political allies of the US or have some form of cooperation. It is unlikely that any of these countries will attempt to aggressively diversify away from the USD, or fear any type of American action to control their reserves.

The only countries that may try to move away from the USD would be China, HK and Saudi Arabia. Of these, HK and Saudi Arabia run a USD peg of their own currencies, and thus cannot move away from dollars in any meaningful fashion. China with $3 trillion of reserves is the only country that can try to diversify, but given its scale of reserves, it also has limited choices. Its own advisors have advised against moving away from the greenback.

There is a school of thought that believes it is only a matter of time before the Chinese RMB becomes an alternative to the USD. China is now the second largest economy in the World (largest in PPP terms), with a local debt market that is now the third-largest in the world. The International Monetary Fund also added China to its Special Drawing Rights basket in 2016, providing a push for other central banks to follow suit.

For China, however, it is necessary to move forward on capital account convertibility and relax the constraints on residents moving assets overseas. With full convertibility, non-Chinese entities may issue debt-denominated in RMB, thereby improving the liquidity and scale of local capital markets and internationalising them. It is highly unlikely that the RMB can ever be a challenger to the USD without full convertibility. However, there seems to be deep reluctance on the part of the Chinese authorities to move along this path for fear of capital flight. China’s money supply is high and a fully open capital account may lead to pressure on the RMB and weaken local equity and real estate markets. Furthermore, there is a disconnect between Chinese money supply, FX reserves and central bank assets. This may only be sustainable with a closed capital account.

While one does not expect any immediate danger to the reserve currency status of the USD, this does not mean that the USD cannot depreciate in value. All signs point to the dollar having peaked, and coming off its highest levels in 30 years. Given the differing outlooks on monetary policy, the political divide in the US and the lack of measures to tackle the longer term fiscal challenges of entitlement spending, one can be bearish on the greenback. This, however, is a very different point from saying that the USD will lose its reserve currency status.

The writer is with Amansa Capital