Context: Various countries have been attempting to De-dollarise the US Dollar.
What is De dollarisation?
De-dollarisation refers to the replacement of the U.S. dollar (currently dominant global reserve currency) by other currencies.
- Reserve currency is a type of currency that is extensively utilized for conducting international trade transactions and is often kept as a reserve asset by central banks around the world.
- In other words, it is a currency that is recognized and accepted globally, and is used as a means of payment for international trade and investment activities.
- Central banks hold reserves of this currency to maintain stability in their respective economies and to facilitate international transactions.
Throughout history, the dominant global reserve currency has shifted several times.
- The British pound was the primary reserve currency during the 19th and early 20th centuries, but it lost its status after World War II, and the U.S. dollar became the dominant reserve currency.
- The U.S. dollar has held this position since then, with over 60% of global foreign exchange reserves held in dollars as of 2021.
- However, in recent years, there have been increasing efforts by various countries to reduce their dependence on the U.S. dollar and to diversify their reserves by holding other currencies such as the euro, Japanese yen, and Chinese yuan.
- This comes in the aftermath of Russia’s invasion of Ukraine.
- The U.S. imposed several sanctions that restricted the use of the U.S. dollar to purchase oil and other goods from Russia, and this has been seen by many countries as an attempt to weaponize the dollar.
- Since international transactions carried out in the U.S. dollar are cleared by American banks, this gives the U.S. government significant power to oversee and control these transactions.
Reasons for popularity of US Dollar
- The dominance of the U.S. dollar in international transactions is not just due to coercion or manipulation by the U.S. government, but rather it is a result of the preference of market participants for the U.S. dollar due to various economic reasons.
- For example, a recent attempt by India and Russia to carry out trade between the two countries in Indian rupees rather than in U.S. dollars has hit a roadblock because the value of India’s imports from Russia far outweighs its exports to the country.
- This left Russia with excess rupees in hand which it was unwilling to spend on Indian goods or assets, and led to Russian demands for the settlement of bilateral trade in U.S. dollars.
- So, even Russia, a long-time friend of India and a long-time foe of the United States, preferred to carry out its trade with India using U.S. dollars since the dollar is far more widely acceptable than the Indian rupee.
- High Level of Trust: The global acceptability of the U.S. dollar as a reserve currency is primarily due to the popularity of U.S. assets among investors, despite the fact that the U.S. has been running a trade deficit for decades.
- The excess dollars accumulated by the rest of the world due to the U.S. trade deficit have been invested in U.S. assets, such as debt securities issued by the U.S. government, indicating the high level of trust that global investors have in the U.S. financial markets.
- Rule of Law: This trust may be due to the ‘rule of law’ in the U.S. On the other hand, China, which supplies the world with huge volumes of goods and runs a trade surplus, has been trying to make the yuan a reserve currency. However, restrictions placed by the Chinese government on foreign access to China’s financial markets and doubts over ‘rule of law’ in China have adversely affected global demand for the yuan.
Need for De- Dollarisation
- Diversification of Risk: Holding a basket of currencies instead of just one currency (i.e., the US dollar) can help to diversify a country’s risk exposure and reduce the potential negative impact of a sudden currency devaluation or other economic shocks/political changes in the US.
- Improving Economic Stability: By diversifying their reserves, countries can reduce their exposure to currency fluctuations and interest rate changes, which can help to improve economic stability and reduce the risk of financial crises.
- Increasing Trade and Investment: By using other currencies, countries can increase trade and investment with other countries that may not have a strong relationship with the US, which can open up new markets and opportunities for growth.
- Reducing US Monetary Policy Influence: By reducing the use of the US dollar, countries can reduce the influence of US monetary policy on their own economies and increase their economic autonomy.
- Direct Trade in Country’s National Currency: Direct trade in a country’s national currency can lead to savings on currency conversion spreads and transaction costs.
- Global Economic Balance: A shift away from the US dollar as the dominant reserve currency could lead to a more balanced global economic system and reduce the risk of economic imbalances and instability caused by the dominance of one currency.
- Geopolitical Benefits: By reducing dependence on the US dollar, countries may be able to improve their geopolitical standing and increase their bargaining power in international relations.
Challenges of De dollarisation
- Market Volatility and Global Financial Crisis: A sudden shift away from the dollar could create market volatility and instability, as many countries and businesses are heavily reliant on the dollar for trade and investment and any change would lead to a potential global financial crisis.
- Trade Disruptions: A move away from the dollar could also disrupt international trade, as businesses and governments adjust to new currencies and exchange rate regimes.
- Exchange Rate Risk: De-dollarisation can expose countries to exchange rate risk, as they may have to convert their reserves into other currencies that are subject to volatility.
- Limited Acceptance: National currencies may not be as widely accepted or trusted as the dollar, which can make it difficult for countries to use them in international trade.
- Currency Manipulation: The dominance of the dollar in global trade allows the US government to manipulate its currency to gain an economic advantage over other countries.
- Geopolitical Risks: A shift away from the dollar can be seen as a challenge to US economic and geopolitical power, which could lead to political tensions and even conflict.
- Difficulty in Establishing a New Global Reserve Currency: Establishing a new global reserve currency can be difficult and complex, as it requires the support of many countries and a stable economic and political environment.
- Potential for Conflict: De-dollarisation efforts by one country or group of countries could lead to conflict with the US government or other countries that benefit from the dollar’s dominance in the global economy.
- Lack of Market Depth: Some national currencies may not have the same level of market depth and liquidity as the dollar, which can make it difficult for countries to use them as a reserve currency.
- Monetary Sovereignty: The hegemonic role of the dollar limits the monetary sovereignty of other countries by making it difficult for them to use monetary policy to stabilise their economies.
- Debasement of the Currency: When a country’s fiat currency enjoys reserve currency status, it gives the country the power to purchase goods and other assets from the rest of the world by simply creating fresh currency. However, such irresponsible expansion of the money supply can cause the debasement of the currency and eventually threaten its status as a reserve currency.
There have been global efforts towards de-dollarisation, including:
- Bilateral currency swaps among countries, promotion of trade in national currencies, and the establishment of alternative payment systems.
- For example, ASEAN countries, China, Japan, and South Korea have bilateral currency swaps amounting to USD 380 billion and rising, while the South African rand is used by several African countries.
- The BRICS’s New Development Bank encourages trade and investment in national currencies by disbursing up to 50% of its loans in national currencies since 2015.
- China has developed the Renminbi and offers clearing and settlement services for cross-border yuan payments and trade.
- Russian banks have started using the China-based Cross-Border Interbank Payment System for international payments as they are debarred from the SWIFT international system.
- Some countries are also exploring the possibility of using cryptocurrencies for international trade and payments, as they offer a decentralized alternative to traditional payment systems.
- Reserve Bank of India (RBI) recently unveiled a rupee settlement system for international trade by allowing special vostro accounts in designated Indian banks, a step towards internationalising the rupee.
- Similarly, India and Russia are considering the use of a third currency or the inclusion of a third country like UAE to facilitate oil trade between the two countries.