Will the dollar lose its reserve status?
Lately, the phrase “USD is losing its reserve currency status” has been appearing frequently in the news. Exactly a year ago, I wrote about the US dollar (USD) not remaining the sole reserve currency by the end of this decade. Since this topic has captured the attention of the media and the general public, I wanted to delve into it again.
I see a couple of different aspects to the discussion about USD as a reserve currency and its potential loss of status:
- USD as a medium of exchange, i.e., goods and services being denominated in USD
- Nations storing their trade surpluses/reserves in USD
Will the dollar lose its reserve status? USD as a medium of exchange
Over the past few decades, most nations and trading entities have primarily denominated their trade in USD. Since the mid-70s, the US convinced the Saudis and later OPEC to denominate their oil sales in USD, giving rise to the “petrodollar system,” which is now showing signs of wear. Trade can be conducted in other fiat currencies like yuan/euro/pound or something physical like gold, or even BTC or seashells (if desired) in theory. The main challenge is for both parties to agree on this medium of exchange and the price to be paid for goods/services (in this medium).
According to a recent Reuters article, “The dollar was on one side of 88% of all foreign exchange trades in April last year, according to the Bank for International Settlements.” Even if a large number of nations (especially outside the Western Bloc) decide to trade in something other than USD, the share of USD will remain fairly high in the short to medium term. There has been far too much “doomsday prognosticating” in some quarters about nations now deciding to trade in other currencies (versus USD).
If less trade is denominated in USD, then it would reduce the demand for dollars, decreasing its relative strength (compared to other currencies). This can help alleviate Triffin’s dilemma, which states that the use of a national currency, such as the U.S. dollar, as a global reserve currency, leads to a current account deficit due to the perpetual demand for dollars worldwide to conduct trade (in USD). This results in a strengthening of the dollar, which makes exports more expensive and leads to the offshoring of certain industries/jobs, such as manufacturing to other nations. This has decimated local economies in parts of the US, such as the Rust Belt.
In theory, a weaker dollar will help US exports become more competitive compared to the rest of the world and also discourage imports, which would now become more expensive. This can help reduce the ever-growing US trade deficits with the rest of the world. This would also encourage the onshoring of jobs/manufacturing back to the US, as the cost differential of offshoring is now reduced.
Will the dollar lose its reserve status? Nations storing their trade surpluses/reserves in USD
The second and much more critical implication of the USD losing its reserve currency status is the impact on foreign nations buying US Treasury bonds with their trade surpluses. According to IMF data, the amount of USD-based reserves has now dropped to 59%.
Russia (2022) and Afghanistan (2021) have discovered the hard way that being on adversarial terms with the West, especially the USA, means that your foreign reserves in USD can be frozen instantly. Many nations outside of the so-called West are now wary of investing more in US Treasuries going forward, as their hard-earned money could be taken away if they refuse to follow the US line in the future. China, which currently has a frosty relationship with the US, has cut its US Treasury holdings to the lowest level in 14 years. Foreign nations had already been slowing down their purchases of US debt since 2013 and will likely be more hesitant moving forward.
This decrease in demand from foreign buyers will have to be made up by someone else. Private institutions and individuals can only buy so much given their capacity (relative to nation-states). A significant portion of this demand will most likely have to be picked up by the Federal Reserve. However, the Federal Reserve is currently trying to actively reduce its balance sheet (which ballooned from ~4.5T to almost 9T during the pandemic spending spree) as part of its Quantitative Tightening (QT) program to rein in the money supply. If they reverse course and actively start buying Treasuries (with newly printed money), this could fuel inflation. After being harshly criticized for allowing inflation to run away last year, they will be hesitant to do so soon (unless some major crisis forces their hand).
The US is currently running a $1.38T+ deficit. This shortfall forces the government to issue even more debt every year to meet its spending obligations.
Last year, the US spent $480B on net interest expenses on the debt, and this amount will continue to increase as the Fed raises rates and/or keeps them high for longer to contain inflation. In February, the Congressional Budget Office (CBO) projected that annual net interest costs would total $640 billion in 2023 and $739 billion in 2024, and reach a staggering $1.4T in 2033. The nonpartisan Peter G. Peterson Foundation estimates around $10.5T in interest payments over the next decade.
It is important to note that roughly half of the debt will mature in the next three years. If the Federal Reserve keeps rates higher to control inflation, it will make the debt that needs to be refinanced more expensive, leading to an even larger debt burden.
Will the dollar lose its reserve status? Epilogue
Most people are missing the forest for the trees, with a significant amount of focus on many nations deciding to transact in currencies other than USD versus the issue of nations not buying US Treasury bonds with their reserves/trade surpluses.
News items such as nations opting to trade in non-USD currencies often grab headlines and clicks, but I believe the more significant issue is nations reducing their holdings of US Treasury bonds.
A lower demand for dollars will not significantly negatively impact the US. Two nations/parties now deciding to trade in another currency will not threaten US hegemony, contrary to what some commentators like Fareed Zakaria (CNN) or Fox News would have you believe.
Similar to today’s geopolitics, we will see a multipolar world in trade/commerce, where multiple forms of exchange media are used in the future instead of primarily the dollar (i.e., USD down but not out!).
The more significant issue, in my opinion, is what nations do with their trade surpluses. Nations will be wary of investing them in Chinese yuan for a multitude of reasons that I discussed last year.
To prevent counterparty “geopolitical” risk by investing in other nations’ currencies, they could choose to invest in gold (record central bank gold purchases last year) and even possibly Bitcoin. Both gold and Bitcoin have their challenges, including additional complexities of verification/audit/storage/transport and massive price volatility, respectively, which would not make it easy for nations to use them extensively.
A lack of good options might cause many nations around the world to hesitate before fully exiting US Treasury bonds, but if they choose to do so, the ripple effects of such a move would lead to a significant debt spiral for the US. In today’s era of populism, it seems unlikely that any politician who wants to get re-elected will cut spending. This means that with the ongoing deficits, the debt must be refinanced with more money printing by governments and central banks.
The US has been able to spend freely for a very long time by having others (like Saudis/OPEC recycling their petrodollars to buy US Treasury bonds) keep their debt cheap. This “exorbitant privilege” that the US has enjoyed as a unipolar superpower is now slowly eroding and has significant financial consequences for the US – a point which, in my opinion, is being severely underplayed in the “USD losing reserve currency” commentary occurring nowadays.
Mohal Joshi