Dollar Dominance, BRICS & Shifting Wealth

Not least as a result of Shifting Wealth - the shift of the centre of gravity of the world economy towards Asia - the BRICS countries are seeking to replace the dollar as the leading currency with the Chinese yuan[1]. The shocks to the world economy caused by US President Trump's isolationism and willingness to impose sanctions can accelerate the rise of the yuan as a lead currency. (Meanwhile, the US are going insane under President Trump, as predicted by the Simpsons already in 2000!).

There is still a lot of plumbing to be done before the dollar dominance can be diminished. This work is in full swing with the establishment of new institutions outside the financial system dominated by the West, the establishment of new transport, energy and digital connections in the context of the Chinese Silk Road Initiative and the disintegration of global trade into regional trading blocks.

BRICS countries and dollar dominance

The five BRICS states form an association with different interests and strengths. If one topic unites these five, it is their rejection of the US-dominated monetary system. Thus the 10th BRICS Summit in Johannesburg in July 2018 once again ended with a call against the dominance of the US dollar. Since the Xiamen Summit in 2017, five selected emerging markets (BRICS Plus[2]) have been invited to promote the de-dollarisation of the global economy.

Since their first summit meeting in 2009 in Ekaterinburg, Russia, the BRICS states have been calling for the US dollar to be replaced as the international reserve currency. In the same year, under the fresh impression of the implosion of the global financial system in the wake of the Lehman bankruptcy, the UN Commission on the Reform of the International Monetary and Financial System headed by Joseph Stiglitz made the demand to replace the US dollar as an international reserve currency, possibly with the basket of Special Drawing Rights (SDR) of the International Monetary Fund. However, Special Drawing Rights are a form of art money that is not traded on foreign exchange markets. They do not fulfil all the functions of money: although SDRs can function as part of a country's official foreign exchange reserves, they cannot be used either to intervene in foreign exchange markets or as an anchor currency. So it's hardly surprising that the political impetus for the SDR as the reserve currency has silted up, even though the SDR basket has become more representative since the Chinese yuan joined in 2016.

The euro could be a serious candidate to reduce dollar dominance as a reserve currency if the institutional conditions were created[3]. In order to be attractive for global transactions, especially for reserve holdings, the euro should be stable in value and crisis-proof. But the reforms of the euro's financial architecture to date have not succeeded in establishing this confidence. Germany's restrictive fiscal policy is also curtailing the supply of risk-free Eurobunds; these would be the obvious alternative to US government bonds, the hitherto dominant form of official reserve holdings. After all, the mercantilist German economic model, which is pinned on external competitiveness, is standing in the way of the internationalisation of the euro because of the Triffin dilemma[4], just as it did in the past for the Deutsche Mark.

A Hundred Years of Dollar Dominance

Ever since the replacement of the British pound as the global reserve currency after the First World War the US dollar has dominated the world economy - for a century now.  The USA had already overtaken Great Britain as the largest economy at the end of the 19th century, and politically it dominated in the wake of the First World War. Today still, the dollar is enthroned in the bel étage of the international monetary system:

1. A large part of international trade, which far exceeds the share of the USA in world trade, is invoiced and settled in dollars. This is also due to the fact that the prices for most raw materials are quoted in dollars. The role of the dollar as the dominant invoicing currency in international trade and its widespread use as a transaction currency has so far been consolidated by network effects.  The global share of the dollar in international payments is now 40 percent, followed by the euro with 35 percent. By contrast, the yuan share has stagnated at just below two percent since 2016 due to devaluation pressure and the implementation of state controls to prevent capital outflows.

2. Network effects are less significant in terms of use as a reserve currency, in which not only liquidity aspects but also diversification arguments play a decisive role. Nevertheless, the dollar remains the dominant reserve currency. At the end of the first quarter of 2018, it accounted for 62.5 percent of the world's allocated official foreign exchange reserves. The euro was in second place at 20.4 percent. The yuan stands at only 1.4 percent[5].

3. The majority of bank financing outside the USA takes place in dollars: According to location-based statistics from the Bank for International Settlements, 62 percent of banks' foreign currency liabilities are denominated in dollars. Similarly, the corporate financing of non-American companies through bank loans and bonds is more denominated in dollars than in other hard currencies[6].

The lead currency functions (means of payment, holding reserves and financing vehicles) are interlinked in multiple configurations[7]. The high proportion of internationally traded goods invoiced in dollars drives the demand for secure dollar claims. Risk-free investments in US dollars generally pay lower exchange rate adjusted returns than risk-free investments in most other currencies. The violation of the uncovered interest parity in turn favors the dollar as a cheap funding currency. This feedback loop applies in particular to the export firms of emerging markets. Because of this violation, taking out dollar loans is generally cheaper than taking out loans in local currency. This increases the incentive for the company to settle its exports in dollars, because it can thus plan its future dollar sales more reliably. This, in turn, enables the company to borrow in cheaper dollars with lower exchange rate risks.

The USA, as the issuer of the global lead currency, enjoys the ´extraordinary privilege´[8], to import foreign capital by providing international dollar liquidity while non-Americans mostly hold their dollar investments in low-interest US government bonds. Some of these capital imports are channelled by the US into high-yield foreign investments, which generates considerable interest gains for the United States. Nonetheless, the rest of the world has also benefited from the dollar's status as a reserve currency. The depth and liquidity of the US financial markets and the economic weight of the US economy make the dollar attractive not just as a transaction and reserve currency. Countries with less liquid financial markets, in particular, are benefiting from the dollar as the reserve currency, partly due to favorable refinancing conditions on the US bond markets. In addition, the dollar has exhibited low inflation rates and relatively high external stability in recent decades.

The Dollar Discomfort of Emerging Markets

So what do the BRICS have to object to the dollar as the lead currency?

1. A most immediate response is provided by the currency crises in Argentina and Turkey, which were only recently the preferred borrowers of foreign banks and global bond markets. Now, in 2018, they have to swallow a rapid collapse in the external value of their currencies; they are paying heavy fines on the ´original sin´[9] typical of emerging markets. As many emerging markets have quite illiquid and narrow financial markets, the violation of the uncovered interest rate parity tempts them to borrow in foreign currency. If the dollar borrowing is made by companies or banks that do not have corresponding dollar revenues, currency mismatches arise in corporate balance sheets. These balance sheet mismatches are a time bomb for private actors, but equally for public budgets via contingent liabilities for public bailouts.

2. Another current concern relates to the United States' ability to impose sanctions. Any transaction conducted in US dollars or through a US bank automatically results in trading partners being subject to US jurisdiction. The US is currently waging an economic war against a tenth of the world's countries with a cumulative population of almost 2 billion people and a GDP of more than 15 trillion dollars. These include Russia, Iran, Venezuela, Cuba, Sudan, Zimbabwe, Myanmar, the Democratic Republic of the Congo, North Korea, but also countries such as China, Pakistan and Turkey, targets of other economic sanctions. The resulting trade war similarly weakens the attractiveness of the dollar in international trade and financial transactions. Countries like Iran welcome the possibility of circumventing US sanctions by exporting goods to China that can be settled in yuan. In July 2018, SWIFT's RMB tracker[10] quoted a 9.9 percent increase in the value of yuan payments for July 2018 compared to June 2018, while transactions in all other currencies  declined by 2.5 percent that month[11].

3. From a wealth perspective, emerging markets are worried about the danger of a depreciation of the US dollar. China (including Kong Kong) and the twelve largest emerging markets recently held official foreign exchange reserves of 6.7 trillion dollars, almost 60 percent of the world's official reserves. Often motivated by their vulnerability to sudden stops (of capital inflows), the demand for foreign exchange reserves is forcing developing countries to transfer resources to the countries that issue these reserve currencies - a case of "reverse aid", particularly benefiting the US. Major emerging economies, often net creditors to the rest of the world and with substantial holdings of US sovereign debt, fear a deliberate devaluation strategy by the US that would devalue their vast currency reserves by hundreds of billions of dollars. China's net foreign wealth has risen steadily over the past three decades, to half of its rapidly growing gross domestic product (GDP). Due to their notorious consumption surplus, the US extended their net debt position to 40 percent of GDP over the same period (Fig. 1)[12]. 

Net foreign assets, 1990 – 2014,, % of GDP

Source: Lane & Milesi-Ferretti (2018).

4. Finally, it also matters when the global economic gravity shift from the USA to China will also be reflected politically[13]. Shifting Wealth is incomplete and possibly endangered in the long run if its economic pillar is not safeguarded by military deterrence and a reduction in dollar dominance. Historically, the global reserve currency came from the leading economy of the time. According to IMF data, China is the largest economy in the world after adjustment for purchasing power; its share of the world product today (2018) is 18.7 percent, while the US share is estimated at 15.1 percent.  Since the USA (and the traditional OECD countries) has lost relative economic weight, the query of the lead currency has been a recurring theme in the context of Shifting Wealth.

Outlook

The dollar still dominates the bel étage of the international monetary system with dominant positions in global payments, reserves and financing vehicles. In the basement, however, the Chinese are already busy laying the pipelines for a reduction in dollar dominance through the yuan. The establishment of new multilateral financing institutions outside the financial system dominated by the West, new transport, energy and digital connections along the Chinese Belt and Road as well as the disintegration of global world trade into regional trading blocs are the prerequisites for the internationalization of the Chinese currency.

According to Eichengreen's account of historical changes in the international monetary system[14], the sequence of internationalization of a currency is: 1. to promote its use in invoicing and settlement of trade; 2. to promote its use in private financial transactions; 3. to promote its use by central banks and governments as a reserve currency.

According to the latest data (2017) from the WTO, China was the largest exporting nation with over 2.26 trillion dollars and a 12.8 percentage share of world trade. China's imports amounted to 1.84 trillion dollars in 2017, making China the second largest importing country after the USA with a global import share of 10.2 percent. The USA's departure from multilateralism and world trade is promoting the rise of the yuan. Mega-projects focused on the US - the Transpacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP) - were suspended. Instead, the Pacific-Asian region is negotiating the China-led trading bloc ´Regional Comprehensive Economic Partnership´ (RCEP), which comprises thirteen countries alongside China, India and Japan and thus more than half of humanity.

Since the end of the yuan´s dollar peg in August 2015, there has been an empirically closer connection (comovement between currencies) between China's bilateral trade links and the respective yuan correlation. Therefore, the RCEP is likely to promote a yuan block in Asia. A rising influence of the Chinese currency has also recently been observed in some Latin American currencies. The growing yuan block will therefore also promote the yuan as a reserve currency in the future for reasons of stability and portfolio theory.

China's Belt-Road Initiative (BRI), with a planned investment volume of over 100 billion dollars, plays a key role in the internationalization of the yuan. The BRI was announced at the Silk Road Summit in Beijing in May 2017 by Xi Jinping, head of state and party leader, to 29 heads of state and government of the participating countries in Asia, Africa and Europe. The use of the yuan is to be promoted by the payment flows (yuan loans) in the countries along the routes accompanying the trading activities. The yuan loans originate, among others, from the Asian Infrastructure Investment Bank (AIIB) founded by China in 2016, which grants BRI infrastructure loans outside the Bretton Woods system dominated by the USA[15].

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[1] Translated version of an invited contribution to debate the dollar dominance in Wirtschaftsdienst.

[2] Argentina, Egypt, Indonesia, Jamaica and Turkey.

[3] S. Dullien (2018), “The German barrier to a global euro”, ECFR, 30^th August.

[4] The reserve currency country should continuously provide the world economy with risk-free liquidity through a current account deficit, which may undermine confidence in the reserve currency in the long run.

[5] IMF (2018), Currency Composition of Official Foreign Exchange Reserves (COFER), http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4, 1^st quarter 2018.

[6] G. Gopinath & J. Stein (2018), “Banking, Trade, and the Making of a Dominant Currency”, NBER Working Paper No. 24485, April.

[7] G. Gopinath & J. Stein (2018), op.cit.

[8] So already then French finance minister Giscard d´Estaing in 1965.

[9] B. Eichengreen, R. Hausmann, U. Panizza, U (2003), „ Currency Mismatches, Debt Intolerance and Original Sin. Why They Are Not the Same and Why It Matters”, NBER Working Paper  No. 10036, October.

[10] SWIFT is the acronym for the private Brussels-based service provider ´Society for Worldwide Interbank Financial Telecommunication´. RMB stands for Renminbi, the alternative name for the currency of the People's Republic of China.
[11] K. Yeung (2018), “ US-China trade war is helping to boost use of yuan in international transactions”, South China Morning Post, 9^th September.

[12] P. Lane, G.-M. Milesi-Ferretti (2018), “The External Wealth of Nations Revisited: International Financial Integration in the Aftermath of the Global Financial Crisis”, in: IMF Economic Review, International Monetary Fund, Vol. 66(1), S. 189-222, March.

[13] Many think that US President Trump is “A Recipe for Disaster”, and the US going insane,  as  predicted in a Simpsons series in 2000 already. See “Simpsons writer says President Trump episode was 'warning to US', The Guardian, 18^th March 2016.

[14] B. Eichengreen, “The renminbi as an international currency”, in: Journal of Policy Modeling, 2011, Vol. 33. 5, pp. 723-730.

[15] H. Reisen (2015), “Will the AIIB and the NDB help reform multilateral development banking?”, Global Policy, September, https://doi.org/10.1111/1758-5899.12250.