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De-Dollarization: Mission Almost Impossible
Currencies

De-Dollarization: Mission Almost Impossible

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26 JUN, 2023

By Stefano Battel

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De-Dollarization

For months, there has been intense discussion about de-dollarization, which refers to the process of abandoning the American dollar as a reserve currency or medium of exchange in trade, perhaps in favor of the Chinese Yuan given the increasing geopolitical relevance of the Asian country.

The idea that the influence of the American greenback on the global economy is declining is not entirely new, but the real possibilities of this happening, without the intervention of an exogenous shock and in a short period of time as the ongoing discussions seem to suggest, are quite remote.

Let's take a step back. Following the invasion in Ukraine, many argued that the freezing of the assets of the Russian Central Bank would be a turning point for the dominance of the dollar, as central banks around the world, to avoid seeing their assets frozen, would hold fewer dollars.

If we look at global currency reserves, it is true that the dollar has declined from around 70% of the total in the year 2000 to about 59% in 2022 (source: IMF). As of that date, the rest of the currency reserves were approximately 20% in euros, 5.5% in Japanese yen, 5% in pounds, and 2.7% in yuan. Looking at the numbers, aside from the Euro, not much has happened in over twenty years

Furthermore, in the last year, when looking at the numbers, there has been an 8% reduction in all reserves held at the end of 2022 compared to the amount recorded at the end of 2021. Given its relative importance in the total reserves, the dollar contributed the most to this decline (8.66%). But euro reserves also decreased by 8.5%, as did all other major currencies (except for the Swiss franc, which saw a strong increase of +21.74%). The yuan experienced a decline of 11.51%.

Some skeptics argue that these data are distorted by exchange rate fluctuations. Indeed, the dollar strengthened in the first three quarters of 2022, which may have increased the value of reserves and the currency's share in reserve portfolios, thus distorting the data. However, central banks rebalance their reserve portfolios in response to exchange rate changes, which should limit the impact of valuations on the shares. When examining the data adjusted for the exchange rate, the share drops from 59% in the fourth quarter of 2021 to 57% in the last quarter of 2022. Indeed, there is a decline, but it certainly cannot be described as a collapse.

The share of the dollar in allocated reserves, adjusted for the exchange rate, has decreased by an average of about 0.6 percent per year since 1999 (Source: Arslanalp et al. (2022)). The 2-percentage-point decline from the fourth quarter of 2021 to the fourth quarter of 2022 is three times larger, but there have been equally significant declines in the past. Among the possible factors behind the decline in shares could be the need for central banks to intervene in foreign exchange markets. As the dollar is highly liquid, it is widely used by monetary institutions when they enter the market to purchase their currencies. Hence, the decline in dollar reserves. A striking example was in 2015 when China, the largest holder of dollar reserves, experienced capital outflows and the need to intervene. It is not coincidental that the decline in the share of dollar reserves in 2022 also coincided with weakness in exchange rates in emerging markets (Source: Arslanalp et al. (2022)).

In any case, the dominance of the dollar is demonstrated not only by currency reserves but also by the fact that more than half of global trade is conducted in the US currency, and half of cross-border loans are issued in dollars. Before the dollar loses its current position, there would need to be significant changes in how it is utilized in all economic activities.

In a globalized economic system, the goal is to trade with as many partners as possible in the fastest and safest way. When a country exports its products and the trade is conducted in dollars, it accumulates dollars. If it exports more in USD than it spends in USD to import from abroad, the country accumulates USD currency reserves that enter the national banking system, and the local central bank must ensure their security and liquidity.

Maintaining money as safe and liquid, in our monetary system, means avoiding credit risk by investing in markets that are highly extensive and liquid, ensuring the possibility of a painless exit if needed. In this regard, the US Treasury market stands out, with a size of over 20 trillion dollars, liquidity, and support from a deep ecosystem of repo markets, meeting all requirements and providing the world with what it needs: a safe and liquid asset to recycle the proceeds in USD from global transactions.

The first obstacle to the growth of the yuan as a reserve and global trade currency is that, in order to achieve such status, the Beijing government would need to liberalize financial markets by relinquishing capital controls. Operators should be able to enter and exit China as they currently do in the United States, both for trade and investments, in order to ensure accessible, liquid, flexible, and cost-effective financial markets. Despite proclamations, Beijing is unlikely to give up an essential element of its governing system.

The second problem, regarding the rise of the yuan, is that China would have to accept absorbing enormous trade deficits with other countries, as the US currently does. Germany, Japan, and even China itself have been able to grow by accumulating consistent trade surpluses because there was a country that continued to import. Countries that accumulate surpluses do so by implementing policies that tend to depress wages and domestic consumption, as Europe does following the German model, and as China does. Is it really conceivable that such a structural change can occur in a short period of time within an economic model?

Let's look at COFER data for the fourth quarter of 2022, which places renminbi reserves at 2.7% of the total allocated worldwide. If we exclude Russia's share, which holds almost a third of all reserves due to exceptional geopolitical and financial circumstances it is facing, the renminbi's share drops to about 1.6%, which is not consistent with claims that other central banks are shifting towards the Chinese currency. Additionally, Chinese assets and liabilities traded internationally represent only 4% of the global total. In other words, Chinese assets and liabilities are not yet sufficient to constitute a serious alternative to the dollar (Source: Zhang (2023)), and the cross-border use of the renminbi for global payments remains around 1.4% of the total cross-border transactions.

There are still too many missing elements for the yuan to become a real alternative to the dollar as a reserve and trade currency. Certainly, nothing is impossible, but to paraphrase Mark Twain: "It could be said that the news of the dollar's demise has been greatly exaggerated."

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