Last week Brazil and China made a deal to shift away from trading goods and services using the US dollar to their own respective currencies. As you may know, when two nations trade, usually each has to convert their currency into a common currency. For the past century, the US dollar has had this role, mainly due to its stability and role as the reserve currency of choice for almost all countries. Brazil and China’s deal has been one of multiple deals made by several countries in recent years to shift away from the US dollar. So why is this significant and what are the possible implications for the world?
The USD as the Reserve Currency of Choice
The ‘American Century’ which saw immense growth of the US economy since World War II saw the US become a global superpower in trade and geopolitics, whilst solidifying its status as a beacon for democracy and capitalism. The US’ credibility and long-term stability has resulted in the USD’s relative stability against all major currencies. Due to the prominence of the currency, most bilateral transactions have occurred with the USD as the intermediary exchange. 59% of foreign exchange reserves held by central banks and 60% of global debt issuance are in USD.
Although most of the globe, including China which devalued the Yuan against the USD in the past to gain export competitiveness, has benefited from the prominence of the dollar, not all countries are happy with it.
The US has historically used the world’s reliance on the dollar to impose sanctions on certain countries such as Iran, North Korea and more recently Russia in 2022. These sanctions restrict the respective economy from using US dollars in international finance, crippling their export and import dependent sectors. However, lately economists have pointed how inflation in the US typically results in inflationary pressures for the rest of the world. When the US records high budget deficits, the Treasury funds it by issuing T-bills which are bought by investors from the rest of the world. Also, when the US Federal Reserve hikes interest rates, many developing countries are affected as the interest payments on their debt, usually denominated in USD, increases causing financial uncertainty and greater risk of default.
To insulate themselves from any negative implications US policy decisions might have, some countries are beginning to explore ways to have less dependence on the dollar. Even in the last 20 years, the percentage of foreign reserves in USD has declined by 11%.
The process of dedollarisation was one of the main initiatives of BRICS (Brazil, Russia, India, China and South Africa), but it became a serious topic of conversation in 2022. In response to the invasion of Ukraine, the US placed sanctions on Russia which practically froze US $300 billion of the Russian central banks forex reserves. The West believed that these economic sanctions would cripple the Russian economy so that it would end the war, however critics pointed out that the dollar’s hegemony was being ‘weaponised’. Although Russia initially began lowering its dependence on the dollar in 2014, it was not until 2022 when the Yuan became the dominant foreign currency in Russia.
India, which continues to import Russian oil despite calls from its Western allies against it, has mainly been trading with Russia in foreign currencies other than the USD. However, India has begun discussions to trade with Russia using the Indian Rupee which should allow Russia to accumulate more foreign exchange as Russian exports to India grew by 384%.
Yet, it is not only BRICS countries which have shown interest in dedollarisation. For the first time, France also settled a payment for LNG from China using Yuan, ending its reliance on the USD for energy and commodity trade. Likewise, Saudi Arabia, the world’s largest exporter of crude oil, is in active talks to move some of its oil sales to Yuan. Moreover, the Saudi Arabian Oil Corporation (Aramco) has signalled that it may include yuan-denominated prices in its oil contracts.
Although it is clear that many countries are attempting to diversify the currency, is it possible for any singular currency to overtake the USD as the reserve currency? Whilst a common currency for BRICS countries is expected to be announced in August this year, critics argue that the uptake of the Yuan would simply replace the US hegemony in foreign exchange with a Chinese one. On top of this, China’s slowing productivity growth over the last few years and lack of returns on its Belt and Road investment initiative has raised questions on whether China can overtake the US as a stable economic superpower.
Will the USD Continue to Dominate?
Realistically, the USD will remain as the dominant reserve currency, although its prominence in terms of global foreign exchange reserves will continue to decline. However, rather than just one singular replacement for the USD, a combination of other currencies including the Yuan and even certain digital currencies will steadily gain a greater proportion of foreign reserves in the future.