The US dollar (USD) is the world’s most dominant currency, playing a central role in international trade, finance and reserves. The dollar has been the major means of trade in the world since the end of World War II. It is the currency that is most frequently used for international trade and other transactions worldwide, as well as the most frequently kept reserve currency. The dollar’s dominance in the world economy offers the US certain advantages, such as easier access to foreign credit and a wider application of monetary sanctions. Despite some challenges and fluctuations, the USD has maintained its status as the global currency for the past century. In this blog post, we will explore some of the factors that contribute to the USD’s strength and resilience, as well as some of the potential challenges and risks that it faces in the 21st century.
The Role of the US Dollar in the International Sphere
Figure 1 : The International role of the US dollar
Source : Bank for International Settlements
The USD’s dominance is evident in several aspects of the global economy. According to the Bank for International Settlements (BIS), the USD was involved in nearly 90% of global foreign exchange (FX) transactions in 2021, making it the single most traded currency in the FX market. The USD is also the most commonly held reserve currency by central banks and treasuries around the world, accounting for 60% of globally disclosed official foreign reserves in 2021. Moreover, the USD is widely used as a currency anchor, meaning that many countries peg their currencies to the USD or use it as a reference for their exchange rate policies. The USD is also the primary currency for international trade, especially for commodities such as oil and gold.
Figure 2 : Dollars and exports: The effects of currency strength on international trade
Source : CEPR
What are some of the factors that support the USD’s international role? Substantial and dynamic nature of the US economy, openness to trade and capital flows, strong property rights, and the rule of law have all contributed to the USD’s dominant position in the world economy. Because of this, the US financial markets have unparalleled depth and liquidity, and there is a plentiful supply of incredibly safe assets denominated in dollars. The US economy’s stability and its openness to trade and capital flows make the dollar a reliable and desirable currency for international transactions. A currency’s use as a medium of exchange can also be used to gauge its significance on a global scale. Many recent analyses of the currency makeup of international trade and financial transactions have emphasised the dollar’s dominance on a global scale. The most widely utilised currency in the world for international trade is the US dollar. In the Americas, the dollar accounted for 96% of trade invoices between 1999 and 2019, 74% in the Asia-Pacific area, and 79% in the rest of the world. Europe is the only exception, as the euro is widely used there. In 2009, during the height of the Great Recession, the euro virtually disappeared from circulation. In addition to the ongoing trade and economic concerns resulting from the United Kingdom’s 2019 exit from the European Union, the conflict between Russia and Ukraine poses further pressures on the euro.
However, the USD’s dominance is not guaranteed or uncontested. There are several challenges and risks that could undermine its international role in the future. One challenge is the rise of other currencies, especially the euro and the Chinese renminbi, which have increased their share of global reserves and trade over time. Another challenge is the diversification of reserve holdings by some countries, which seek to reduce their dependence on or exposure to the USD. A third challenge is the backlash against US financial sanctions, which have driven some countries to seek alternative payment systems or currencies to avoid US jurisdiction. A fourth challenge is the impact of COVID-19 on the US economy and fiscal position, which could erode confidence in the USD’s value and stability.
Dedollarisation and Its Impact on International Trade
Dedollarisation is the process of significantly reducing the amount of dollars used in international trade and financial operations, which lowers demand for the dollar among corporations, institutions, and individuals at home. This procedure has the potential to lessen the global capital market’s hegemony denominated in dollars, which is used by lenders and borrowers worldwide to transact business. A handful of alliances in Asia, Africa, and South America are looking to end dependency on the US. The BRICS and ASEAN groups are at the forefront of challenging the US dollar’s status.
The impact of dedollarisation on international trade can be multifaceted. Through dedollarisation, nations can diversify their economies and lessen their reliance on a single currency. Countries can grow their domestic financial markets, attract investment in home businesses, and boost economic growth by encouraging the use of their own currency or regional substitutes. Increased international commerce and investment flows can be facilitated by dedollarisation. Countries can lower transaction costs and simplify trade across borders by using alternative settlement systems or regional currencies. This may stimulate regional trade and investment, fostering economic integration and collaboration. Dedollarisation helps countries to retake control over their monetary policy and exercise greater autonomy over their economic affairs. Countries can better address internal economic difficulties and implement policies in line with their economic objectives by decreasing their dependency on foreign currencies. This in turn can promote sustainable growth and improve economic stability.
While dedollarisation holds the promise of diversification and reduced dependency on the USD, it introduces a spectrum of challenges that demand thoughtful consideration. One critical aspect is the inherent currency risk associated with the shift, as countries expose themselves to fluctuations in alternative currencies, necessitating a meticulous risk management strategy. Furthermore, concerns arise regarding the liquidity and market depth of these alternative currencies, particularly in comparison to the widely-accepted USD. The journey towards de-dollarisation requires addressing questions of international acceptance, as the USD’s historical credibility poses a formidable challenge that necessitates concerted efforts to establish trust in alternative currencies. Economic interdependencies, such as exchange rates, interest rates, and capital flows, may experience turbulence, demanding careful management to prevent volatility and uncertainty. Additionally, the geopolitical implications of dedollarisation cannot be ignored, as it may strain international relationships, requiring diplomatic finesse and cooperative approaches for a smooth transition. In essence, while the benefits are evident, navigating the path to de-dollarisation demands a strategic and holistic approach to mitigate potential pitfalls and ensure a resilient global financial landscape.
In conclusion, the transformative impact of dedollarisation on international trade underscores the need for a strategic recalibration in global markets. As nations contemplate diversifying away from the USD, the identified challenges–from currency risk to market liquidity and international acceptance–highlight the intricacies involved in this monumental shift. To navigate this global transformation successfully, market participants must embrace adaptive financial instruments and risk management strategies that account for the complexities of alternative currencies. Collaborative efforts are paramount, fostering regional coordination and diplomatic engagement to ease the geopolitical tensions that may arise. Moreover, there is a pressing need for the development of innovative financial mechanisms that enhance the credibility and liquidity of non-USD currencies. The future of international trade demands a proactive approach that balances the benefits of dedollarisation with the requisite adaptations in global financial infrastructures. By embracing change and fostering cooperation, nations can navigate this shift, ensuring a resilient and equitable international trade landscape for years to come.
The views and opinions expressed in articles submitted to the Comparative Advantage Blog are those of the author and do not necessarily reflect the views of The Moot Court Bench.