Insight - Is the US dollar’s primacy at risk?

The US dollar’s share of the world’s foreign exchange reserves has been falling gradually, and the structural changes in world economic and financial order as well the evolution of financial technology have weakened the dollar’s market share in global cross-borders payment systems.

FOR decades, this question has been resurfacing: Will the US dollar continue to be the world’s dominant reserve currency and continue to dominate the international monetary system?

The US dollar’s share of the world’s foreign exchange reserves has been falling gradually, and the structural changes in world economic and financial order as well the evolution of financial technology have weakened the dollar’s market share in global cross-borders payment systems.

The US Federal Reserve’s (Fed) resolve to get soaring inflation (9.1% in June 2022) back down to more acceptable level (Fed’s inflation target of 2%) through more interest rate hikes has helped to strengthen the dollar.

The broad US Dollar index, which had strengthened by 3.5% in 2021, continued to increase by 7.1% as of mid-July 2022.

Higher Treasury yields have made the US dollar more attractive to long-term investors, especially central banks and sovereign funds as they take into account the inflation’s return impact on their strategic allocation of assets and portfolio investment.

As of Aug 1 this year, at the levels (UST two-year at 2.8964%, five-year at 2.6911% and 10-year at 2.6590%), the US bond yields are becoming more attractive compared other comparable advanced and emerging bond markets.

This will increase if US inflation starts to slow, which is likely to happen by 2023.

Enhancing the greenback’s appeal is the interest rate differential, which became a natural tail wind for the dollar. With the Fed’s hawkish bias to tackle inflation head on, and reinforced by quantitative tightening resulted in tighter financial conditions, this will prove a challenge for most assets classes and should help to buoy demand for the US dollar as a safe haven amid economic uncertainty and interest rate differential gains.

The US dollar’s dominant status as world reserve currency and its high liquidity has always been the investors’ undisputed safe haven currency choice.

In times of economic turmoil, investors’ flight to quality shed riskier assets and acquire less volatile ones.

This happened in 2008-2009 global financial crisis when the global demand for the US government bonds was held steady.

Will the US dollar lose its dominance status in the global international system? Over the years, structural changes in the world economic and financial order, geopolitical power play as well as the emergence of new technology and digital payment have undermined the US dollar’s role.

The US dollar’s share of global reserve currency has been shrinking to 58.9% in the first quarter of this year (1Q22) from 62.2% in 2010; 71.1% in 2000 and 65.1% in 1997. Have there been any significant shift into other reserve currencies?

It is observed that the reduced share of the US dollar hasn’t been matched by increases in the shares of the other traditional reserve currencies: the euro (1Q22: 20.1%, 2000:18.3%); Japanese yen (1Q22: 5.4%, 2000: 6.1%); and pound sterling (1Q22: 5%, 2000: 2.8%).

It is observed that currencies of smaller economies such as the Australian dollar, South Korean won, Swiss franc, Swedish krona and other currencies have featured in recent years.

The combined share of shifting from the US dollar stood at 7.85% in 1Q22, from 6.12% in 4Q16.

These smaller economies’ currencies relatively less volatile and higher returns have appealed the central banks and investors.

New financial technologies have integrated online and cross-borders payment systems (automated market making and liquidity management) make it cheaper and easier to trade the currencies of smaller economies.

The bilateral swap arrangements and lines between some Asian central banks and the Fed and the People’s Bank of China respectively not only to meet the US dollar and yuan liquidity needs creates confidence that their currencies will hold their value against the dollar and yuan.

Nevertheless, it is observed that these non-traditional reserves’ currencies tend to fluctuate widely against the US dollar and they have rarely drawn on their bilateral swap lines with the Fed.

A regression analysis shows that having a Fed swap line is associated with a nine-percentage point increase in the dollar share of the recipient’s reserves.

Will the yuan’s rise challenge the US dollar’s dominance? Although the share of the yuan held as reserves more than doubled to 2.88% in 1Q22 from 1.08% in 4Q16, its increasing share is constrained by the country’s relatively closed capital account.

China has entered into bilateral currency swap agreements with 41 countries around the world from 2009 to 2020 with the total amount exceeding 3.5 trillion yuan (US$554bil or RM2.47 trillion).

These agreements allowed the central banks to settle bilateral trade and investment transactions in yuan or other local currencies.

This in a way will gradually reduce the reliance on the US dollar and also to avoid minimise the dollar value of local currencies due to the Fed’s tighter monetary policy.

The important attributes for the international acceptance as a global reserve currency, the currency of a particular country not only carries a significant weight of economic and financial, but it is a reliable and stable unit of exchange (safe haven status).

The fundamental value of the currency must be backed by the stability of the economy and financial system, the implementation of track records of sound, transparent and predictable policies.

Lee Heng Guie is executive director of the Socio Economic Research Centre. The views expressed here are the writer’s own.