De-dollarization: What Happens if the Dollar Loses Reserve Status? | Investing

One of the more intriguing financial trends that gained steam last year was the de-dollarization movement. This is an effort by a growing number of countries to reduce the role of the U.S. dollar in international trade. Countries like India, China, Brazil, Malaysia and Bolivia, among others, are seeking to set up trade channels using currencies other than the almighty dollar. With so much of the world economy reshaping itself in the post-pandemic landscape, is the reserve status of the U.S. dollar going to be the next domino to fall?

To answer that, it’s important to understand how the dollar got to its current status and why some folks wish to change it.

For centuries, the world has had what’s known as a reserve currency. This is the currency in which the majority of the world’s international transactions are handled. Historically, these were the currencies of a series of European colonial powers, including Spain, France and England at various points. These empires often backed their currencies with precious metals, typically gold, in addition to the implicit backing of the state.

Following World War I, the British economy struggled to regain its vigor. Much of the world’s gold flowed from London to New York for safekeeping and speculation in the roaring 1920s U.S. equity bull market. America’s dominant role in World War II further cemented New York as the financial capital of the world, and the dollar as its most important currency. The greenback was formally made the world’s reserve currency in 1944 as a result of the Bretton Woods Agreement, a status that sterling had previously held.

The timeline then fast forwards to 1971. In that year, President Richard Nixon abandoned the gold standard. From that point on, the dollar has been backed not by precious metal, but purely by the full faith and credit of the U.S. government. And since 1971, numerous people have called for the end of the U.S. dollar as the world’s reserve currency. Will the 2020s be the tipping point when these calls turn to action?

There are several factors that have led to the dollar maintaining its international reserve currency status. One is the so-called “petrodollar.” The vast majority of the world’s oil transactions occur in dollars. As the global oil trade amounts to billions of dollars per day and all countries need energy, this creates a great deal of demand for dollars to facilitate these transactions.

While oil is the most obvious example, there’s a broader need for a world unit of exchange. Consider a scenario where a Brazilian farmer sells soybeans to a Japanese condiments company. It’s highly unlikely that the Japanese firm would have Brazil’s currency, the real, on hand to pay the farmer. Similarly, the Brazilian grower is not going to want to accept Japanese yen in exchange for their soybeans. Thus, the logical solution is to use an intermediary to convert yen into dollars, buy the soybeans with dollars and then have the producer convert those dollars into their local currency.

To that point, the Federal Reserve estimates that between 1999 and 2019, the dollar accounted for 96% of international trade transactions in the Americas, 74% in Asia and 79% around the rest of the globe. Globally, banks used dollars for approximately 60% of their nondomestic deposits and loans. And in the foreign exchange market today, the U.S. dollar is on one side of almost 90% of all transactions.

There has been much discussion about trying to create an alternative to the dollar. The euro looked like it might have a chance at the turn of the century. But the 2008 financial crisis and various political and economic shocks in Europe since then have diminished the standing of a central European currency as a world standard. Japan has its own issues with a stagnant economy and shrinking population. China is unlikely to become a reserve currency anytime soon given the extreme capital controls that its government places on the use of the yuan.

All other potential candidates are likely too small to be a reserve currency. The Swiss franc, for example, is known as a stable and well-regarded currency. However, the economy it’s tied to, Switzerland, is tiny and would not be able to support the huge capital flows required of an international reserve currency.

After a period of stability on the monetary front, 2022 and 2023 brought renewed calls for a meaningful alternative to the dollar. This started in 2022, when the U.S. imposed all-encompassing sanctions against Russia following that country’s invasion of neighboring Ukraine. Various other world leaders took umbrage at the idea that the U.S. could freeze their funds due to any sort of diplomatic or military dispute.

This has translated into some direct action: The U.S. dollar now accounts for 58% of foreign exchange reserves held by overseas central banks, a record low. Gold, the most ancient widely accepted international currency, has chipped away at some of the dollar’s dominance, accounting for 15% of reserves, up from 11% six years ago.

Geopolitics isn’t the only hot-button issue, however. Inflation is also weakening the standing of the dollar on the international stage. Since the 1980s, the U.S. has maintained a low and steady inflation rate, giving savers around the world the confidence to hold their assets in dollars. In recent years, however, inflation soared to previously unimaginable levels, calling into question the security and stability of the dollar for long-term savings and investments.

As if that weren’t enough, early 2023 brought the regional banking crisis. Silvergate, Silicon Valley Bank, Signature and First Republic were all large and credible American banking institutions that failed in rapid succession. While the crisis was quickly contained, the U.S. Treasury and Federal Reserve were forced to step in with unprecedented guarantees in order to quell the crisis. This is unnerving in its own right, and it also chips away at the credibility of the U.S. economy more broadly. Strings of bank failures are what people expect in struggling emerging markets, not the financial capital of the world.

Against this backdrop, leaders of countries such as China, India and Brazil have been calling for moves to trade directly with each other in their own currencies while cutting the U.S. dollar out of the equation. This would incrementally diminish the role and importance of dollars while creating a multipolar financial world where the next tier of economies would have significantly more say in global affairs.

In August 2023, this idea was taken even further. Russia and South Africa, along with the aforementioned three countries, comprise what’s known as BRICS, a group of emerging countries in a loose economic alliance to counter Western influence. At an August summit, BRICS agreed to induct six new countries into its bloc: Argentina, Egypt, Ethiopia, Iran, Saudi Arabia and the United Arab Emirates.

These admittances will make even more imposing a group of nations that already accounts for about 40% of the global population. But more importantly, Brazilian President Luiz Inacio Lula da Silva floated the idea of creating a single BRICS currency that members could use to transact with one another. No concrete plans were committed to or laid out, but merely verbalizing the idea on the world stage shifts the Overton window of what’s acceptable to discuss publicly when it comes to countering the dominance of the U.S. dollar in trade.

While no BRICS currency is imminent, the idea is out there and it’s no longer a harebrained and fringe concept. A future counterweight to the greenback could take a number of different forms, such as a central bank digital currency, a stablecoin, a basket of existing BRICS currencies or a currency backed by precious metals like gold and silver.

It’s important to realize that reserve status is something that, historically, has been gained or lost over a long time horizon. It’s unlikely that the world will wake up one day with dollars no longer holding international appeal. Rather, in examples such as the British pound, there was a multi-decade process by which it went from the center of world economics to a second-tier currency.

That said, if the dollar gradually loses its place atop the world financial pyramid, what would happen next? For the U.S., it would likely mean less access to capital, higher borrowing costs and lower stock market values, among other effects. Having the world’s reserve currency has allowed the U.S. to run large deficits in terms of both international trade and government spending. If foreigners no longer want to hold dollars for savings, it would force significant belt-tightening at home.

As for what would replace the dollar, it’s hard to forecast at this point. It’s possible to imagine a world in which the euro or Chinese yuan eventually becomes the primary reserve currency, but a great deal would have to change in world politics to get to that point. Some economists also propose a financial system backed by either precious metals or cryptocurrency, though implementation of these sorts of models could prove to be a considerable challenge.

To reiterate, it’s rather unlikely that the dollar would simply stop being the world’s reserve currency overnight. That said, there is a distinct possibility that the dollar’s overwhelming role in international trade and commerce could gradually diminish in coming years. Particularly depending on how things such as the banking crisis and inflation play out, there could be a significant move to reduce global dependency on the dollar. How should investors prepare for that possibility?

A first-principles solution for many investing problems, including weakness in the U.S. dollar, is diversification. Arguably, diversification is one of the few free lunches available in finance. By spreading capital across many different asset classes, sectors and countries, investors naturally get protection against a variety of potential crises.

And yet, unfortunately, many people fall victim to what’s known as home-country bias. People are naturally inclined to own substantially more assets in their home country, perhaps due to familiarity, overconfidence or convenience.

A heavy investment in U.S. assets has worked well in recent decades. So it’s understandable why Americans might be tempted to keep all their assets in U.S. stocks, bonds and real estate. However, many countries that once looked dominant ended up delivering catastrophic losses for investors. Consider German stocks in the 1930s or Japanese stocks in the 1990s for examples of how formerly high-flying equity markets can suddenly become terrible investments.

In a world where the U.S. dollar lost much of its value, the easiest protection against that is simply to own assets denominated in currencies such as euros, yen, Canadian dollars or emerging market currencies that would be expected to naturally appreciate as the dollar declined.

Beyond geographic diversification, there are several more specific ideas that could prosper in a world where the U.S. dollar loses reserve status. One of these would be to invest in emerging markets. It seems likely that countries like China and Brazil would enjoy a substantial increase in the values of their currencies and assets in a world where capital was gushing out of dollar-based assets. As much of the strength of the U.S. economy is tied to the technology sector, a de-dollarized world is probably one where the technology industry has lost value and other industries such as manufacturing or basic materials have gained in importance. Many emerging-market economies are based around these latter two industries.

The investing playbook for inflation also applies for fighting de-dollarization. That is to say that if the dollar plunges in value, there is likely to be a large rise in inflation within the American economy. In times of inflation, assets such as energy, precious metals and real estate tend to fare well. An investor could consider an allocation to these sorts of holdings not just as a hedge against a falling dollar, but also for the benefits they provide in times of inflation or geopolitical unrest.

For decades now, there has been a great deal of speculation about a potential plunge in the value of the dollar. 2024 is almost certainly not going to be the year when the dollar’s reserve currency status outright ends. That said, it pays to be prudent. Between inflation, sanctions, banking crises and a strengthening BRICS contingent, there are storm clouds on the horizon for the dollar’s hegemony. Investors may consider taking steps such as internationally diversifying their portfolios to be prepared in the event of a significant dollar devaluation.