The U.S. dollar is under fire from rival nations. What happens to markets if the greenback loses its world dominance?

By Joseph Adinolfi

The International Monetary Fund, not the Bank for International Settlements, added China’s yuan to its Special Drawing Rights basket. This error has been corrected.

Is ‘King Dollar’ in danger of losing its crown?

Probably not yet, but the rapid unwind of last year’s torrid rally in the U.S. dollar, combined with efforts by Beijing and others to ease their dependence on the buck, have helped to reinvigorate speculation that the greenback’s dominance over international trade and finance may be moving toward its twilight.

Talk about “de-dollarization” has intensified and Wall Street analysts have joined in, publishing research reports forecasting more competition for the buck in trade and global reserves alongside assessments about where the dollar is heading in the coming months, and how the adoption of so-called central bank digital currencies might shake things up.

To be sure, many currency strategists and economists have pushed back against the notion that the dollar is anywhere close to shedding its reserve status, citing its dominance in global trade and as a widely used reserve asset by central banks.

The dollar’s sharp appreciation last year caught many currency strategists off guard, as has its reversal over the last six months.

After hitting its strongest level in more than two decades in late September, the ICE U.S. Dollar Index , a measure of the currency against a basket of six major rivals, has fallen more than 10%, according to FactSet. The dollar hit its lowest level against the euro in more than a year on Thursday, with the shared currency trading at roughly $1.10.

As a result, the dollar has been the worst-performing G-10 currency over the past month, according to a team of analysts at Rabobank.

Alan Ruskin, a macro strategist at Deutsche Bank who has covered currencies for years, noted that de-dollarization talk is coming back in vogue less than a year after the 50th anniversary of the collapse of the Bretton Woods monetary system. Under Bretton Woods, a gold-backed U.S. dollar assumed a central role in a the global postwar economy.

The Bretton Woods system collapsed when President Richard Nixon announced the abandonment of the gold standard in August 1971. But the dollar’s status as the indispensable global reserve currency endured.

Years later, more than a decade of quantitative easing and rock-bottom interest rates have helped undermine this hard-won credibility, Ruskin said, noting the rise of cryptocurrencies like bitcoin as one sign of a “revolt” against the greenback. Central banks doubled down on these policies following the advent of the COVID-19 pandemic, spurring inflation and with it more skepticism abroad.

“The money printing, with its overt seigniorage extraction, and inflation repercussions, has only further encouraged those in the developing world that want to establish a multipolar currency system more in keeping with their growing share of global GDP,” Ruskin said in a research note emailed to MarketWatch.

Seigniorage refers to stealth profits that governments reap from issuing currencies.

Now, a fresh challenge to the dollar’s stability may loom on the horizon as Congress prepares for another ugly showdown over the debt ceiling, analysts said, while world leaders including France’s Emmanuel Macron have said that international dependence on the dollar should be reduced.

A blistering rally unravels

The U.S. dollar appreciated sharply in 2022, bolstered by the Federal Reserve’s aggressive interest-rate hikes, and a scramble for safety as stocks and bonds in markets around the world sold off in tandem.

Now that the Fed is saying it is nearly done hiking rates, other central banks like the European Central Bank are expected to close the gap between European and U.S. interest rates.

Already, the dollar is poised to "catch down" to the decline in Treasury yields, which have fallen sharply over the past month, said Steve Englander, global head of G-10 currency strategy at Standard Chartered, in a recent report for clients. 

Marvin Loh, a global strategist at State Street, told MarketWatch in a phone interview that State Street’s pricing-party models show the greenback is still too expensive.

“If the Fed really is done hiking rates, you could continue to see the dollar weaken through the end of the year,” Loh said.

Of course, the dollar’s selloff shouldn’t be conflated with changes in its status as a reserve currency, said Marc Chandler, managing director at Bannockburn Global Forex.

Shifting tides

Putting aside the dollar’s ups and downs, the greenback remains the most popular currency for both international payments and global central-bank reserves, which reflect its status as the undisputed international reserve currency. But its hold on the global economy has weakened somewhat over the past few decades.

The greenback accounted for 58.4% of central-bank foreign-exchange reserves during the fourth quarter of last year, down from roughly 70% in the late 1990s when the euro was first launched, according to the most recently-available data from the International Monetary Fund.

Central banks hold foreign currencies for a number of reasons, according to the World Economic Forum, including to ward of crises and help to facilitate international trade.

But the buck’s popularity as a currency used to settle international transactions has barely budged in recent years, even if it has dimmed a bit over the years since China joined the World Trade Organization.

The most recent data show the U.S. dollar was used to settle just over 40% of international trade, putting it just ahead of the euro, according to the Society for Worldwide Interbank Financial Telecommunication, or SWIFT, which is used by banks around the world to facilitate the flow of money across the global economy.

History has shown that it often takes decades, if not centuries, for a currency’s global reserve status to fade. Often, it lingers even after its host country’s economic power and prestige has peaked, according to UBS Group’s Solita Marcelli and Alejo Czerwonko, who explored the long-term outlook for the dollar’s role in the financial system in a recent note to clients.

The greenback usurped the British pound sterling’s position as the global reserve currency of choice nearly 100 years ago in the mid-1920s, according to a paper from the National Bureau of Economic Research. Before the sterling, the Dutch guilder and Spanish galleon dominated trade involving European nations and their colonies.

“Even as great economic powers rise and fall, their currencies’ reserve status tend to survive well past the peak of their influence,” the UBS team said.

Talk of the Chinese renminbi surpassing the dollar has abounded for years. Yet the Chinese currency has made little headway in increasing its use in international trade. Its use in foreign reserves has increased slightly since it was added by the International Monetary Fund to the Special Drawing Rights basket in late 2016.

China’s government-controlled central bank maintains a tight grip on the yuan, and although the currency trades in offshore hubs, it isn’t easily swapped for other foreign currencies. These remain widely cited obstacles to its usefulness in conducting international trade, analysts said.

“The yuan’s exchange rate is determined by the Chinese government, not the market,” said Brad McMillan, chief investment officer for Commonwealth Financial Network.

Notably, central-bank buying of gold has surged over the past year following Russia’s invasion of Ukraine in February 2022. Central banks bought 1,136 metric tons of gold in 2022, the most on record going back to 1950, with heavy buying from central banks in Russia, China, the Middle East and India.

The UBS team said they expect gold to comprise a larger share of reserves in the years ahead.

‘TINA’

But when it comes to international trade, the U.S. dollar remains the undisputed king. Other than the euro, which has played second fiddle since its launch, no currencies match the dollar in terms of liquidity, ease of convertibility and credibility, analysts said.

Deutsche Bank’s Ruskin cited a long list of factors required for another currency to compete with the dollar. They included: an economy that’s open to the ebbs and flows of international trade and foreign investment, a liquid bond market that’s open to foreign participation, the acceptance of an exchange rate that’s set by the market, confidence in the rule of law, political governance and financial regulation, along with a few other factors.

It’s difficult to find another currency that satisfies all these requirements.

While describing the dollar’s status, Bannockburn’s Chandler used the acronym “TINA” — shorthand for “there is no alternative.”

“There just aren’t any other options out there right now,” he said.

-Joseph Adinolfi

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04-18-23 0759ET

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