The dollar in a multipolar world

The world’s best-known currency traces its origins back to a town called Joachimsthal in what is now the Czech Republic. Coins made from the silver mine in the town in the 16^th century were dubbed ‘Joachimsthalers’, and this was later shortened to ‘thalers’. The moniker was eventually attached to many different coins all over Europe, and the name was also eventually anglicised to ‘dollar’.

Several of these different coins found their way to the New World and other European colonies, including the Spanish dollar and the rixdollar (from the German Reichsthaler, and which was used extensively in the old Cape Colony). When the US became independent in the late 18^th century, dollar was chosen as the name of its currency.

The rest, as they say, is history, and the US dollar today is the world’s predominant currency, a position it has held since the Second World War. Apart from the US, many other countries, from Australia to Zimbabwe, have adopted the dollar name for their currencies.

Today, some 58% of the value of foreign exchange reserves is in US dollars, while 88% of foreign exchange transactions and 54% of export invoices are in US dollars, according to the Atlantic Council’s dollar dominance monitor. By contrast, the euro represents 20%, 31% and 30% respectively and China’s renminbi 2%, 7% and 4% respectively.

This level of dominance is unusual by historical standards. In the late 19^th century, when the British pound was the world’s dominant currency, it faced competition from other currencies such as the French franc. However, since the 1940s, the dollar has faced little real competition for its position.

What could change this position of predominance? And could this change happen soon? To answer these questions, we first need to look at the reasons why the dollar managed to build up such a hegemony in the first place.

One reason is the dominance the US has enjoyed in the global economy since the Second World War. The US has been the world’s largest economy for decades, and while it has fallen from about 40% of global GDP in 1960 to about 25% now, it remains the world’s largest economy. In addition to representing the biggest economy, the US dollar has also become the easiest currency to do business in. During the Cold War years, and after the collapse of the Soviet Bloc in 1990, the US had no real competition when it came to deep and liquid capital markets (more on this below).

The challenge of the BRICS

Since then, however, we have seen other economies emerge to challenge the US. China’s share of global GDP has risen from 4% of global GDP in 1960, to about 17% now. Estimates differ, but economists reckon that it will overtake the US as the world's largest economy sometime in the next decade. India’s share has also risen, to about 7%.

The emergence of the BRICS bloc, first made up of China, Russia, India and Brazil, and later expanded to include South Africa, Egypt, Ethiopia, Iran, Saudi Arabia and the UAE, has created a multipolar world that is less dependent on the US than it was before.

On top of this, the rise in global tensions caused by, for example, the war in Ukraine and the imposition of tariffs by the US on China, may hasten plans by these emerging powers to reduce their dependency on the US dollar. In 2015 BRICS members launched what is called the Cross-Border Interbank Payment System (CIPS), a settlement mechanism that uses the renminbi and by July this year had 150 direct participants and 1401 indirect participants (it is still dwarfed by the 11,000 members of SWIFT, the global international payments messaging system, however).

An intra-BRICS payment system is at an early stage of negotiations, while members also have bilateral and multilateral agreements with other members, focusing on currency swap and cross-border central bank digital currency (CBDC) agreements.

What makes a reserve currency?

Can these initiatives topple the mighty US dollar? To answer, we need to first look at why a reserve currency is useful, and what qualifies a currency for that status. A reserve currency is helpful to users because it creates a standard for critical transactions, payments and loans, and as an objective means for pricing portfolios, commodities and other assets.

According to the Atlantic Council, six things are needed to qualify a country’s currency for this role:

• A sizeable domestic economy
• An important economy in terms of global trade
• Large, deep and open financial markets
• A convertible currency
• Use of the currency as a peg or anchor
• Stable economic conditions and policies.

Writing in the Financial Times, Robert Armstrong et al (‘The multipolarity thesis: the verdict’, by Robert Armstrong, Ethan Wu and Adam Tooze, 12 October 2023), argue that a reserve currency requires three features to make it “unfailing”: it must be widely accepted; it must be fungible between financial assets and real-world goods and services; and it must be useful for invoicing or for underwriting cross-border loans. The dollar has these qualities, supported by the fact that the US remains the largest open economy in the world, as well as by the rule of law and a liquid financial market.

On both the Atlantic Council’s and Armstrong et al’s criteria, these qualities of the US dollar create a network effect. Like a dominant technology or application (such as a popular social media platform like Facebook) or a global language like English, users often have little choice but to use the dollar or have invested heavily in systems built around the exchange of dollars. This makes switching to a different standard difficult and expensive. Businesses trading internationally are unlikely to stop invoicing in dollars, at least until they have to.

However, economist and writer, Nouriel Roubini, argues that these advantages are not as clear-cut as they are made out to be. Roubini points to the increasing use of sanctions (such as against Russia and its supporters) and restrictions on investment in national security-sensitive sectors, as ways in which other countries may be prompted to limit their exposure to the dollar.

And the US dollar’s predominance is not always an advantage for other nations that trade in it. For example, in the aftermath of the post-Covid supply chain disruptions and the jump in inflation that followed it, it became clear to many countries that the US monetary authorities primarily acted with the needs of the US in mind. Many countries in Africa, such as Nigeria, Kenya, Ghana, Angola and Tanzania, faced severe dollar liquidity problems as US interest rates hit multi-decade highs, highlighting these countries’ vulnerability on this front.

Fiscal and monetary policy could also undermine the dollar’s power over the medium to long term. The Congressional Budget Office suggests that the US’s debt-to-GDP ratio could reach 122% by 2034. While the US dollar’s reserve currency status has shielded it from the effects of running large budget and current account deficits in the past, it’s not a given that it will be able to do so indefinitely.

A lesser, but still major role

Roubini’s concerns are legitimate, but perhaps overstate the dollar’s vulnerability to pretenders. For one thing, through its policies of running current account surpluses and a managed exchange rate, along with capital controls, China appears unready (and unwilling) to let the renminbi assume the reserve currency mantle (yet).

Nonetheless, with the US’s heft in terms of percentage of global GDP continuing to diminish, and more and more countries becoming conscious of the risks of exposure to the US’s economic fundamentals through the US dollar, a case can be made for some diversification.

As noted above, countries are already taking steps to lessen their dollar dependence. While the dollar’s 58% share of foreign exchange reserves is way ahead of the rest of the pack, it is down from 71% in 1999. It’s likely then that central banks will continue to diversify their holdings, into other currencies and assets such as gold.

Equally, China will increasingly find it difficult to keep growing the way it did during the early part of this century – through exports – and will have to switch to find ways to stimulate its domestic economy. That may require the relaxing of capital controls and a free-floating currency, which would become more attractive to others as a unit of exchange.

A multipolar world, with different trading blocs, also implies a role for other currencies. BRICS initiatives such as CIPS and CBDC agreements, will be keenly watched.

A diminished role for the US dollar needn’t mean that another currency usurps its role completely, however. There is a case for a world where the dollar remains the leading currency of choice in a multipolar world, but where it is not as utterly dominant as it has been over the last 80 years. This would bring it into line with the status of the reserve currencies of previous generations and arguably would be a healthier world economically, with less dependence on the liquidity and policies of the US economy.

Further reading and references:

Dollar Dominance Monitor (Atlantic Council)

The future of reserve currencies in a multipolar world, HSBC, 4 July 2024

CBO: National Debt to Reach Record Share of GDP in Just Three Years, Senate Budget Committee, 18 June 2024

A bipolar currency regime will replace the dollar’s exorbitant privilege, by Nouriel Roubini, Financial Times, 5 February 2023

The multipolarity thesis: the verdict of Unhedged and Chartbook, by Robert Armstrong, Ethan Wu and Adam Tooze, Financial Times, 12 October 2023

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