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Memo 04.01.2022 10 minutes

Dethroning the Dollar

invest in dollars or yuan

The yuan is a long way from becoming the world’s reserve currency.

For 50 years or more we have heard frequent forecasts of the dollar’s decline. Economists, political pundits, and newspaper commentators have drawn on bouts of inflation, geopolitical and military setbacks, or simply ebbs in public confidence to declare that the dollar will soon lose its status as the world’s reserve currency; that is, it will cease being the default denominator in world trade and the primary repository for the foreign reserves of the world’s central banks.

Yet through it all, the dollar has retained its status almost undisturbed. True, America during this time has lost relative economic and financial power as well as geopolitical stature. But the dollar persists as the globe’s reserve currency because no viable alternative has ever arisen, and despite recent enthusiasms about China’s yuan, that remains true. The dollar will continue as the world’s reserve currency for the foreseeable future.

The Ukraine crisis provides a recent sign of the dollar’s abiding status. The months prior to the invasion showed no special preference for the dollar over other currencies, but as soon as trouble started, the international community fled to its presumed safety as the world’s reserve. Against the euro, the dollar had fluctuated in a stable range for quite some time, but then rose 10 percent in a matter of days after the tanks rolled. The dollar’s value against the Japanese yen repeated this pattern. Relative to China’s yuan, the dollar had been in decline for the three months up to the Russian invasion, when a sudden movement toward the greenback allowed it to recoup all those losses in just days. These moves may fail as definitive proof of the dollar’s status, but they are certainly consistent with the way a reserve currency is sought in times of trouble.

The dollar has served as the world’s unchallenged reserve currency since the late 1940s, when this country’s economy dominated the world, accounting for no less than half of global gross domestic product (GDP). The United States possessed the most stable socio-political environment in the world and had overwhelming geopolitical and military prominence. The scale and ceaseless activity of its financial markets reinforced any preference for the dollar by allowing importers and exporters to trade the currency easily and at any time, and also by offering anyone who held dollars a wide array of investment options. Britain, it may be recalled, had currency control regulations until 1979, and France did not entirely liberalize its currency until 1989. What is more, America’s reputation for following the rule of law reassured dollar holders wherever they resided that they were safe from expropriation and would receive a fair hearing should any dispute arise.

The first doubts about the dollar arose in the early 1970s. By then, Europe and Japan had rebuilt their once war-ravaged economies. Their exports were outcompeting American producers. The United States was running a disturbingly large trade deficit. President Richard Nixon wanted to address the matter by adjusting the prevailing Bretton Woods system of fixed exchange rates to remove the advantages it had given Germany and Japan to help with their respective economic recoveries. When these two countries refused to consider a change, Nixon unilaterally ended the system and hastened the currency adjustments by severing the dollar’s tie to gold. The dollar’s value crashed against the deutschemark and the yen, effectively erasing much of the advantage of German and Japanese exports by making their goods dearer on global markets and making American goods cheaper. Commentators, shocked by the sudden changes, declared the dollar finished as the world’s reserve currency. But for all the turmoil, the greenback retained its status. Neither Germany nor Japan, for all their renewed economic strength, could match the dollar’s political, military, and financial backing.

Another round of dollar-demise forecasts arose in response to the great inflation of the 1970s and early 1980s, no doubt helped by America’s humiliation in Vietnam. Double-digit inflation certainly damaged the dollar’s reputation for stability, but it was a global phenomenon and did comparable damage to other currencies. And though Vietnam and the oil embargos of those years made the United States appear weaker, no other country could match America’s stature, much less its global reach. The dollar retained its status.

Japan’s rise in the 1980s renewed the plausibility of dollar-decline scenarios, largely in favor of the yen. But if Japan had sufficient economic and financial strength to support a global reserve, it lacked the required geopolitical and military stature. Besides, Japan knew that supporting a global reserve would stymie the continued success of its export-oriented economy, and accordingly deflected any suggestions of the yen replacing the dollar. Then, at the turn of the century, the coalescing of the European Union around the euro brought yet another round of dollar-decline forecasts. In a short time, however, any such talk stopped as it became apparent that the euro had problems with Greece, Italy, and other weaker participants in the common currency. The dollar retained its status.

Now the speculation about dollar dethroning revolves around the rise of China’s economy and the attendant prominence of its currency, the yuan or renminbi. The concern is certainly understandable. China’s economy and the breadth of its trade have risen at prodigious rates. China’s economy rivals America’s in size and scope, and its trade levels may have surpassed those of the United States. Beijing certainly has ambitions to make the yuan a global currency. Its so-called Belt and Road initiative has heightened China’s geopolitical profile and allowed Beijing to raise the yuan’s international stature by insisting that all nations involved in the initiative base their trade in yuan and not in dollars, at least in their negotiations with China. China has also insisted on a yuan base in several bilateral trade agreements with a wide range of countries, among them India, Saudi Arabia, the United Arab Emirates, Iran, South Korea, and Japan. Nor has Beijing hidden its intentions. Chinese representatives at the G-20 have repeatedly accused the United States of “abusing” the dollar’s reserve status and living off paper money with no real prosperity. An editorial in Xinhua, China’s official news service, mused that “it is perhaps a good time for the befuddled world to start building a de-Americanized world.”       

Even if the yuan had all the necessary elements to support a reserve currency—which it currently lacks—it would take it a long time to unwind all the customs and practices that have grown up during the decades of dollar dominance. The Federal Reserve calculates, for instance, that the dollar is a part of some 85 percent of all the world’s currency exchanges. The next most significant is the euro at 35 percent, which includes euro-dollar transactions. For all Beijing’s pushing, the yuan at most constitutes 5 percent of these exchanges. About 80 percent of all trade contracts globally are denominated in dollars, whether an American is involved or not. The yuan barely exceeds 5 percent. According to the International Monetary Fund (IMF) some 60 percent of all central bank currency reserves are held in dollars, down from 70 percent at the turn of the century but still an overwhelming proportion. The next highest is the euro at 20 percent. China’s yuan amounts to a mere 2 percent.

China is not yet ready even to begin repainting this picture of dollar dominance. Its economy is certainly big enough, though its geopolitical and military profiles are largely regional and certainly do not compare with the global reach of the United States. The yuan’s real problems, however, are legal and financial. China, which pursues mercantilism and cronyism, can make no claim to operating a system under the impartial rule of law. Not only has the country violated patents and copyrights on every continent, but it has blatantly stolen technology and trade secrets from all its trading partners. It regularly alters rules with no recourse offered to either domestic or foreign interests, and Beijing threatens to expropriate assets from any who do not bow to its political demands. No one would want his or her international holdings subject to such behavior. Meanwhile, the yuan suffers from serious financial shortfalls. Trading in China’s markets is far from free; these markets cannot offer yuan holders the array of investments available in dollars and many other currencies; nor can they provide the easy trading into and out of the yuan that a reserve currency demands.

For all Beijing’s ambition, it may find itself disappointed should the yuan supplant the dollar. China has an export-oriented economy that runs a huge trade surplus and depends in part on a cheap yuan to make its goods attractively priced on global markets. A reserve currency demands a very different economy. Because so many must hold the reserve currency and the amounts must grow in tandem with world trade, the economy behind the reserve always imports more than it exports. The difference feeds this need for currency holdings. Markets bring this about because the demands from holders of the currency bid up its foreign exchange value above the level that would otherwise balance exports and imports. This fact has ensured that the United States has run a trade deficit just about every year since the dollar gained dominance. To replace the dollar with the yuan, China would have to give up on its export-led growth model. This reality was why Japan rejected reserve status for the yen when it was mooted in the 1980s. Making the change that Japan rejected may be a step too far for Beijing. It would certainly involve much painful dislocation.

The U.S. economy and the dollar may not be what they once were relative to other economies and currencies. The greenback nonetheless still stands as the world’s best option to fill the role of global reserve, and will for a considerable time to come. Those who point to inflation or this country’s relative economic and geopolitical decline may describe one reality, but they seem unwilling to recognize the lack of any alternative or the remaining relative strengths in the dollar’s favor.

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