Deep Dive: Why We Think De-Dollarization Fears Are Faulty Logic

Chatter about the dollar potentially losing its status as the world’s reserve currency abounds. The din has grown since Putin invaded Ukraine and triggered US sanctions—which largely hinged on restricting Russian access to the global financial system. Russia has, by necessity, sought alternatives to the dollar in settling trade (mostly oil) and other matters. But their doing so has also rekindled vast speculation around Russia banding together with China, Brazil, India and others to lead a push toward “de-dollarizing” the global economy—removing the dollar’s central role in trade and as a central bank reserve asset. Many fear doing so would shatter demand for US debt, drive up interest rates and make US federal debt unaffordable. We have followed these fears for more than a decade. They have long been faulty, in our view, and we see little here that changes that now. This Deep Dive will round up the major themes and arguments we see on this, putting them in one place.

A Decades-Old Faulty Fear

The greenback has held the title of World’s Chief Reserve Currency since it overtook the British pound in the 1950s. Foreign leaders decried this phenomenon almost from the get-go. In the 1960s, French Finance Minister Valéry Giscard D’Estaing first connected this role to US debt, arguing reserve currency status inflated demand for dollar assets, keeping US Treasury yields artificially low—granting the US an “exorbitant privilege.” In 2010, then-Brazilian Finance Minister Guido Mantega (who served under then-and-current President Luiz Inácio “Lula” da Silva) argued an “international currency war” was underway, in which central banks—including America’s Fed—were purposefully weakening their currencies to make exports cheaper.^[i] The claim fueled a speculative cottage industry, with some theorizing the “currency war” would culminate in foreigners ditching the dollar. Now Lula is back in office and arguing the country and its trade partners should move towards using their own currencies in settling international trade. His speech citing this made headlines, but the ideas aren’t new. Similarly, in 2013, the BRICS nations (Brazil, Russia, India, China and South Africa) talked up alternatives to the dollar-dominated international system.^[ii] They still are talking about it, though that reality looks as distant now as then. Still, despite the long history of action-less talk, many argue the switch is imminent. But the context suggests we are seeing more of the same.

Beyond geopolitical chatter, some point to gold as evidence this time is different. They cite an alleged breakdown in the inverse relationship between 10-year Treasury Inflation-Protected Securities (TIPS) yields and gold prices as evidence. Conventional thinking suggests both assets attract money as inflation rises, pushing gold prices up while TIPS yields fall (and their prices rise).

But gold and TIPS yields have remained relatively high in recent months. Some therefore conclude gold is overtaking the dollar as the world’s preferred safe haven. Yet, viewed on a longer timeline, their inverse relationship isn’t so strong, and there have been divergences before. In our view, much of the concern stemmed from a short-term focus and a tortured chart.

In our view, there is still little sign the dollar’s central status will go away any time soon. We think it is worth looking at a few reasons why.

The Dollar Is Still the Most Widely Held—By a Lot.

Given the magnitude of Western sanctions, some speculated a Russian move away from the dollar would usher in a broad shift away from the greenback. But the data don’t show it. As of Q4 2022, the latest data available, the dollar comprised 54.1% of all global foreign exchange reserves—hugely above all others.^[iii] The second most popular foreign reserve is the euro, at 18.9%. Japan’s yen is third at 5.1%. Yes, as Exhibit 1 shows, the dollar’s share of global reserves has trickled down from 71.5% over the last 20 years. But that isn’t hugely relevant. As Exhibit 2 shows, the actual holdings of US dollars by foreign central banks is up over that time. It simply has a somewhat smaller slice of a much bigger global reserve pie.

Exhibit 1: USD’s Smaller Share of Global Reserves

Source: IMF, as of 5/10/2023. Percent of allocated reserves in dollars, euros, yen, pounds and yuan, 2002 – 2022.

Exhibit 2: Foreign Dollar Reserves Are Up Over That Span

Source: IMF, as of 5/10/2023. World currency reserve composition in dollars, euros, yen, pounds and yuan, 2002 – 2022.

Some may see the dip in 2022 as alarming. We don’t think it is. In large measure, it is an aftereffect of the year’s super-strong dollar. Those currency swings led some central banks, mostly in Emerging Markets (EM), to sell down dollar assets and buy those denominated in their own currencies, aiming to offset weakness.

In our view, the dollar’s persistent dominance owes itself to the US’s huge economy, which has deep, liquid and open financial markets with strong legal institutions behind them. So while near-term fluctuations may come and go, these structural, long-term things aren’t likely to change overnight.

A Huge Share of International Transactions Still Use the Dollar

For all the talk about Russia and China or Saudi Arabia moving off the dollar, the signs of this in data are limited at best. According to the Bank for International Settlements (BIS), 88% of foreign exchange transactions use the dollar.^[iv] (Note: This number is out of 200%, given all currency transactions have two sides.) But our point remains unchanged: The dollar dominates international transactions.

Furthermore, the BIS estimates about 50% of trade globally is invoiced in dollars, despite America accounting for only around 10% of global trade.^[v] Offshore funding markets prefer the greenback, too. According to the BIS: “As of the second quarter of 2022, the amount of debt and loans denominated in USD where neither the issuer/borrower nor the lender is a US resident is estimated to be 88% of total international USD-denominated debt and 65% of total international USD bank loans.”^[vi] Shifting to other currencies would likely require massive changes in how global economies transact with one another—something unlikely to occur soon or fast, in our view.

There Are No Viable Near-Term Replacements

Most importantly, no country can simply declare its currency a medium of global exchange—markets decide this, and again, market depth, liquidity, accessibility and legal structure are keys. With that in mind, consider: China employs currency controls that limit outflows and foreign investors’ access to the yuan. It isn’t sufficiently liquid. Nor are its bond markets, which also have controls on foreign investor access. The Russian ruble? Please—virtually no nation outside Russia wants to employ it now. A potential “BRICS” currency is highly unlikely to materialize or be all that stable anyway. It took European nations decades to complete the euro, despite their sharing similar government structures, geographic proximity and a willingness to surrender national central banking and some significant economic autonomy. Even then, many worry about its fragility, given the mid-2010s sovereign debt crisis. And it still lacks sufficiently deep bond markets to replace the dollar (ditto for the pound and Swiss franc). Now, consider the BRICS: These countries have radically different political systems, economic policy, histories of financial stability and more. Maybe their project wouldn’t be as ambitious as the euro. But if so, what chance does it have of dethroning the dollar?

Others point to Special Drawing Rights (SDRs), an international reserve asset introduced by the IMF to help provide liquidity to member nations. But the SDR isn’t a currency. It is a basket of five currencies—the dollar, euro, yuan, Japanese yen and British pound. You read that right—it includes the dollar. About half of the basket is US dollars, actually, so it wouldn’t replace the dollar at all.^[vii]

Some point to select EM central banks’ record gold purchases in recent months, arguing that is a move off the dollar. But we think this overstates it. History shows central banks’ gold holdings ebb and flow over time—all while the dollar has been the chief reserve currency. Moreover, they often don’t time their gold buying very well. For example, they were net sellers from 2000 – 2010, when gold prices tripled. They have been net buyers since then, and gold prices have largely moved sideways. Furthermore, central banks’ recent buying sprees are just a minor U-turn in a longer-term trend away from gold. In 1950, gold represented 30% of EM reserves—now it is only 7%.^[viii] Similarly, developed markets’ gold share was 17% in 2021, way down from 80% in 1950.

What About the Petro-yuan?

This doesn’t mean reports detailing discussions among non-Western nations to settle oil purchases in their respective currencies—specifically, China buying oil with yuan—are fake news. But what is lacking here is perspective and scale. Consider: Whatever China is doing in the oil trade is limited. Nearly all oil futures contracts are denominated in USD. And those futures contracts comprise the vast majority of financial transactions in oil, outweighing actual oil exchange by 88x daily, according to the Financial Times.^[ix] In Q4 2022, oil futures trades denominated in yuan—which take place on the Shanghai International Energy Exchange (INE) only—represented just 5.1% of total global futures trades.^[x] Over the same period, more than 80% of oil futures trades were denominated in dollars. And that says nothing of the majority of country-to-country oil trade still being priced in USD.

Even if Other Nations Eventually Move Off The Dollar, There Is Little Suggesting This Would Create a Debt Crisis.

Despite claims the dollar’s primary reserve currency status grants the US an “exorbitant privilege,” we don’t see much evidence. For one, the Treasury doesn’t collect a fee when others transact with the USD, so there is no benefit there. As for foreign central banks keeping US yields low by holding lots of Treasurys in reserve, we find the evidence here weak. Despite the dollar’s dominance last year, the US had some of the highest long-term interest rates among major economies.^[xi] Higher than Japan, whose 161% debt-to-GDP ratio far exceeds America’s.^[xii] It has 10-year yields of 0.4%.^[xiii] Or France and its 99.4% debt-to-GDP ratio, which is similar to the US’s.^[xiv] As we write, French 10-year yields are 2.8% compared to America’s 3.4%.^[xv] Where is the privilege?

Yes, most of these data are backward looking. Over the long-term future, it is possible the world moves away from the dollar—but we think it is highly unlikely to happen fast. And even if this happens, we don’t think it automatically means disaster. Consider the last time a currency lost its reserve status, when the dollar dethroned the British pound after the Suez Crisis in 1956. The switch brought on a whirlwind of fears and speculation, but its overall effects were quite muted. UK Gilts didn’t collapse. Their yields now aren’t far off of US Treasurys—further proof the status doesn’t provide much benefit.

Actually, a world with diverse currency reserves and trade conducted in many currencies is arguably an economic plus. While it may limit sanctions’ power, it would also make trade more efficient and direct—freer. And it could boost liquidity. But for investors in the here and now, that world is still distant. Fears of it are false, in our view, both on the impacts and the immediacy.