The strength of the US dollar has been a key theme in global markets since the US Federal Reserve began raising interest rates last year. Despite the Fed’s conditional interest rate pause in May and possible cuts later this year, the dollar remains expensive, especially when compared to the yuan, which recently moved past the psychologically significant exchange rate of seven to one US dollar.
This could partially explain the notably vocal debate by economists and market participants on “de-dollarisation”, the gradual unwinding of US dollar dominance in global trade and finance and the move towards a broader diversity of currencies. Past iterations of this debate focused on the Japanese yen and the euro, but now the yuan is the clear challenger.
Past challengers to global dollar dominance are worthy of analysis since neither the yen nor the euro managed to dethrone the US dollar, primarily because of the US outcompeting both economies from a macro perspective.
Japan’s economy seemed unstoppable in the 1980s. The country had rapidly closed its technology and productivity gap with the US, becoming the world’s second-largest economy. However, it never fully recovered from the bubble economy popping in 1991 as Japan’s population was ageing and shrinking.
Deflation set in, and the Bank of Japan set out on a course of ultra-loose monetary policy, including market intervention and rock-bottom long-term rates. Japan’s weight in global economic and financial activity faded rapidly, with its markets becoming increasingly localised and central bank-dominated.
The euro zone stands in contrast to Japan as its currency’s appeal relied on geopolitics as well as macroeconomic and financial heft. The launch of the euro in 1999 brought more than the harmonisation of a western European economic bloc already larger in population than the US and competitive in terms of gross domestic product, productivity and technology.
It also offered a unique growth model which required each new European Union member to be admitted in stages, giving the euro zone a way to expand organically through economic growth while adding new populations and economies. So why is the euro still playing second fiddle to the US dollar about 25 years after its launch?
Unlike the US, the EU’s widening single market and currency was not accompanied by progressively deeper unification in politics and economic management. Instead, the euro zone crisis of 2010-12 showed that government bonds were not fungible and underlying sovereign risk and financial exposures were different.
With these recent examples in mind, how can we evaluate the currency challenge from China? Unlike Japan and the EU, China’s efforts to internationalise the yuan have been clear and deliberate, rolling out policies to encourage take-up of the currency by global financial actors that paralleled the country’s overall economic expansion.
Chinese policy turned in a different direction in 2015, when the yuan came under pressure and authorities devalued the currency while tightening capital controls on residents. These controls raised concerns about whether the exchange rate or interest rates represented market prices that balance true supply and demand.
Even so, recent events suggest several major developing economies are eager to shift away from the US dollar. Russia and China are trading gas in yuan and roubles. Saudi Arabia is also considering trading in yuan with China. Meanwhile, Brazilian President Luiz Inacio Lula da Silva has said he supports an alternative trading currency for the BRICS grouping of Brazil, Russia, India, China and South Africa.
These anecdotes are compelling, but do they add up to significant financial implications? I say no – at least not yet. The US dollar share of international payments remains roughly stable at around 40 per cent, while the euro accounts for some 30 per cent of extra-euro zone transactions. Meanwhile, the dollar’s reserve share is up significantly from its post-2008 lows.
Parallel payments systems such as China’s Cross-Border Interbank Payment System are growing, but the available information suggests they are having little effect on the pricing of trade, international reserves or financial assets in general. For now, it appears that take-up of CIPS is driven by geopolitical rather than economic or financial considerations.
The available figures don’t suggest rapid or substantial movement away from the US dollar. Given that the yuan is still not fully convertible, what is driving the narrative around its being a competitor to the dollar? The likely answer is that the de-dollarisation story is about geopolitics rather than macro or financial competition.
Geopolitical considerations are certainly salient for some developing countries, but the world’s major reserve holders, other than China and Russia, are unlikely to switch out of US dollar assets any time soon. Many of these countries are part of the US alliance system and are unlikely to feel more secure with exposure to China.
While India is not formally part of the US alliance system, it has its own tensions with China and is moving closer to the US while decoupling from Chinese technology and investment. Saudi Arabia has expressed interest in trading in yuan with China, but the Saudi riyal is still pegged to the US dollar.
From this view, genuine de-dollarisation is still not a major near-term possibility. What is more likely is a continued fragmentation of international payments into other currencies. Ultimately, the US dollar will be dethroned if the US falls behind in economic heft and competitiveness, not by geopolitical manoeuvring.
David Chao is a global market strategist (Asia-Pacific) at Invesco