TODAY, the world’s financial rhythm remains American. The US dollar assumed the role of the world’s dominant reserve, payment and settlement currency after WWII. The country’s position as the sole financial superpower gives it extraordinary influence over the Destinies of nations.
For 70 years, the United States has used this power rather routinely, as a matter of reality. Of late, however, it has been engaged in “financial warfare” in the service of its foreign policy. This has prompted nations to “break free” of US dollar hegemony, including preventing “US sanctioned nations” free access to US dollar-based financial system with devastating impact.
The dollar is central to the global monetary system – used worldwide as a unit of account, store of value and medium of exchange. Most commodity and forex contracts are denominated in it. It represents more than one-half of all cross-border interbank claims (a proxy for international payments). That’s five times US share of world goods imports, and three times its share of exports. About two-thirds of world reserves is held in US dollars.
It is the preferred currency of central banks and capital markets (accounting for 65% of global securities issuance). The irony is people rushed to buy dollars during the subprime crash, even though Wall Street caused it. They did so again in March this year despite US bungled response to Covid-19. The global finance plumbing is US dolar-based – most international transactions are ultimately cleared in US dollars through SWIFT (banks’ main cross-border messaging system) and CHIPS (US-centric clearing house network) through New York by US “correspondent banks.” Denied access to this infrastructure, the institution is isolated and financially crippled. The United States began flexing its financial muscles (including imposing hefty penalties) after the terrorist attacks of September 2001.
Trump has since “weaponised” it to a new level – to-date, it has over 30 active financial and trade-sanctions programs. Early this year, it used this dominance to cut-off support to the Iran and Iraq regimes, adversely affecting their use of oil revenues.
This use of the dollar to extend its policy reach is “an abuse of power, ” i.e. bullying; Russia refers to its use, a “political weapon.” Even allies (EU, Japan, UK) are concerned Trump is undermining US role in maintaining orderliness in global commerce and finance. There is already widespread talk to “dethrone” the US dollar, through the dedollarisation of assets; more use of domestic currencies in its trade workarounds and swaps; and new banking payments mechanisms anddigital currencies.
Also, nations have expanded settlement of bilateral trade in their own currencies, or gold; even barter. Russia has gone the furthest, including dedollarising parts of its financial system; reducing US dollar share of its foreign reserves (40% to 24%); cutting its bank’s holdings of US dollar Treasuries to under US$10bil from US$100bil; bringing down its exports denominated in US dollar to 62%; and shifting US dollar trade with China and India to non-US dollar settlements; and denominating over 40% of its crude oil tenders in euros.Like Russia, China has begun to set-up “building blocks” to become more autonomous, including a yuan-denominated crude oil futures contract (“petroyuan”) on the Shanghai exchange. US allies are flirting with it, too. But, EU first has to reform the inner workings of the euro and complete work on banking union, fiscal integration, etc., before it is ready to create a global electronic invoicing euro currency.
US dollar’s role as a reserve currency point to three distinct benefits: (i) lower transactions cost; (ii) macroeconomic policy flexibility, including foreign financing of its deficits; and (iii) leverage to benefit allies. Of course, it carries costs: (a) tends to hurt exports by being strong and stable; (b) overhang of debt overseas opens domestic economy as hostage to sudden capital movements; and (c) needs to bail-out the system.
That’s why the UK, Japan and Germany shied away. However, because the world has changed, EU has since started to push for a stronger international role for the euro. But becoming a serious reserve currency requires: (a) large, deep and liquid capital markets; (b) a secure bonds infrastructure, especially in government bonds; (c) wide use in world trade; and (d) a big economy that’s integrated into global markets.
Without fiscal union, EU lacks a supranational, liquid euro bond; its capital markets are not robust enough – a real banking union would help. Euro’s share of global reserves is down to 20%. Russia also tried – cuts US dollar share of its reserves to 24%. Issues most debt in roubles and euro; only 60% of its exports is settled in US dollars, and 40% of its oil sales contracts is denominated in euros. It has still a long way to go.
China had longed wish to internationalise. But, its capital controls remain a serious problem: it limits how much outsiders can access its currency. In 2017, Bond Connect was launched – allowing foreigners to invest in offshore bonds through Hong Kong, and scrapped investment quotas.
China has since made good progress: (i) offshore yuan deposits are rapidly rising; (ii) issues of yuan “dim-sum” bonds are getting popular; (iii) boom in forex transactions suggests growing usage, especially in hubs like Hong Kong, London, New York and Paris; (iv) more offshore investment products are denominated in yuan; and (v) Hong Kong today lists ETFs, gold futures and property investment trusts in addition to Chinese equity. China’s advances are global: it has a vast global trade and investment network; Chinese FDI is mainly in yuan; it settles 15% of its foreign trade in yuan. Today, more globally yuan payments are processed by banks.
One-fifth of European trade with China is settled in yuan, as is 55% of payments among them. Since 2018, yuan-denominated oil futures were launched in Shanghai, as are margin deposits on iron ore futures in Dalian. China’s commodity exchange is emerging. Most of all, central banks are warming up to the yuan – since inclusion in IMF’s SDR (a basket of five elite currencies), its share of global reserves has risen to 2.1%;
China has already signed currency swap arrangements with over 60 nations. Today, the “yuan bloc” accounts for 30% of global GDP – second only to US dollar (at 40%). China opened up its US$13 trillion bond market (world’s second largest), which accounts for 51% of all bonds issued by EMEs.
Foreigners now hold 3% of this market and 9% of its government bonds. Its main attraction: good yields and diversification benefits. Further, the yuan has been among the most stable currencies in the world since mid-2016. Its real effective exchange rate – against the basket of currencies of its trading partners, adjusted for inflation – has risen by just 0.2% over the past four years. The yuan’s stability is partly by design, and by good luck; backed by foreign exchange reserves held steady at US$3.1 trillion since mid-2016.
US geopolitical rivals’ desire to escape the dollar dominance is real. In designing its new e-Yuan, China wants a head start on the dollar; it is reported to be considering creating a common cryptocurrency with other BRICS nations (Brazil, Russia, India and South Africa). Similarly, on its part, EU is determined to encourage its members to eliminate “undue reference” to US dollars in payments and trade invoicing.
EU’s main initiative has involved Iran. It tried to create a way for its banks and firms to trade with it through Instex (a clearing house created for this purpose by Britain, France and Germany, with European Commission’s support) by-passing US dollars or SWIFT. The stuttering performance of Instex reflects the sheer scope of the dollar reach: US claims jurisdiction if a transaction has any American “nexus, ” even though not denominated in dollars. Despite this, more EU states are determined to join Instex. It’s EU’s intention to expand its financial reach – through a network of global electronic central bank digital monies that serves as a global invoicing currency, excluding US dollars. Also, its capital market needs greater depth and liquidity, key factors in choosing a currency for commerce. As Trump continues to use sanctions aggressively, efforts to circumvent them will accelerate. The reality is that US does not have a monopoly on financial ingenuity.
What then are we to do
There’s no question the world urgently needs a multinational currency reserve regime. The dollar is being weaponised to bully. This won’t do. Nations, including US allies, are looking for and working on an effective but viable and sustainable option. This will take time. The search is still very much work-in-progress. Euro and e-Yuan look promising. But they have a way to go. Like it or not, any e-currency has to be central bank-backed to be credible, and where the public can readily access it.
Still, central banks face hurdles in offering dedicated digital currencies and related accounts to the public. Understandably, many central banks have been hesitant in creating digital currencies. As I see it, they remain worried on how to monitor transactions to prevent fraud and hacking, and whether digital currencies should be linked to interest rates. It’s a responsibility, I think, central banks really don’t want to take-up.
Kuala Lumpur, June 22,2020
Former banker, Harvard educated economist and British chartered scientist, Prof Lin of Sunway University is the author of “Trying Troubled Times Amid Trauma &Tumult, 2017–2019” (Pearson, 2019). Feedback is most welcome.
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