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05 May 2023

Exorbitant, not much longer

“Change is good, but dollars are better,” a US author of romance novels once wrote. A similarly light-hearted sentiment inspires the discussions about the future role of the US dollar as the world’s leading currency. The consensus view is that the dollar is safe. I think the consensus is wrong. This won’t be a story with a happy ending.

The dollar is the foundation of US global leadership, and the future of the dollar is therefore intricately linked to the debate about geopolitical fragmentation. Brazil’s president, Luiz Inácio Lula da Silva, asked during his recent visit to China: “Why should every country have to be tied to the dollar for trade?… Who decided the dollar would be the (world’s) currency?”

These are good questions. The perhaps surprising answer is that he himself made that decision, together with the other presidents and former leaders of the so-called Brics: Brazil, Russia, India, China, and South Africa. Their economic development models succeeded but also critically depended on the US dollar. During the period of hyper-globalisation, which I would date from 1990 until 2020, the US became the global importer of last resort, and allowed its trade deficit against the rest of the world to increase. China and many other fast developing economies built up savings in the currency they got paid for, the US dollar. They invested those savings into US bonds and other assets. The willingness of the US to absorb the world’s savings surpluses was the engine of globalisation. It assured that the dollar would maintain its role as the leading global currency.

This mechanism explained what happened in the last 20 years, but it won’t tell us what will happen in the next 20. The dollar-fans make the implicit assumption that the geopolitical and geo-economic environment will stay broadly the same.

If the five Brics countries, and the EU for that matter, wanted to end their dependence on the dollar, they would have to do more than just choose another currency to trade in. It is not menu choice, as Lula suggested during the same speech. He and his fellow Brics leaders would have to change they interact with the rest of the world, and with each other.

China is key. It is the world’s second largest economy. In 2021, China derived 43% of its GDP from investment. This is approximately twice the level of the US and other western countries. If China managed to shift parts of its GDP to consumption, it would invariably reduce its external trade surplus, because consumers tend to buy more imported goods. If you want to become less reliant on the US dollar, this is where you would have to start. As a second step, China and the other Brics countries could start trading more with each other, become more self-reliant in their supply chains, and set up their own financial infrastructure.

Shifting economic models is hard. Three years after Brexit, the UK is still struggling to wean itself off a model that depended on close integration with the EU. Germany is finding it hard to maintain competitiveness without cheap Russian gas and with impaired global supply chains. It takes decades to build industrial production lines and supply chains. In China, there are an awful lot of vested political interests at regional level, which rely on the investment boom going on forever. If President Xi Jinping was really keen on extricating from the US dollar, he would need to impose policies that would meet with resistance from regional leaders. In parallel, China would also need to a start a long process of shifting at least part of its $3.2 trillion worth of foreign reserves held in dollars into other currencies. All of this would take a long time, one or two decades may be.

The reason why I think China, Brazil and other countries will ultimately go down that difficult route is the over-use of economic sanctions by the US. When Russia invaded Ukraine last year, the first decision taken by the western alliance was to freeze Russia’s central bank reserves held in the west. Previously the US had threatened German companies involved with the Nord Stream gas pipeline, by cutting them and their banks off their entire dollar cash flows. If two people transact in dollars through their banks, the transaction flow goes through US jurisdiction at one point. This is why it possible for the US administration to impose sanctions in the first place.

The Obama administration has started to develop dollar-based economic sanctions into a primary policy tool. Dollar sanctions have since become a mainstay of US diplomacy. The most insidious version are so-called secondary sanctions. European companies, for example, were forced to comply with US sanctions against Iran because they would otherwise have lost access to dollar markets. On top of those financial sanctions, the US has become far more aggressive in the use of targeted trade sanctions. The Trump administration banned Huawei. The Biden administration banned high-performance semiconductor sales to China. The EU is also now cautious starting to subject trade policy to geopolitical considerations.

I am not making a moral or political case against sanctions. Sanctions can bring short-term policy successes, but they come with a long-term cost that is often not accounted for when sanctions are imposed. That cost will be a reduced role of the dollar as the world’s largest currency. Sanctions give incentives to countries to re-organise their economies. We are seeing this happening in Russia right now.

Having the world’s leading currency constitutes an exorbitant privilege. This expression is often attributed to General Charles de Gaulle. The more you use and abuse a privilege, the less of it you have left. This is the mechanism I see at work here.

This is the non-fiction version of a story, in which dollars are not necessarily better.

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