Since 2010, a period marked by economic, financial and geopolitical shocks, the dollar has steadily appreciated relative to most other currencies. The dollar’s real effective exchange rate has increased by nearly 40% from the end of the 2008 financial crisis and remains the ultimate safe haven for investors.
Most of the calls for a demise of the dollar as the dominant currency in the global financial architecture rest on the changed structure of the global economy, particularly the rise of China. Over the last few decades, the US economy’s share of global gross domestic product has declined, while China’s and other emerging markets’ have increased. The dollar’s share of global foreign reserves has declined – falling from a peak in the early 2000s of around 65% to well below 60% in the second quarter of 2023.
The euro remains the second-largest reserve currency with a stable share of around 20%. After the euro, the most obvious contender to dollar dominance is the renminbi. The renminbi’s share has increased to more than 3% since the middle of the last decade, but remains well below the share of other ‘secondary’ reserve currencies such as sterling or yen.
When the Chinese currency was included in the special drawing rights basket, expectations for a rapid rise in the global financial architecture were high. In the 2023 UBS Reserve Management Survey, investors favoured the renminbi as a means for diversifying away from the dollar – largely due to its strong economy and positive interest rate differential with the dollar.
However, the disclosed average long-term allocation of reserves to the renminbi did not increase significantly in subsequent surveys. The recent rise in US interest rates, coupled with a slowing Chinese economy and negative interest rate differential, appears to have slowed this down. According to the 2023 RMS survey, the average long-term (10-year) target allocation of reserves to the Chinese currency has fallen from 5.8% to 5.2%.
If the world has been moving to a so-called ‘multipolar currency system’, the pace of this shift has been glacial. The dollar’s share of global reserves might continue falling slowly but this is hardly a demise of its dominant position.
Most recent calls for the demise of dollar dominance have rested on geopolitical developments. Following the invasion of Ukraine, the US and its allies targeted reserves held by the Central Bank of Russia, raising concerns among central banks about sanction risks stemming from foreign exchange reserves and whether they can continue to be perceived as a ‘safe’ asset.
Respondents were split on whether the impact of the US-China confrontation on the internationalisation of the renminbi will be positive or negative. The currencies that are expected to benefit the most from geopolitical developments were the euro and dollar, followed by the renminbi and the yen. Geopolitical developments matter for reserve management but so far there is no broad consensus on what we can expect going forward.
Some of the recent calls on the ‘imminent’ demise of the dollar also rest on the growing importance of the renminbi as an invoicing currency in international transactions and the debate about whether a Brics (Brazil, Russia, India, China and South Africa) shared currency offers a feasible alternative. The renminbi is currently the fifth-largest currency in international payments, constituting 3.7% of the global share as of September 2023. The Chinese currency has good momentum as more countries – including Brazil and Russia – switch to the renminbi for international payments. However, the Chinese currency still lags sterling and yen and is well below the dollar and the euro.
The Brics currency discussion is very much about politics, not economics, and appears to be a non-starter given the lack of a regional integration among the member countries. The ‘cohesion’ problems that surround the euro more than 20 years after its launch act as a reminder of the difficulties with creating a common currency.
What would need to happen for there to be a significant decrease in the use of the dollar as either a transaction currency or as a store of value in global reserves? There are several factors to watch in the years to come.
De-pegging from the dollar
While most currencies are free floating or managed, there are notable exceptions. First, Gulf Co-operation Council currencies are de facto pegged to the dollar and their oil exports are largely invoiced in dollars. The often-rumoured shift away from dollar invoicing, particularly for exports to China and other Asian countries, would only be a realistic assumption once the GCC currencies are de-pegged from the dollar and managed against a basket of currencies. Until this happens, it is very unlikely that GCC countries will shift away from the dollar either as an invoicing currency or as a means for accumulating wealth in global markets via central banks or sovereign funds.
This year will mark the 40th anniversary of the dollar peg for the Hong Kong dollar. The Hong Kong Monetary Authority has already made it clear that it has no intention of de-pegging the currency. The dollar peg has been a pillar of macroeconomic stability for GCC countries and Hong Kong over the years. A shift to another foreign exchange regime would mark a more serious challenge to the dollar-dominated global financial system.
The demise of a reserve currency can be self-inflicted. The dominant role of a currency not only rests with the positive network externalities generated by its widespread use in international transactions, but also on its ability to act as a store of value.
Demand for US dollar denominated assets – stocks and bonds – is still strong given the performance of the US corporate sector and the interest rate differential in favour of the greenback. This demand could however be dented in the future by unsustainable public debt dynamics and domestic political tensions. The euro’s challenge to dollar dominance came to an end following the euro fiscal crisis in the early 2010s.
The internationalisation of the renminbi is a strategic priority for China and shows no signs of changing in the future. However, the lack of convertibility is still a factor preventing the currency from competing at par with the dollar and the euro. Geopolitical tensions and sanction risk have somehow dented the appetite of central banks for onshore renminbi assets but there is no consensus among central banks. Many central banks remain fully committed to Chinese bonds and, should geopolitical tensions reduce in the future and the renminbi be made convertible, the internationalisation of the renminbi would accelerate significantly.
Central bank digital currencies are often mentioned as a potential game changer for the global financial architecture and progress has been made across multiple jurisdictions. However, their launch does not appear imminent as several issues – above all the interoperability across borders – still need to be addressed.
Demand for diversification of reserves away from the dollar is growing, driven by geopolitical, economic and financial dynamics. So far this process has been slow as the US economy – and its currency – outperforms expectations. The dollar is and will remain for the foreseeable future the main store of value for global investors, including reserve managers. Geopolitical tensions favour the dollar as investors search for a haven and further escalations do not necessarily point to an imminent weakening of its dominant position.
A more radical departure from current exchange rate and commodity pricing arrangements across Asia and the Middle East, dramatic US domestic political developments and an acceleration in the issuance and cross-border movement of CBDCs would significantly accelerate the diversification process.
Massimiliano Castelli is Head of Strategy and Advice, Sovereign Institutions, UBS Asset Management.