China and Brazil have reached an agreement to settle trades in each other's currency, marking another shift away from the US dollar's dominant position in international trade. Over the past 15 years, China has replaced the US as Brazil's primary trading partner, with the two countries' bilateral trade expected to reach $200 billion this year. This agreement comes as part of China's broader effort to internationalize its currency, the yuan, and reduce its reliance on the US dollar in global trade.
In a meeting last week, ASEAN finance ministers and central banks governors discussed efforts to reduce dependence on major currencies through the Local Currency Transaction (LCT) scheme. This is an extension of the previous Local Currency Settlement (LCS) scheme that has already begun to be implemented between ASEAN members.
This means that an ASEAN cross-border digital payment system would be expanded further and allow ASEAN states to use local currencies for trade. An agreement on such cooperation was reached between Indonesia, Malaysia, Singapore, the Philippines, and Thailand in November 2022. This follows from Indonesia’s banking regulator, stating on March 27 that the Bank of Indonesia is preparing to introduce its own domestic payment system.
Indonesian President Joko Widodo has urged regional administrations to start using credit cards issued by local banks and gradually stop using foreign payment systems. He argued that Indonesia needed to shield itself from geopolitical disruptions, citing the sanctions targeting Russia’s financial sector from the US, EU, and their allies over the conflict in Ukraine.
Moving away from Western payment systems is necessary to protect transactions from “possible geopolitical repercussions,” Widodo said.
The US dollar has long been the dominant global reserve currency and a universal unit of account in international trade. Because of this, every major central bank, treasury, and significant corporation in the world holds a significant portion of their foreign exchange reserves in US dollars. This preference for the dollar has also driven demand for US government bonds in international financial markets. However, recent events have led to a growing number of countries considering alternative reserve currencies.
One factor driving this shift is the use of the US dollar in economic warfare. The exclusion of Iran and Russia from dollar-based trading systems such as SWIFT has prompted other nations to consider contingency plans. India and Malaysia, for instance, have recently begun using the Indian Rupee to settle certain trades, and there have been recurring warnings about Saudi Arabia and other energy exporters abandoning the dollar. Additionally, increasingly erratic US monetary policy is causing some investors to seek alternative currencies.
Simply substituting the US dollar with the fiat currency of a smaller economy is unlikely to be a viable replacement strategy. There are significant historical, technological, financial, and ingrained obstacles to moving away from the dollar, including network effects to surmount. Moreover, a number of countries, including East Timor, Ecuador, El Salvador, the Federated States of Micronesia, the Marshall Islands, Palau, Panama, and Zimbabwe use the US dollar as their de facto currency. In addition, no less than 22 foreign central banks and currency boards have pegged their currencies to the US dollar due to the relatively transparent nature of its monetary policy.
Alternative reserve currencies being considered include cryptocurrencies, digital currencies issued by central banks, and collections of commodities representative of a nation's or region's competitive advantage. For example, certain African nations could trade in currencies backed by titles to rare earth metals, while certain South American nations could trade in currencies backed by copper deposits. Such a currency order has been dubbed "Bretton Woods III," and some non-commodity proposals resemble the now-abandoned Facebook currency plan, Libra (later Diem).
However, there are obstacles to these alternative reserve currencies, including concerns about cybersecurity, lack of trust in central bank digital currencies, and the challenges of creating a market for commodities-backed currencies. Additionally, the role of the US dollar in international demand for US Treasuries means that efforts to establish alternative reserve currencies could result in a decline in demand for tradable US debt, potentially leading to higher yields and increased debt service payments on US Treasury securities.
The long-term fate of the US dollar as the lingua franca of international trade may already be sealed, as de-dollarization efforts continue. However, it is unlikely that the dollar will disappear entirely. It will likely remain an important global reserve currency for the foreseeable future, but with a smaller share of the market. The US dollar's dominance in international trade has been eroding gradually over the past few decades, and this trend is likely to continue as China and other countries work to reduce their reliance on the dollar.
Moreover, the rise of digital currencies, particularly cryptocurrencies, has further challenged the dominance of the US dollar. Cryptocurrencies such as Bitcoin and Ethereum have gained popularity as alternative payment systems and stores of value, with some experts predicting that they may eventually become a new form of global reserve currency. Some countries, such as China and Russia, are already developing their own digital currencies, which could potentially challenge the US dollar's role in global trade.
Despite these challenges, the US dollar still remains the dominant global currency. It is estimated that about 60% of all foreign currency reserves and 40% of all cross-border payments are denominated in US dollars. The US economy is still the largest in the world, and the US dollar's position is supported by the deep and liquid US Treasury market, which provides a safe haven for investors during times of market turmoil.
However, there are concerns that the US government's increasing debt levels and budget deficits could eventually erode the dollar's dominance. The US national debt has surpassed $28 trillion, and the budget deficit is expected to reach $3 trillion in 2021, fueled by massive stimulus spending and tax cuts. Some experts warn that this could lead to inflation, higher interest rates, and a weaker dollar, which could make it more difficult for the US government to finance its debt.
In addition to economic factors, there are also geopolitical factors that could impact the future of the US dollar. The ongoing tensions between the US and China, Russia, and other countries could lead to a further erosion of the US dollar's dominance in global trade. Some countries may seek to reduce their dependence on the US dollar and diversify their currency reserves as a way to reduce their vulnerability to US sanctions or other economic pressure.
In conclusion, while the US dollar remains the dominant global currency, there are growing challenges to its position. The rise of digital currencies, increasing debt levels and budget deficits, and geopolitical tensions are all factors that could impact the future of the US dollar. It remains to be seen how these factors will play out in the coming years, but it is clear that the role of the US dollar in global trade is not set in stone.
References:
- IMF. (2020). Currency Composition of Official Foreign Exchange Reserves (COFER).
- Federal Reserve Bank of St. Louis. (2021). Debt to the Penny.
- Congressional Budget Office. (2021). The Budget and Economic Outlook: 2021 to 2031.
- O'Connell, B. (2020). Geopolitical implications of the dollar's dominance. Council on Foreign Relations.
- Cai, J., & Rong, Z. (2021). The Impact of the De-dollarization on China's Economy. International Journal of Economics, Commerce and Management, 9(2), 65-76.
- Cochrane, J. H. (2021). De-dollarization: a user's guide. National Bureau of Economic Research.
- Das, S., & Pandey, V. (2018). De-dollarization: A comprehensive review. Journal of Economic Surveys, 32(2), 335-369.
- Prasad, E. S. (2014). The dollar trap: How the US dollar tightened its grip on global finance. Princeton University Press.
- Briefing, A. (2023, March 29). ASEAN Finance Ministers and Central Banks Consider Dropping US Dollar, Euro and Yen, Indonesia Calls for Phasing Out Visa and Mastercard. ASEAN Business News. https://www.aseanbriefing.com/news/asean-finance-ministers-and-central-banks-consider-dropping-us-dollar-euro-and-yen-indonesia-calls-for-phasing-out-visa-and-mastercard/
