The inevitable decline of the American Dollar

For the moment, the US believes the dollar’s reserve currency status is secure. Given the nation’s economic, political and social problems, this belief will be tested.
Image used for representational purpose.
Image used for representational purpose.Express illustration | Mandar Pardikar

Like Mark Twain said about himself, the report of the dollar’s death is exaggerated—though its health problems are multiplying.

The dollar dominates trade, payments and reserves. About 96 percent of trade in the Americas, 74 percent in the Asia-Pacific region, and 79 percent in the rest of the world is denominated in the currency.

Only in Europe, where the euro is dominant with a 66 percent share, is its market share low. About 60 percent of international and foreign currency claims (primarily loans) and liabilities (primarily deposits) are in US dollars. Its share of foreign exchange transactions is around 90 percent. US dollars constitute around 60 percent of global official foreign reserves. These shares are disproportionate to the size of the US economy (around a quarter of global GDP, or 15 percent adjusted for purchasing power).

The dollar’s difficulties are largely self-inflicted. Incontinent fiscal and monetary policy—with the US budget deficit and government debt at around 7 percent and over 100 per cent of GDP, respectively—has diminished long-term purchasing power of the dollar. Since 1972, it has fallen by 99 percent against gold and lost 90 percent of purchasing power of real goods and services.

American policymakers have sought to weaponise the dollar in multiple ways to further political objectives, compensating for economic weaknesses such as a lack of competitiveness in particular. The US has sought to exclude foreign entities from international payment systems like SWIFT.

There are secondary sanctions penalising people and organisations not subject to US legal jurisdiction. If a Russian entity is under sanctions, anyone dealing with it may be liable to prosecution, even if it is complying with laws in its own nation. This is done via the tenuous nexus of dollar payments through the US banking system. International banks and others have been prosecuted for transactions legal in their country. The threat has been sufficient to deter dealing with US-sanctioned entities.

Weaponisation extends to asset seizures.

In the wake of the Ukraine war, the US and its allies have frozen $300 billion of Russian central bank dollar holdings. The Biden administration passed the REPO Act authorising the confiscation of about $20 billion worth of Russian assets held by US banks, primarily government securities that were legitimately purchased, and transferring it to Ukraine. Selective cancellation of US government obligations held by a foreign power is now a policy option, despite its doubtful legal basis. It would represent a selective US government default.

American policymakers also exert disproportionate influence on currency values and the cost of capital globally. A strong dollar and devaluation of local currencies fuels imported inflation in many emerging nations.

Borrowers with US dollar-denominated debt now face higher debt servicing costs. A rise in US government bond rates result in a similar increase in term interest rates globally, increasing borrowing costs.

These factors are driving foreign public and private institutions’ increasing reluctance to transact in dollars or hold dollar assets. But American authorities assume continuation of the dollar hegemony because of limited alternatives.

Two principles lie at its heart. The first is the ‘policy trilemma’ or ‘impossible trinity’ proposition of economists Robert Mundell and Marcus Fleming. It argues an economy cannot simultaneously maintain the following—a fixed exchange rate, free capital movement and an independent monetary policy. The second is the paradox named after economist Robert Triffin. This states that where its money functions as the global reserve currency, a nation must run large trade deficits to meet the demand for reserves. Any aspirant to a new global reserve currency status faces an unacceptable loss of economic control and must run large current account deficits.

Other essential requirements include deep liquid capital markets, high credit quality, suitable clearing, custody and transfer mechanisms, strong governance, legal enforceability, and universal acceptance.

Potential contenders such as the euro or yuan do not meet all the standards. Other options like IMF Special Drawing Rights, a ‘world currency’, a blockchain-based digital mechanism or a return to a gold standard are unrealistic. But a shift is underway.

Russia’s MIR and China’s Cross-Border Interbank Payment System offer alternative fund transfer arrangements. Nations are denominating trade in different currencies. China has reduced its US Treasury holdings to below $800 billion, down 40 percent from a decade earlier. Foreign investors have moved into real assets, primarily business and commodities. The Chinese Belt and Road Initiative is one example. Central bank purchases of gold and other currencies reflect these pressures. But the biggest change may be fundamental.

A trading and reserve currency is needed due to imbalances. Where India imports more than it exports to China, if denominated in rupees, would leave the Chinese with surplus Indian currency. Alternatively, if denominated in Chinese yuan, India would have to finance the deficit. This requires unfettered access to investments or funding in respective currencies. If trade is more bilaterally balanced over time, then there would be no surpluses to invest or deficits to finance, reducing the need for a reserve currency such as dollars.

The structure can be extended to encompass trading blocs, where imbalances net out between members when aggregated. It implies a world of multiple trading and reserve currencies, which has existed at various times in history.

A world based around bilateral or multilateral autarky has implications for growth and development. Trade and capital flow volumes would fall. It would diminish the ability to trade freely as well as sourcing investment capital for growing economies. Comparative advantages would be lost. But this approach is implicit in the evolving industrial structure driven by sovereignty and economic independence concerns.

The diminution of the dollar’s status would affect the US’s ability to fund its continuing budget and trade deficits. Dollar interest rates may have to rise and the currency devalue. The role of its capital markets and financial institutions would decline. American political prestige and power would suffer.

For the moment, America believes the dollar’s reserve currency status is secure. Given its economic, political and social problems, this belief will be tested. All major economic shifts go through phases—impossible, unlikely, plausible, likely and finally, inevitable. The dollar is progressing through these stages.

(Views are personal)

Satyajit Das | Former banker and author

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