Shifting Tides: The Silent Rise of De-Dollarization

The US dollar has been the world's dominant reserve currency for decades, with countries around the globe holding large amounts of it to facilitate international trade and investments. However, the trend toward de-dollarization has been growing recently, as countries seek to curtail their dependence on the US dollar and diversify their reserve holdings. Will the dollar be replaced as the global currency?

The US dollar has been hailed as the global currency for decades now. However, its dominance seems to be under threat, and there has been instances of de-dollarization across the globe. De-dollarization refers to the process by which countries minimize their dependence on the greenback and seek alternative reserve currencies. This shift is a harbinger of a major transformation with implications for future international trade, investments, and monetary policy.

Rise of the dollar

Countries all over the world hold reserve currencies. These are foreign currencies held by a country's central bank and other monetary authorities to stabilize exchange rates, facilitate international transactions, and encourage financial confidence. In 1944, post-World War II, the Bretton Woods Agreement was signed by 44 countries, establishing a collective international currency exchange regime pegged to the US dollar, which was based on the price of gold. This gave the dollar more power.

Despite the dollar's historical dominance, several factors have emerged in recent times, sparking the wave of de-dollarization.

Factors driving de-dollarization

Geopolitical, economic, and strategic considerations have led several nations to initiate de-dollarization of late. Some of these factors are mentioned below:

• US sanctions – Nations such as China and Russia have sought to reduce the dollar's influence to counter perceived American supremacy and mitigate the effects of US sanctions.
• Currency war – Other nations, particularly those in the Eurozone, are actively pursuing de-dollarization. The main objective is to establish the dominance of their currency, the euro. If successful, it would help improve their global economic standing and achieve greater financial independence.
• BRICS – The BRICS nations (Brazil, Russia, India, China, and South Africa) have been slowly moving away from a global financial system dominated by the US by choosing to trade in their national currencies; the bloc has already taken the first step toward establishing a new currency.
• Persistent trade deficits – The US has long been a net importer, resulting in a substantial trade deficit. As the dollar is the global reserve currency, countries still trade in it despite the deficit. However, exporting nations including China hold a significant US dollar surplus and plan to invest in other currencies and assets. This might lead to a rise in the use of the Chinese yuan as a substitute for the US dollar.
• Stability factor – Concerns over the dollar's long-term stability have arisen from high national debt, prompting countries to diversify their reserve currencies. In December 2022, US government debt represented approximately 123.4% of nominal GDP compared to 123.6% in the previous quarter.

The beginning of the end

Since 2014, when the US imposed economic restrictions on Russia and obstructed its trade in dollars, various countries have considered alternatives to the greenback. The introduction of the euro also assisted nations in breaking the dollar's monopoly. Over the past eight years, many nations have executed bilateral agreements to avoid a scenario similar to Russia's. The global trade of the dollar was estimated to decline by more than 20% in the last four years. As per IMF estimates, the dollar's share in the central bank's foreign exchange reserves was reduced to 59% in 2022, as opposed to 70% in 1999. Other countries are expected to follow suit and push for de-dollarization in the coming year. 

A few countries have taken steps toward de-dollarization:

1. In July 2022, the Reserve Bank of India announced a plan to allow international trade to be settled in rupees.
   • Reuters reported that the UAE and India would formalize a plan to trade non-oil commodities in rupees as an alternative to the dollar.
     
   • India has connected with Malaysia and recently announced they would begin settling specific trades with the Indian rupee.
2. Indonesia has started promoting the use of local currency to settle international trades in order to replace the dollar.
   • The Chinese yuan is anticipated to be a front-runner for replacing the dollar. In March 2023, Russians bought yuan worth 41.9 billion rubles (USD538 million), exceeding the previous purchase of 11.6 billion rubles in February 2023.
     
   • The yuan is gaining popularity in Brazil, as Brazilian bank Banco BOCOM BBM — owned by
     
   • Bangladesh decided to pay Russia the equivalent of USD318 million in yuan for constructing a nuclear plant there.
     
   • China has settled a test transaction for natural gas with France in yuan.
3. Brazil and Argentina are in the process of creating a single currency for the two major countries.
   
4. For the first time, Saudi Arabia has announced that the country is agreeable to trading in currencies other than the US dollar.

Benefits and challenges

Internationalizing other currencies would increase their use in cross-border transactions, investments, and reserve assets, which has many potential advantages. First, a more diverse reserve currency system can contribute to greater global financial stability by reducing the sensitivity to shocks emanating from a single dominant currency. Second, the internationalization of currencies can improve the financial independence of issuing nations, granting them greater policy flexibility and economic independence from external forces.

However, there are various challenges that de-dollarization represents:

• As nations lower their reliance on the US dollar, alterations in the composition of global reserve assets may result in fluctuations in capital flows and asset prices. Hence, policy coordination and risk management are imperative to control financial instability in emerging markets and countries with huge dollar-denominated debt.
• An alternative reserve currency must be supported by a strong economy, strategic monetary, and fiscal policy framework to achieve the necessary liquidity, stability, and acceptability levels. Apart from the dollar, no single currency currently meets these criteria.
• The US maintains the most flexible financial markets, with transparent corporate governance and almost no discrimination between domestic residents and foreigners, which allows the dollar to be widely used in international trade. To compete with the US dollar, other nations, such as China, must provide the same benefits to foreigners.
• De-dollarization may increase the volatility of currency exchange rates, particularly during the transition's initial phases. As market participants adapt to a shifting environment and re-evaluate their currency preferences, exchange rate fluctuations may become more pronounced. This, in turn, could influence trade, investment, and capital flows, especially in financially weak countries. There is a need to develop a deep and liquid domestic economy in a bid to adapt to de-dollarization, which could be a formidable obstacle for nations with less developed financial systems.
• The US dollar is considered a haven or "store of value." Nearly 60% of foreign reserves (i.e., currencies held by central banks to help manage their nation's monetary system and exchange rate) consist of the US dollar, mainly due to its relative stability vis-à-vis other currencies.

So, what does the future hold for the US dollar? While it is unlikely that the US dollar will lose its status anytime soon, the trend toward de-dollarization is likely to continue. As more countries seek to diminish their dependence on the greenback, we may see the emergence of alternative reserve currencies such as the euro, yuan, or even digital currencies such as Bitcoin. This could have grave implications for the global financial system and impact the standing of the US dollar.