Financial Powerplays

Introduction

Recent discussions about the US dollar's dominance in global trade, particularly in the oil sector, have intensified. As stories circulate about potential shifts towards other currencies, notably the Chinese yuan, it's essential to dissect the realities and myths surrounding the dollar's role. This comprehensive analysis delves into the historical context, current trends, and future prospects of the US dollar in global economics, highlighting key facts, figures, and statistical data.

Historical Context and the Myth of the US-Saudi Agreement

A wave of misinformation recently suggested that a 50-year-old US-Saudi agreement to price oil in dollars had expired. Contrary to this narrative, no such formal accord ever existed. Historically, oil has been priced in US dollars long before the 1973 OPEC oil embargo, with the British pound also playing a role. In 1974, following the embargo, the US and Saudi Arabia signed an agreement establishing the Joint Commission on Economic Cooperation. This agreement aimed to sustain their economic relationship, encouraging Saudi investments in the US, particularly in Treasury bills, and securing US military aid for Saudi Arabia.

The Pre-eminence of the US Dollar

Despite some erosion of its dominance, the US dollar remains the world's foremost currency. It accounts for approximately 58% of global foreign reserve holdings and is involved in 88% of all foreign exchange transactions. Additionally, 54% of global export invoicing is conducted in dollars. The oil market, including the vast oil derivatives sector, which is 23 times larger than physical crude oil flows, continues to operate predominantly in dollars. No other currency, including the Chinese yuan, currently poses a significant threat to this status.

US Economic Strength and Changing Dynamics

The US's position as the world's largest oil producer, with net petroleum exports reaching 1.64 million barrels per day in 2023, reinforces the dollar's dominance. A forthcoming US-Saudi security and defense treaty, potentially encompassing civil nuclear arrangements and discussions on Palestinian statehood, further underscores the strategic economic ties between the two nations.

In late 2023, Saudi Arabia and China initiated oil trades denominated in yuan, supported by a $7 billion currency swap agreement to mitigate reliance on the dollar amid US sanctions concerns. This development, however, is part of a broader geopolitical realignment rather than a definitive shift away from the dollar.

Geopolitical Realignment and the Role of the Yuan

IMF's Gita Gopinath highlighted the growing geopolitical divide, with countries aligning towards either the US or China. Since early 2022, the USD's share of trade finance payments for the "China bloc" has declined, while the RMB's share has doubled from around 4% to 8%. This shift reflects broader geopolitical trends rather than a direct challenge to the dollar's supremacy.

China, the top trading partner for about 120 countries, has made significant strides in promoting the yuan. Its Cross-Border Interbank Payments System (CIPS) has gained traction, and approximately 23% of China's total goods trade is now conducted in yuan. Despite these advances, the yuan's share of global payments remains modest at 2.2%, and its share of trade credit is about 4.5%.

Precautionary Measures Against Western Sanctions

The global economic landscape has been reshaped significantly by Western sanctions, particularly those targeting Russian foreign reserves. Following the Russia-Ukraine conflict, the US and its allies froze a substantial portion of Russia's foreign reserves, amounting to hundreds of billions of dollars. This unprecedented move has prompted countries worldwide to reassess their dependence on the US dollar and take precautionary measures to safeguard their economic sovereignty.

Many nations, particularly those with geopolitical tensions with the West, have accelerated their efforts to diversify their foreign exchange reserves. This trend includes increasing gold holdings, entering bilateral currency swap agreements, and exploring alternatives to the dollar for international trade. For instance, China has signed 30 bilateral currency swaps with other central banks to insulate its trade from dollar dependency and mitigate risks associated with US sanctions.

Challenges to the Yuan's Dominance

Several factors limit the yuan's potential to supplant the dollar. It is not freely traded, and many OPEC+ countries continue to peg their currencies to the dollar. Major economies like the EU, Japan, and South Korea predominantly trade in dollars, and global traders benefit from dollar-denominated pricing as a hedge against oil price volatility.

Furthermore, high US interest rates in recent years have increased the cost of dollar-denominated trade financing, contributing to a slight decline in the dollar's role in trade payments. However, this shift has not primarily benefited the yuan. Instead, nontraditional reserve currencies like the Australian dollar, Canadian dollar, and others have seen increased usage.

Impact of US Sanctions and Trade Policies

The US's extensive use of sanctions has prompted countries like Russia, Iran, and Venezuela, accounting for about 14% of global oil flows, to seek alternatives to the dollar. The yuan accounted for nearly 42% of foreign currency trades in Russia by 2023, reflecting a strategic move by China and Russia to diminish the dollar's influence. China's trade with US-sanctioned states underscores its efforts to establish the yuan as a viable alternative for international trade, albeit with limited success.

The Rise of Gold as a Reserve

Another notable trend is the increased use of gold as a reserve, particularly among countries in the China bloc. This rise is driven by concerns over economic uncertainty and geopolitical risks, including sanctions. Gita Gopinath noted that since 2015, the share of gold in the FX reserves of the China bloc has been rising, contrasting with stable gold holdings in the US bloc.

Gold reserves have seen a resurgence as a hedge against geopolitical instability, particularly in the wake of the Russia-Ukraine war. Countries facing potential sanctions risk have turned to gold to diversify their reserves, reflecting a cautious approach to dollar dependency.

Current Trends in Global Trade and Finance

The Russia-Ukraine war and subsequent sanctions have accelerated the diversification of global trade currencies. However, the shift away from the dollar has been gradual and uneven. The yuan's increased role in trade finance for the China bloc is notable, but its global influence remains limited compared to the dollar.

According to the Centre for Strategic and International Studies (CSIS), the yuan's share of global trade payments and reserves is still relatively small. SWIFT data indicates that the yuan accounts for just 2.2% of global payments, and its share of trade credit is around 4-5%. These figures highlight the challenges China faces in promoting the yuan as a dominant global currency.

Future Prospects and the Dollar's Resilience

While the US dollar's share of global reserves has decreased from 70% in the late 1990s to 58% today, it remains significantly higher than any other currency. The reduced role of the US dollar has not been matched by corresponding increases in the shares of the euro, yen, or pound. Instead, nontraditional reserve currencies, including the Australian dollar, Canadian dollar, and South Korean won, have gained prominence.

In an IMF paper, researchers Serkan Arslanalp, Barry Eichengreen, and Chima Simpson-Bell highlighted the diversification of reserve currencies, noting the rise of nontraditional currencies alongside the dollar's continued dominance. This trend underscores the complexity of the global financial system and the multifaceted nature of currency dynamics.

Conclusion

Despite the dynamic and sometimes volatile global economic landscape, the US dollar remains the pre-eminent global currency. The narratives of its decline, often fueled by misinformation, overlook the dollar's deep-rooted advantages and the significant challenges other currencies, notably the yuan, face in attempting to replace it. While the geopolitical landscape continues to evolve and alternative currencies and assets like gold gain prominence, the dollar's entrenched role in global trade, finance, and reserves endures. For now, the death of the dollar remains a tale for social media, not an economic reality.