De-dollarization: The Inevitable Is Now Happening

by Kanishk Mehta

On August 14, 2023, Indian Oil Corporation Ltd, India’s leading oil company, completed the purchase of approximately one million barrels of oil from UAE’s Abu Dhabi National Oil Company (ADNOC). What made this transaction significant was its historic nature, being India’s first payment for crude oil to UAE in Indian rupees. This transaction exemplifies a strategic shift in international trade for India. It follows a circular issued by the Reserve Bank of India (RBI) titled “International Trade Settlement in Indian Rupees” on June 11, 2022, which permits all exports and imports to be denominated and invoiced in rupees (INR). The internationalization of the rupee, while inherently beneficial, gains heightened relevance and timeliness due to the escalating concerns of de-dollarization, rendering it particularly conducive for India's economic diversification.

What exactly is de-dollarization?

De-dollarization refers to the strategic process through which nations aim to reduce their dependence on the United States dollar (USD) across various financial functions, including its role as a reserve currency, medium of exchange, and unit of account.

Breaking it down:

• Reserve Currency: A foreign currency held in significant quantities by central banks as part of a country's foreign exchange reserves, crucial for international trade and investment.
• Medium of Exchange: A reliable and universally accepted intermediary or financial instrument with inherent value, commonly used in international transactions.
• Unit of Account: The standard denomination of money used to measure and compare value, integral for financial accounting and analysis.

How did the US dollar get so dominant?

The US dollar's status as the world's reserve currency traces back to the 1944 Bretton Woods Conference, where nations established the IMF and the World Bank. Initially pegged to gold, the dollar offered stability post-Depression. However, by the 1960s, the US faced dwindling gold reserves, prompting Nixon's 1971 decision to suspend gold convertibility, ending the Bretton Woods system. This pivotal move led to the adoption of a floating exchange rate regime by 1973.

Despite attempts to stabilize currencies, the dollar's dominance persisted due to factors such as market liquidity, financial innovation, investor confidence, and network effects. It emerged as the preferred medium of exchange and store of value globally. Contributing to its dominance are its stable value, the size of the US economy, and geopolitical influence. Additionally, the depth of the US treasury market cements the dollar's status as the leading global reserve asset.

How does the US dollar's dominance benefit the USA?

Famously coined as an "exorbitant privilege" by former French Finance Minister Valéry Giscard d'Estaing in the 1960s, the US dollar’s status as the global currency has empowered the US in the following ways:

1. Lower borrowing costs: Global demand for US dollar-denominated assets reduces the interest rates on US government bonds, aiding in managing the nation's external debt burden.
2. Financial leverage: The US dollar's predominant role in international transactions enhances the effectiveness of US financial sanctions, augmenting the country's ability to enforce its foreign policy objectives.
3. Enforcement mechanism: The widespread use of the US dollar in global trade enables the US to exert control over financial transactions, facilitating the implementation and enforcement of sanctions on targeted entities.
4. Strategic influence: The ubiquity of the US dollar amplifies the impact of US sanctions, restricting the ability of blacklisted entities to engage in international commerce and compelling adherence to US policies.
5. Reinforced trade dominance: As the primary reserve currency, the US dollar strengthens the nation's position in global trade and finance, consolidating its economic strength and geopolitical standing.

Does the US dollar's dominance have any downsides for the USA?

The US does face drawbacks from the global dominance of the US dollar:

1. Economic imbalance: A strong dollar cheapens imports and raises export costs, harming domestic industries and potentially causing job losses.
2. Trade deficit impact: Dollar dominance can contribute to persistent trade deficits, undermining economic stability.
3. Currency manipulation: Other countries' practices of artificially devaluing their currencies to boost exports can disadvantage US exporters.
4. Financial turbulence: During instability, heightened demand for the dollar may worsen trade imbalances, posing challenges to domestic industries.
5. Vulnerability to shocks: Dependency on the dollar exposes the US to external economic disruptions, amplifying volatility.

What's the global impact of dollar dominance?

The dominance of the US dollar in global finance wields profound implications for economies worldwide, influencing trade dynamics, financial stability, and policy decisions:

1. Currency volatility: Fluctuations in the US dollar, driven by policy decisions and market dynamics, create uncertainty in global trade and financial markets, impacting currency valuations worldwide.
2. Trade competitiveness: The predominance of US dollar transactions in international trade complicates the effectiveness of currency depreciation strategies for enhancing export competitiveness, affecting economies like India.
3. Debt exposure: Dollar-denominated debts, particularly prevalent in emerging markets' corporate sectors, expose economies to risks associated with changes in global interest rates and exchange rate movements.
4. Dependency risks: Reliance on a single currency for trade and reserve holdings increases vulnerability to economic shocks originating from changes in US monetary policy or market sentiment.
5. Global financial stability: While the US dollar's status as a global reserve currency offers benefits such as liquidity and stability, its dominance poses systemic risks, necessitating careful management by policymakers worldwide.

Why the surge in de-dollarization trends?

Economic shifts and geopolitical tensions have spurred a global trend towards de-dollarization:

1. Economic vulnerabilities: Reliance on the US dollar exposes nations to risks stemming from fluctuations in its value, US monetary policy changes, and concerns over inflation due to significant budget deficits.
2. Sovereignty and diversification: De-dollarization efforts aim to enhance economic sovereignty by diversifying currency reserves and transactions, reducing reliance on the dollar and aligning with national economic interests.
3. Risk mitigation: Diversifying away from the dollar helps mitigate risks associated with potential US sanctions or economic pressures, enabling countries to pursue independent financial strategies and bolster financial resilience.
4. Geopolitical tensions: The US's involvement in conflicts like those in Iraq and Afghanistan has strained international relations, prompting some nations to seek alternatives to the dollar to reduce dependence on US-centric financial systems.
5. Rise of alternative currencies: China's promotion of the renminbi as a global currency and the emergence of decentralized cryptocurrencies present viable alternatives to the dollar, diversifying global currency options.

How quickly is de-dollarization happening, though?

De-dollarization efforts have gained momentum, but the US dollar still dominates: it accounts for approximately 59% of official foreign exchange reserves as of Q1 2023. Bank of International Settlements data reveals that the dollar is involved in 88% of global trade transactions. The liquidity of the US treasury market impedes de-dollarization, with its $23 trillion size providing a financial haven. Some countries, wary of currency volatility, are cautious about de-dollarization. Yet, policies in nations like India and UAE facilitating trade payments in local currencies, along with strengthening China-Russia ties, signal a gradual erosion of the dollar's influence.

What are the challenges to de-dollarization?

1. Market Disruptions: Could lead to short-term disruptions and uncertainties in global financial markets, affecting trade, investment, and currency values.
2. Transition Challenges: The process of de-dollarization may pose logistical and economic challenges, particularly for countries heavily reliant on the US dollar.
3. Economic Volatility: Shifts in currency preferences could increase volatility in exchange rates, interest rates, and asset prices, impacting businesses and investors.
4. US Economic Impact: Reduced demand for the US dollar may negatively affect the US economy, influencing factors such as trade balances, interest rates, and inflation.
5. International Coordination: Achieving a smooth transition to alternative currencies requires international cooperation and coordination, which may be challenging to achieve.

Who are the contenders? Is the Indian rupee a viable alternative?

In the quest for an alternative to the US dollar, several contenders emerge. The Euro, renowned for stability despite occasional political tensions within the Eurozone. China's Yuan is rising due to China's economic growth, although its centralized control raises concerns. The Japanese Yen boasts stability backed by a strong economy, albeit with limited global reach. Cryptocurrencies offer decentralization and borderless transactions, yet their volatility hampers widespread adoption. Special Drawing Rights (SDRs) offer stability through a currency basket managed by the IMF but are largely confined to institutional use.

The Indian Rupee demonstrates potential as an alternative to the US Dollar owing to India's flourishing economy and expansive tech sector. With a population exceeding a billion, India presents an extensive market for investment and trade. However, capital controls, limited convertibility, and macroeconomic volatility currently restrict its broader adoption. To unlock its full potential, India could address these challenges by liberalizing exchange rate mechanisms, fortifying its monetary policy framework, and facilitating capital account convertibility to enhance the Indian Rupee's appeal as an alternative to the US Dollar.

References

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