Much has been written about how the weaponization of trade, the imposition of sanctions, and the U.S. exclusion of SWIFT can trigger faster de-dollarization, as countries that exhibit diplomatic and economic autonomy will be wary of using U.S.-dominated global banking systems. This school of thought argues that this could also trigger a change in the overall structure of the global currency market, as potential foreign policy coercion or sudden disruptions will not be welcomed by countries, which will begin to explore how to build strongholds. The US dollar, which is the world’s reserve currency, may see a steady decline in the current context as major central banks may look to diversify their reserves into other assets or currencies such as the euro, renminbi or gold.
The “de-dollarization” of many central banks is imminent, driven by a desire to insulate them from geopolitical risks, where the US dollar’s status as a reserve currency can be used as an offensive weapon. Thus, the war in Ukraine and the ensuing economic sanctions will send central banks back to their drawing boards to reassess their dependence on the dollar. Efforts are already underway for the possible introduction of a new Russia-China payment system bypassing SWIFT and combining the Russian SPFS (Financial Message Transfer System) with the Chinese CIPS (Cross-Border Interbank Payment System).
The notion of de-dollarization fits well into the thought experiment of a multipolar world where each country will seek to enjoy economic autonomy in the sphere of monetary policy. The main geopolitical adversaries of the USA – Russia and China – have already started this process of de-dollarization. Other smaller powers are also joining the ranks. India has also had to work out alternative arrangements, including an exchange agreement, with certain countries sanctioned in the past.
Russia began its three-pronged efforts towards de-dollarization in 2014, when sanctions were imposed for the annexation of Crimea. First, Russia reduced its share of dollar-denominated assets to about 16% in 2021. It had already announced that it would cut the dollar from its $186 billion National Wealth Fund. Second, it reduced its share of dollar-denominated trade, prioritizing national currencies in bilateral trade. The use of USD in Russia’s exports to the BRICS has dropped from around 95% in 2013 to less than 10% in 2020. Third, Russia also developed a national electronic payments system called “Mir” in 2015 after several companies payment processing companies denied services to Russian banks.
However, these steps were not enough to effectively protect “Fortress Russia”. China, on the other hand, intends to use trading platforms
and its digital currency to promote de-dollarization. China has established RMB trading centers in Hong Kong, Singapore and Europe. In 2021, the People’s Bank of China submitted a “Global Sovereign Digital Currency Governance” proposal to the Bank for International Settlements to influence global financial rules through its digital currency, the e-Yuan. The IMF already added Yuan to its SDR (Special Drawing Rights) basket in 2016. In 2017, the European Central Bank exchanged EUR 500 million of its foreign exchange reserves into Yuan-denominated bonds. However, the lack of full RMB convertibility will impede China’s de-dollarization ambition.
Despite these efforts, the US dollar continues to reign supreme, having sealed its position in the early 1970s with an agreement with the oil-rich Kingdom of Saudi Arabia to conduct the global dollar energy trade. The dollar’s status was enhanced by the collapse of the Bretton Woods system, which essentially eliminated other developed market currencies from competing with the dollar. This reserve currency status allows the US government to refinance its debt at low cost, while also providing foreign policy leverage. Currently, about 60 percent of central banks’ foreign exchange reserves and about 70 percent of global trade is carried out using USD. The association of the dollar as a “safe haven” asset also has a psychological angle and, like old habits, people continue to view the currency as a relatively risk-free asset. Given this psychological bias, the world will continue to prefer the dollar as a “store of value” and “medium of exchange”, fulfilling the basic functions of money. Furthermore, the sudden dumping of dollar assets by opposing central banks will also pose risks to their balance sheet as it will erode the value of their overall dollar-denominated holdings.
So, despite the triggers for the move away from the dollar, in reality it will be a lengthy process. In addition to the euro and gold, most other foreign currencies have some inherent risks associated with them. With historically “neutral” Switzerland joining the EU in imposing sanctions on Russia, this eliminates the Swiss franc from being an asset that can act as a hedge against economic sanctions.
Central banks are left with very few options to diversify. That said, a drop in the dollar’s stature is inevitable as major economic powers like China and India rise. The Western hegemony of the financial system was challenged when the 2008 global financial crisis exposed underlying cracks in the US economy. Furthermore, demographic factors will continue to challenge Europe’s growth prospects. The rise of Asia as an economic power will increase the importance of currencies such as the Yuan and Indian Rupee. But while the frequent use of the US dollar as a potential weapon to achieve foreign policy objectives will undoubtedly accelerate the de-dollarization process, there is still a long way to go.
This column first appeared in the print edition on March 17, 2022 under the title ‘The Notion of De-dollarization’. The writer is chief economist of the Mahindra & Mahindra group. With contributions from Sarbartho Mukherjee, Associate Economist, M&M. Views are personal