The current status of the dollar and challenges to dollar supremacy
Traditionally, a country’s economic dominance has been a key factor in the strength of its reserve currency. At present, the dollar remains the main currency of international trade – about 60 percent of foreign exchange reserves are in dollars and about half of all cross-border loans and international debt are denominated in dollars. The US Treasury bond market remains the deepest and most liquid in the world, and during the 2008 recession and recent COVID-19-related economic shocks in 2020, the dollar served as a safe haven for international investors. Foreign governments hold over a third of outstanding US Treasuries, a much larger proportion than in other developed economies. Still, the shrinking share of the US economy in global economic output and disruptions in the financial system raise fundamental questions about the dollar’s sustainability as a global reserve currency. The U.S. share of global GDP declined from 40 percent in 1960 to 24 percent in 2019, and China’s production rose from 4 percent to 16 percent over the same period.
Today the dollar has three main rivals: the EU’s euro, the Japanese yen and the Chinese renminbi. With 21.2 percent of the official foreign exchange reserves, the euro is arguably the second most important currency in the world. The euro has several properties that make it an attractive alternative to the dollar. The euro’s economic and monetary union (EMU), for example, has a large domestic economy and is central to world trade. Europe’s deep and liquid financial markets and the political predictability of the European Central Bank (ECB) make the euro a convincing means of international payment. However, the euro is facing structural weaknesses that make its ability to challenge the dollar difficult. The unique institutional structure of the euro area as a currency area without a corresponding fiscal union undermines the supervisory and regulatory powers of the ECB. The yen, which accounts for six percent of the official foreign exchange reserves and is the third largest reserve currency in the world after the euro and dollar, faces similarly significant internationalization barriers. These barriers include burdensome regulatory requirements, uneven liberalization of domestic financial markets, and persistent economic stagnation. In addition, raw materials – which are still invoiced in dollars today – make up a significant proportion of Japan’s imports. For these reasons, barring significant unforeseen geopolitical or technological developments, neither the euro nor the yen will question the hegemony of the dollar anytime soon. That does not apply to the renminbi.
According to most of the metrics used to assess the international significance of a currency, China’s renminbi lags far behind the dollar, euro and yen. At the end of 2020, only 2.2 percent of official foreign exchange reserves were held in renminbi, less than dollars, euros and yen, but also pounds sterling. Nonetheless, due to China’s robust economic growth since the 1980s, its rapid integration into the global economy, and its central position in international trade, the renminbi is considered to be the dollar’s greatest long-term threat. (China is now a larger trading partner than the US in 128 countries.) As evidenced by the creation of CIPS, the introduction of the digital renminbi, and previous attempts to internationalize the renminbi, China’s efforts to undermine the dollar are also more aggressive and explicit than in other countries. The IMF’s decision to add the renminbi to its Special Drawing Rights (SDR) basket in 2016 suggests that these efforts are beginning to bear fruit. (The SDR is an international currency reserve that the IMF distributes to supplement the existing reserves of member countries; its value is determined by five currencies – the dollar, the euro, the yen, the renminbi and the pound.)
The renminbi still faces several economic and political challenges in terms of widespread international acceptance as a global trade, investment and reserve currency. At present, China tightly controls its capital account, which means that strict conditions and some total restrictions are placed on the inflow and outflow of foreign capital into the country. A country’s capital account (sometimes referred to as a “financial account”) consists of the financial flows consisting of foreign direct investment, portfolio investment, cross-border credit (and other investments), and the use of the country’s foreign reserves in relation to the country’s exchange rate. In the case of China, the central bank also intervenes to control the renminbi’s exchange rate by buying or selling the renminbi to keep its exchange rate below its floating market value. (This, in turn, makes Chinese exports cheaper and more attractive.) These factors contribute to investors’ reluctance to trade the renminbi and limit its ability to become an international currency. A lack of market-driven interest and exchange rates, mature and liquid financial markets, and foreseeable legal frameworks continue to undermine the renminbi’s ability to become a more attractive investment vehicle than the dollar.
In Hong Kong, too, China is facing the challenge of an uncertain future. Hong Kong serves as the primary channel for foreign investment into the Chinese market, with two-thirds of all FDI capital flowing into and out of China through Hong Kong. Hong Kong is the world’s largest offshore renminbi center, providing clearing, settlement (over 70 percent of global renminbi transactions are processed in Hong Kong), financing and asset management in renminbi. China’s adoption of its national security law in June 2020 and the protests that followed have created an uncertain future. Under the National Security Law, individuals and businesses in mainland China can be brought to justice, a move that greatly expands the CCP’s influence. In response to the law’s passage, international companies are considering relocating their operations out of Hong Kong, with the American Chamber of Commerce finding that over 40 percent of international companies, led by financial firms, are now considering relocating their operations out of Hong Kong. A diminishing role for Hong Kong as an international financial center would significantly set China’s efforts to internationalize the renminbi and globalize its economy.
As daunting as these challenges may be, China, Russia and the EU are making slow strides in their continued attempts to seek alternatives to the dollar, and the adoption of Central Bank Digital Currencies (CBDCs) could greatly aid their efforts. Questions also arose about the ability of centralized systems such as SWIFT to keep pace with technological advances. In 2016, banks were targeted by a series of cyber attacks by misusing their SWIFT accounts. The most successful attack resulted in the theft of $ 81 million from the Central Bank of Bangladesh. Despite new cybersecurity measures in 2018, SWIFT fraud and cybercrime have risen steadily since 2016, with four out of five SWIFT members reporting at least one case of fraud since 2016. Security concerns about existing systems and the potential of digital currencies to both increase transaction speed and reduce costs (by eliminating the need for intermediaries) are fueling interest in accelerated adoption. A far-reaching transition to the use of digital currencies could reduce dependence on the current dollar-dominated global infrastructure, even without a country directly overtaking the US economically. For China, the recent pilot rollout of a digital renminbi could accelerate the liberalization of capital movements and the development of financial markets, while providing a tool for direct trade in renminbi and bypassing international middlemen like SWIFT. Russia and the EU are both considering introducing their own digital currencies, which will create new ways to break away from dependency on the dollar. While the existing CBDC infrastructure is still in its infancy, the simultaneous and ongoing efforts of China, Russia and the EU over time have the potential to undermine the dollar’s influence in the long term.
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