The dominance of the dollar in the global financial system is not going away soon. But if it does, the currency’s loss of preeminence in world markets will be the very least of the US’s problems. We should all be concerned about a malign scenario in which the international role of the dollar is degraded because of US inaction in tackling its own financial and economic problems.
For all the talk about the dollar’s demise, its share in global reserves is nearly 60%, much higher than the next highest contender, the euro, at about 20%, while the renminbi is less than 3%. The dollar’s share in international lending and in trade invoicing is similarly elevated, while almost nine out of every 10 foreign exchange transactions involve the dollar.
The reasons are not mysterious. The US economy is huge, and it is also more innovative, entrepreneurial and faster-growing than nearly all of its advanced-economy counterparts. America’s financial markets are the deepest, most liquid and open in the world. The rule of law is strong, with investor protections that apply to residents and foreigners alike. And US Treasury securities are considered among the safest in the world.
No real contender to replace the dollar
The euro is hamstrung by a weak economy and a still-fragmented fiscal system and capital market. China is building an international payments infrastructure free of the dollar, and over a quarter of the country’s trade is now settled in renminbi. It could well take a slice of the dollar’s role as a means of payment, but its role as a store of value will remain limited: the renminbi isn’t convertible; capital controls abound; and China’s regulatory environment is far from transparent and predictable. By the same token, cryptocurrencies are far too untrustworthy to replace the dollar.
Some argue that US use of financial sanctions – ‘weaponisation’ – will undermine the dollar. If the US unilaterally deploys sanctions at every turn, that could accelerate dollar demise. But if the US imposes financial sanctions multilaterally, in concert with its allies – for example, blocking Russian central bank and oligarch assets – any fallout should be small. Around three-quarters of foreign government holdings of US safe assets are held by countries with some form of military tie to the US.
The Brics group, meeting in Kazan, Russia, has announced a plan for an alternative payments system. The summit unveiled a new Brics banknote featuring the flags of its original members – Brazil, Russia, India, China and South Africa (now expanded to a broader group including Egypt, the United Arab Emirates, Ethiopia and Iran). However, we do not think the chances of that idea ever being implemented are high.
Benefits of dollar dominance for US are overstated
Even if the dollar lost its preeminent role, how bad would that be for the US economy? Our answer is: not so bad. Although the dollar has long been accused of giving the US a so-called exorbitant privilege, that privilege is much exaggerated. Let us examine the benefits of seigniorage – profits made by a government issuing currency. Substitution of the $1tn in dollars held overseas into US Treasury bonds, at 4% interest, would cost $40bn – less than 0.2% of gross domestic product.
What about lower interest rates? In view of the safety and liquidity of US Treasury bonds, the US might pay lower rates. But US real Treasury yields have been similar or higher to those in Germany or Japan for the past couple of decades.
A third possible advantage is to boost the value of the dollar, leading to larger current account deficits as the US lives beyond its means. But the US is hardly the only country to run large and persistent current account deficits, as examples like Türkiye and Australia show.
Fourth, some observers point to the benefit of the dominant dollar in providing insulation from external shocks. With most imports invoiced in dollars, changes in the exchange rate have a smaller impact on US import prices and inflation. But since the US is a large economy with a small import share, that is not all that important.
So US benefits from dollar dominance are hardly exorbitant. The key issue is not whether the dollar’s global role declines, but why. One can imagine a benign scenario where the US runs sound fiscal, trade and macroeconomic policies, but the dollar’s role declines because strong growth in the rest of the world, reduced risk and further financial innovation lead to diversification away from the dollar for payments and reserves. The net result is that the US becomes better off.
But we are concerned about a malign scenario. The world fragments into blocs amid rising protectionism. The US ratchets up the use of financial sanctions and acts as an increasingly unreliable partner abroad. The country fails to tackle its unsustainable fiscal path. Politicians compromise the Fed’s independence and policies. Inflation gets out of control, Treasury yields soar and global markets fall into turmoil. These developments undermine the very reasons why the dollar became dominant in the first place, and the international role of the dollar erodes.
In this scenario, there will be far more for the US – and the world – to worry about than some technical changes in the currency markets. It is critical that the country gets its house in order, in all senses of that word.
Steven Kamin is Senior Fellow, American Enterprise Institute, and a former Director, International Finance Division, Federal Reserve Board. Mark Sobel is US Chair, OMFIF, and a former Deputy Assistant Secretary, International Monetary and Financial Policy, US Treasury.
This article is based on a presentation given at an OMFIF seminar in Washington DC on 25 October 2024. Kamin and Sobel are joint authors of ‘Dollar Dominance Is Here to Stay for the Foreseeable Future – The Real Issue for the Global Economy Is How and Why’.
