For the foreseeable future, the dollar will be the world’s largest reserve currency holding and the most important currency for financial security. Only the dollar provides the deep pool of liquidity necessary for massive crisis trades. Only the U.S. Federal Reserve is trusted to act decisively in crises. The euro is a collection of puddles of liquidity and the ECB is not seen as decisive. While U.S. economic policy and stability are questioned, relative to the European Union and Japan the U.S. position continually strengthens.
Beneath that position, however, a tectonic shift is beginning.
The rise of the rest, particularly China, steadily dilutes the importance of the United States. Countries gradually diversify their reserves. Asian swap agreements gradually dilute the importance of dollar liquidity. Denomination of trade in euros grows steadily, in RMB spectacularly. China’s ¥2.4 trillion of active swap agreements promote local currency trade and investment.
Second, the Fed is mobilizing resistance to the dollar. The first big decline in the role of the dollar followed the 1971 dollar devaluation, which helped stimulate the subsequent emergence of the euro. Then, Treasury Secretary John Connally dismissed foreign pain with “It’s our currency, it’s your problem,” and other countries reacted. In today’s more globalized world, Fed policies are spreading much more pain—property and debt bubbles, inflated prices of staple foods, resultant political instability—over a much longer period of time. While Germany belatedly modified its inward-looking approach to monetary policy just enough to save Europe, the United States has failed to modify Fed norms to befit its hegemonic global role. While Connally’s bluntness has been replaced by bureaucratic professorialism, the message is still “It’s our currency, it’s your problem,” supplemented in foreign eyes by “let the Egyptians eat cake.” In a world out of balance, with unusual, aggressive, and distortive monetary policies, there is a vacuum in the international monetary system. The debilitating consequences for the dollar’s role will dwarf 1971.
Third, reactions against the widespread U.S. use of sanctions against any institution that clears in dollars and offends U.S. foreign policy have been dramatic. A rush into Hong Kong dollar transactions, to avoid U.S. clearing, has strained Hong Kong monetary authorities’ ability to manage the huge surges. Major institutions now avoid SWIFT and CLS because clearing through U.S. firms entails risk of future sanctions. If the stampede continues, this will weaken U.S.-based clearing institutions and evolve away from U.S. dollar proxies to unlinked substitutes.
U.S. refusal to reform and expand the International Monetary Fund and World Bank has backfired. China Development Bank is now more important than the World Bank. Together with originally small initiatives like the BRICS bank and the Asian Infrastructure Investment Bank, this may create a rapidly expanding RMB-based sub-system.
The dollar is secure against challenges from the yen and euro. The RMB currently lacks characteristics of a global currency, including deep, open capital markets, a trusted legal system, and market-determined currency and interest rates. But these weaknesses may fade quickly. The RMB has already surged past the euro as the second currency of international trade. A quarter-century from now, the global monetary system may have two major curren- cies, the dollar and the RMB, and highly diversified swaps and foreign exchange reserves.
This article first ran in the International Economy magazine’s Fall 2014 issue.
The views expressed in this article are the author’s own and do not necessarily reflect Fung Global Institute’s editorial policy.