Xia Le, Chief Economist for Asia at BBVA.

The US dollar has been the dominant currency in the current international monetary system (IMS) for a long time. It is widely used to settle cross-border transactions, both in trade and finance. It is the primary invoicing currency for major global commodities, including crude oil, copper, iron ore etc. USD-denominated assets make up the majority of foreign reserves held by governments and monetary authorities around the world. Furthermore, the private sectors outside the USA also consider the greenback to be an essential form of storing their wealth.

There has been a recent surge in interest among the international community regarding de-dollarization, which is being evidenced by a number of emerging signs. For instance, in May, Brazilian President Lula and Argentine President Fernández vowed to devise a mechanism that would allow their local currencies to be used in bilateral trade instead of the USD. Additionally, a few Gulf countries, including Saudi Arabia and the United Arab Emirates, are currently exploring the possibility of settling their crude oil exports in currencies other than the USD. Furthermore, official statistics from China indicate that in the first quarter of 2023, the RMB accounted for a greater share of global payments than the USD.

Despite the enthusiasm of some national leaders on the topic, scholars generally maintain a cautious approach. For instance, Eichengreen (2023) argues that "reports of the dollar's demise have been greatly exaggerated." Arslanalp et al. (2022) did not find any evidence that US financial sanctions have a negative impact on other countries' decision to accumulate USD assets as part of their foreign reserves. However, while the analysis above focuses primarily on the role of the USD as an international reserve currency, de-dollarization may also occur in the areas related to other functions of the USD.

What are the drivers behind the de-dollarization? Will the de-dollarization become an irreversible trend? Or it is just a fad? If the former is the case, in what way will it will proceed? What it means for the IMS? This section will explore these questions through the lens of international currency’s functions.

The USD dominance as an international currency

According to canonical theories, money has three primary functions: serving as a unit of account, a medium of exchange, and a store of value. An international currency like the USD also fulfills these three functions, with particular emphasis on their role in facilitating cross-border economic activities. To gain a better understanding of the USD's dominant role in the current IMS, it is helpful to examine it through the lens of its functions.

Unit of Account:

The USD is the primary invoicing currency for major global commodities, including crude oil, copper, iron ore etc. Its widespread international acceptance also makes it the most important currency for invoicing and settling transactions in global trade. In fact, studies have shown that from 1999 to 2019, the USD was used for 96% of trade invoicing in the Americas, 74% in the Asia-Pacific region, 20% in Europe, and 79% in the rest of the world. In total, the USD is used for invoicing over half of global trade.

Medium of exchange

In global trade, the same currency is generally used for both invoicing and settlement, with settlement directly corresponding to the function of medium of exchange. In addition, The USD fulfills this function of international currency, as cash of the USD can be used by overseas residents as a means of payment outside of the USA.

The USD continues to dominate in this respect. Its banknotes (cash) has the largest amount of overseas circulation, estimated to be around USD 950 billion as of Q1 2021. In comparison, the Euro has the second largest amount of banknotes circulated outside the ECB’s jurisdiction, which only totaled around USD 350 billion at the same time.

Store of Value

One way to measure a currency's function as a store of value is by looking at its usage in official foreign exchange reserves. As of Q4 2022, the USD still accounted for 58% of globally disclosed official foreign reserves, although this has declined significantly from its position of 71% of global foreign reserves in 2000. The shares of other major international currencies, such as the Euro (20%), Japanese yen (6%), British pound (5%), and Chinese RMB (3%), remain far behind.

For private sectors outside of America, USD-denominated assets are widely held as a global safe asset. For instance, more than 60% of foreign debt instruments are issued in USD, well ahead of the Euro (23%).

The drivers behind the de-dollarization

It is not a coincidence that the issue of de-dollarization has gained momentum under the current circumstance. Many of the drivers of this trend have historical origins, but the unpredictable advent of the pandemic has shifted people’s attention to global economic concerns. Additionally, US policy reactions to the pandemic, such as ultra-loose monetary and fiscal policies, have further highlighted the problems of existing USD hegemony. As a result, more people have started to question the existing International Monetary System (IMS) in the aftermath of the Covid-19 pandemic.

A confluence of factors contribute to the growing interest in de-dollarization:

1. Spillover effects of USD dominance: The current IMS, dominated by the USD, has led to significant spillover effects of US monetary policy on the rest of the world. When the US Federal Reserve implements policy changes, strong spillover effects force other countries to deal with consequences they may not want to accept.

This issue has been widely recognized and discussed. As the classical impossible trilemma theory in international finance taught policymakers, they need to sacrifice the fixed exchange rate so as to maintain their monetary policy independent and, at the same time, allow for free capital movement.

However, foreign policymakers have found their options further limited in the new millennium due to increasingly radical US monetary policy adjustments. For example, during the two episodes of the US subprime crisis (2008) and the Covid-19 pandemic (2020-2021), the US Fed deployed ultra-loosening monetary policy (in the name of quantitative easing) to stimulate the economy. And now the US Fed is hiking the policy rate at an unprecedented pace.    

All in all, violent adjustments of US monetary policy caused massive capital movement internationally, which forces other countries to synchronize their policy with the Fed regardless of their economic situation. They also led to the external imbalance of many emerging markets and sow the seeds of financial instability.

2. US financial sanctions: Even before the pandemic, the USA has a penchant to leverage its USD hegemony to impose financial sanctions on other countries. In particular, the US government can effectively block a country’s access to the USD clearing system to impair its capability of maintaining normal trade and financial transactions with the rest of the world.

Since the outbreak of the Russia-Ukraine war in 2022, the US has escalated financial sanctions against Russia to a new height, including freezing the Russian central bank assets and excluding a number of major Russian banks from the SWIFT system.

The escalation of US-led financial sanctions, along with its frequent usage, have substantially raised many other countries’ concerns about “currency weaponisation” and prompted them to diversify their portfolios away from USD-denominated assets.

3. elevated fragmentation risk: The growing risk of fragmentation in the world's economy and financial system also contributes to de-dollarization. Since the US launched a trade war against China, concerns about global economic and financial fragmentation have intensified. The geopolitical tension could lead to the breakdown of global supply chains, potentially resulting in multiple independent supply chains centered around different economic superpowers.

It is envisaged that these superpowers, out of the security consideration, will urge other participants along the chain to shun their competing currencies in the settlement of cross-border transactions. A few countries that are devising or have already established the international clearing system of their local currencies. They are preparing for the worst scenario of global economic fragmentation.  

Will this time be different?

It is not the first time for the USD hegemony to meet with grave challenges. Over the past seven decades after the World War II, the dominant role of the USD in the IMS has been tested during some episodes, including the breakdown of Bretton Wood system, the fast rise of Japanese Yen in the IMS during 1980s, the creation of the Eurozone etc. Nevertheless, the USD can always adapt to the violent changes of the international environment and secure a grip of dominance in the IMS. Will this time be different?

A couple of factors suggest that this time might be different from previous challenges to USD hegemony. First, past challengers were US allies, and their currency competition took place amid deepening economic and trade ties. However, the US now appears determined to push for some degree of economic fragmentation with major competitors, particularly China and Russia. This rising risk of economic fragmentation could lead to a bifurcation of the global financial system and increased use of alternative currencies as discussed in the previous section.

Second, technological progress has made it possible to replace the USD in many scenarios. The rapid growth of electronic payment technology has reduced the demand for cash, and international travelers can now use mobile payment options instead of USD banknotes. Additionally, the development of cryptocurrencies has given rise to new digital assets that could potentially become global safe assets in the future. Central banks worldwide are also exploring Central Bank Digital Currencies (CBDCs) to prepare for upcoming currency competition.

In conclusion, the ongoing de-dollarization appears more sustainable than in the past. However, even the most optimistic advocates of de-dollarization don't expect the USD hegemony to collapse around the corner. Instead, it could take several decades for the USD to relinquish its dominance and integrate into a new multi-polar IMS.

How it will proceed?

The de-dollarization is taking place on several fronts. People can again perceive and predict the trend through the lens of money functions.

Unit of Account:

Other currencies are going to erode the share of the USD in invoicing global commodity trade. In this respect, not only China is trying to denominate their imports of crude oil and iron ore in the RMB but also BRICS countries set out to push for the commodity trade invoicing in local currencies.

Moreover, there are more options available for invoicing or settling the international trade between non-USA countries. The Bank of International Settlement is piloting an umbrella program to facilitate the local-currency clearing between countries. Several countries proactively invite foreign institutions to participate in their self-devised clearing system for cross-border settlement.

Medium of exchange

The popularization and development of electronic payment reduces the demand for cash. Although many foreigners will continue to hold the USD banknotes as an asset, their role as a payment means is set to be weakened among the international travelers.

This trend will become even more pronounced if more central banks unveiled their CBDCs. The size of greenback’s overseas circulation will diminish.

Store of Value

Other countries used to favor USD denominated assets as their foreign reserves because they were the most liquid assets during bad times. Nowadays, more and more countries feel the need to guard against financial sanction risks associated with their foreign reserves. Therefore, it become a natural choice for many countries to diversify their portfolios towards gold and towards nontraditional reserve currencies, such as the RMB.

Moreover, central banks of emerging markets can consider to sign bilateral currency swap lines with their peers of big economies, China’s PBOC or ECB etc. These bilateral currency swap lines can perform as a liquidity backstop if the country falls into a liquidity crunch.

For overseas private sector, diversification away the USD is also important. In addition to gold and assets denominated in alternative currencies, the mushroomed digital assets could provide more investment options for private sector.

Conclusion

The de-dollarization shows signs of acceleration in the aftermath of the Covid-19 pandemic. The main drivers behind it include strong spillover effects of USD dominance, frequent use of US financial sanctions as well as the increasing fragmentation risk of global economy. Our analysis further shows that it appears more sustainable than in the past and is expected to proceed on several fronts associated with money functions.  

The caveat is the de-dollarization process is doomed to be fraught with risks even though its destination, a new multi-polar IMS, sounds reasonable and promising. We highly recommend that global public and private sector to pay due attention to this lengthy and chubby process so as to better identify and manage the associated risks.