The Chinese yuan is far from replacing the dollar

Is the dollar in danger? Article from the famous magazine The Economist answers how the United States itself can destroy the reign of the most powerful currency in the world

After the collapse of the Bretton Woods system of fixed exchange rates in 1973, the prestige of the dollar seemed destroyed. The United States devalued its currency twice in just one year. “The dollar is considered throughout the world as a sick currency,” said a writer from New York Times; Predictions of falling dollar usage were rife. These views, notes Barry Eichengreen of the University of California, Berkeley, in his book Exorbitant Privilegethey couldn’t be more wrong. The United States’ share of the global economy, measured in PPC (purchasing power parity), fell from 27% to 23% in 2000. But as the rest of the world parked its growing wealth in New York and governments accumulated reserves to defend their currencies, demand for dollars grew.

In the 21st century, the pattern repeated itself. Amid predictions of loss of its status — and despite a further drop in the United States’ share of global production to 16% — the “dollar king” maintained his throne. For trade, international investment and foreign exchange transactions, the dollar remains by far the currency of choice (see chart). His appeal gives the United States a seemingly endless supply of credit and the power to cripple foreign financial entities with sanctions. Its strength means that, at market exchange rates, the United States accounts for more than a quarter of the world economy, the same as in 1990.

It’s not that there haven’t been changes. The dollar’s dominance has diminished in reserves and commercial revenue. The fraction of reserves that central banks hold in dollars peaked in 2001 at 73%, and has since fallen to 59%, according to data from the FMI. Take away distortions such as the effect of dollar appreciation and real participation fell to 56%, according to research by the IMF’s Serkan Arslanalp and two co-authors, including Mr. Eichengreen.

China is responsible for the dollar’s decline in trade revenue. As it tried to internationalize the yuan and escape the United States’ control over the financial system — demonstrated by sanctions against Russia following its invasion of Ukraine — the Chinese government has spent the last decade trying to do more business in yuan. It has made its trading partners more comfortable with using the currency, for example by opening swap lines to provide yuan credit and launching a cross-border payments system. Around 25-30% of China’s trade in goods and services is now settled in its own currency.

Taken together, these declines in the dollar as a reserve currency and as a basis for commercial revenue may seem like harbingers of a downward spiral. It is more useful to hold a currency as a reserve today if it brings many options for trading tomorrow. Therefore, a high share of reserves and trade turnover should, in theory, reinforce each other, according to research by Gita Gopinath of the IMF and Jeremy Stein of Harvard University. Reverse this idea and, in theory, the dollar would be in trouble.

But the twin declines are not interconnected enough to harm the dollar’s position. In IMF data, the dollar’s share of reserves has only fallen to where it was in 1995. And it was not China that absorbed that share, nor the euro, which Europe uses for most of its own trade and is the dominant currency in parts of Africa. Instead, they are, as one joke goes, other currencies called “dollars” or “kronas”: those of Australia, Canada, New Zealand, Singapore, Denmark, Sweden and Norway. “They are the currencies of small, open, well-managed inflation-targeting economies,” says Mr. Eichengreen.

It’s good to be king

These currencies are also, for the most part, from allies of the United States, which makes it difficult to sustain the argument that the drop in the share of reserves says a lot about the loss of Western hegemony. And of the remaining official dollar holdings, three-quarters are owned by governments with military ties to America, says Colin Weiss of the Federal Reserve. Surprisingly, note Mr. Arslanalp and his colleagues, the yuan’s share of international reserves has declined since 2022, when Russia invaded Ukraine, triggering American sanctions and speculation that countries would abandon the dollar for fear of similar treatment.

As for trade, flows involving at least one advanced economy, excluding China, account for two-thirds of the global total, calculates Gerard DiPippo, now of Bloombergand Andrea Palazzi, from the Center for Strategic and International Studies. It is difficult to see why these countries would switch to the yuan as they are mostly US allies. Excluding them, just 25% of global trade would be left on the table, three-quarters of which is between emerging markets that do not include China. Switching these flows into the yuan is a difficult task given the risks of holding the currency.

Federal Reserve researchers concluded in 2023 that the dollar’s ​​dominance “has remained stable over the past 20 years.” Why is it so difficult to move it? One reason is network effects: the more people use dollars, the greater their incentives to keep using them. This is visible in currency trading, where the liquidity of the dollar means that for some currency pairs, it is cheaper to trade through the dollar — that is, sell a holding for dollars and then buy the desired currency — than trade directly between two currencies other than the dollar.

It is often said that the dollar’s status confers a “exorbitant privilege”.
Network effects, however, do not guarantee the status quo forever, as demonstrated by the decline of former reserve currencies such as the British pound and the Dutch guilder. The problem facing the dollar’s rivals is that they simply cannot offer such a secure and liquid store of value, and in large quantities. China’s authoritarian system and control over its capital account, which restricts how much money can be taken out of the country, makes investors nervous. Europe lacks safe, jointly issued assets like US Treasury bonds. Nowhere else offers the American combination of rule of law, deeply liquid markets and an open capital account, which means investors know they can withdraw their money easily.

More likely than another country to gain these characteristics is America to give them up, whether by design or accident. Many American critics question the dollar’s dominance. In the influential book Trade Wars are Class WarsMichael Pettis of Peking University, and Matthew Klein, a financial writer, argue that the dollar’s status as the default location for the world’s economies means that mercantilist countries like China accumulate vast amounts of American assets due to their consistent trade surpluses.

Because these global capital flows have long been thought to lower U.S. interest rates and, by strengthening the currency, increase the purchasing power of its consumers and businesses, the dollar’s status is often seen as conferring a “privilege.” exorbitant” — that is, an unfair and extreme advantage. But Pettis and Klein say this status raises the cost of U.S. exports and hurts its manufacturing workers. JD Vance, Donald Trump’s running mate, made a similar argument. Robert Lighthizer, US Trade Representative during the Trump presidency, suggested the possibility of bringing down the dollar by charging a “market access fee” on foreigners who hold US assets.

This argument is not entirely illogical. However, it is difficult for researchers to identify how much foreign purchasing of dollars strengthens the dollar, compared to how much that same demand lowers interest rates (which, in turn, weakens the dollar). Simple comparisons of bond yields show little exorbitant privilege. In fact, American interest rates tend to be higher than in other parts of the world, in part due to its strong economy.

American companies can simply borrow at lower rates
It is easier to see the advantage that the dollar confers not in interest rates, but in the amounts of debt issued. The US has accumulated net public debt worth 99% of its GDP and continues to have a huge deficit of 7% of GDP. The UK faced a bond market crisis in 2022 with lower levels of debt and borrowing.

The private sector also benefits. American assets make up more than a quarter of the global stock of investments in financial instruments, up from less than a fifth in the mid-2000s, according to Goldman Sachs. A paper by William Diamond of the University of Pennsylvania and Peter Van Tassel of Caption Partners, an investment firm, concludes that

demand for dollar assets reduces all US interest rates compared to a counterfactual scenario, not just the government’s. American companies can then simply borrow more cheaply.

An American administration that interfered with the dollar’s role as a reserve currency would risk forgoing these benefits — which is why it has generally been Treasury policy to support the status quo. Despite Vance’s concerns and Trump’s laments about a strong dollar, the Republican Party platform promises to maintain the dollar as the world’s reserve currency.

This leaves the possibility of an accidental loss of status. The Bretton Woods system collapsed because the United States was unable to satisfy global demand for its assets, given the dollar’s peg to gold, without compromising its security. The problem became known as the “Triffin’s Dilemma”named after Robert Triffin, the economist who identified it. Now economists talk about a “Triffin’s new dilemma”in which the appetite for dollars encourages American debt, threatening the conditions that make greenbacks so attractive.

Triffin’s new dilemma is unlikely to cause a dramatic crisis until there is a viable alternative to which investors can flee on a large scale. However, it is conceivable that US debt could gradually make dollar debts appear less secure. This would not mean the triumph of another currency. More likely, the world would have to live without a liquid, safe and abundant asset. Viewed this way, true “exorbitant privilege” is more widely distributed than critics suggest. Americans get cheap debt, foreigners get a safe store of value. If this service disappears, the entire world will pay the price.