Dollar Dominance — Dilution, not Demise

Dollar Dominance — Dilution, not Demise

Market events following the Russia-Ukraine conflict in 2022 have stoked a debate regarding the future dominance of the US dollar. At first blush, such a discourse seems perfunctory. According to a Fed study, in the twenty years through 2019, the USD accounted for 96% of cross-border transactions in the Americas, and 74%, in the Asia-Pacific region. Based on a BIS survey in 2022, 88% of FX trades involved currency pairs with the USD on one side. The share of foreign currency debt issuance denominated in USD has remained steady at around 70% since 2010. Crucially, the Fed’s swap lines and repo facilities to select foreign central banks underscore the dollar’s central funding role in the global financial architecture. But proponents of the dollar’s demise highlight [1] the threat to its role as a medium of exchange, as reflected by the increased use of alternative currencies for trade settlement, especially for commodity transactions, and [2] its reduced appeal as a store of value, given secular trends in the composition of official reserve assets. Admittedly, there has been an increase in the use of EM currencies for settling energy trades. Estimates suggest at least one-fifth of global oil transactions are now invoiced in non-USD currencies. Russia, the second largest exporter of oil, presents a case in point. Among its buyers, China, India and Turkey now pay for Russian oil in yuan, ruble and dirham. Notably, 95% of bilateral shipments between China and Russia are settled in either yuan or ruble. Still, a breakthrough in the yuan as a reserve currency is not imminent, given minimal progress on capital account convertibility since its inclusion in the IMF’s Special Drawing Rights (SDR) basket in 2016. It is true that the USD share of FX reserves held by global central banks — involving mainly Treasuries — has witnessed a trend decline to 58% last year, down from a peak of 72% in 2001. Over the same period however, there has been a concurrent accumulation in higher-risk overseas assets by quasi-government agencies (e.g. sovereign wealth funds) and private institutions (e.g. insurance companies) around the world, Asia and Europe in particular. In an environment of quantitative easing, negative interest rates helped spur an insatiable appetite for yield. Given the breadth and depth of US markets, the overall dollar exposure of international investors likely remains significant, in both equities as well as credits. Our prognosis is that the dollar’s status is not at imminent risk of being displaced. While emerging alternatives might over time dilute the dollar influence at the margin, a lethal threat to its hegemony is not in sight. That said, currency dominance should not be conflated with currency strength . Indeed, from a strategy standpoint, the cyclical outlook for the dollar appears less constructive, in our view.

First, an extended period of US market outperformance has led to crowded allocations by international investors. The dollar is therefore subject to the whim of unfavorable technicals, should unhedged positions be cut. Such flows could reflect profit-taking, strategy change, or forced selling induced by mark-to-market losses. Specifically, inordinate FX movements — most recently in Taiwan — could trigger an unwind of carry trades, where purchases of dollar assets are funded by currencies with lower rates. Moreover, in US Treasuries, with more than 60% of offshore holdings concentrated in the front-end bucket of 0–5 years, the market could be vulnerable to liquidation upon maturity. Second, the fundamental theme of US exceptionalism seems to be faltering. The macro policy path has turned markedly less predictable, and has in fact fueled recession fears. Specifically, the lack of clarity on tariffs is likely to exert a toll on future investments, given the cross-border nature of production grids. In fact, it is likely that growth challenges extend beyond manufacturing, with services sectors like tourism and education potentially hard hit. In turn, weaker prospects could accentuate debt sustainability concerns, potentially leading to negative credit actions. Projections by the IMF suggest the US debt-to-GDP ratio could exceed 140% by the end of this decade. Third, geopolitical headwinds against the dollar are likely to persist. In the absence of creditable substitutes, traditional “safe haven” currencies like yen and euro stand to benefit most. The salutary effect could ripple onto select EM currencies as flight-to-quality proxies. Likewise, the diversification appeal for gold in reserve assets ought to gain more traction. On the other hand, the viability of new vehicles remains unclear in the foreseeable future. Crypto alternatives continue to grapple with issues of security and regulation. The proposed BRICS currency is likely to be more theatrics than substance, despite concerted attempts by EM nations to bypass the dollar. The upshot of our analysis is that, notwithstanding the emergence of potential challengers, the US dollar will maintain an undisputed lead as a reserve currency over the secular horizon. However, it faces severe near-term headwinds emanating from economic deceleration, geopolitical uncertainty and unsupportive technicals. With the laggard markets outside of the US poised to play catch-up, we see select non-USD assets as offering the twin benefits of value and diversification.