Is the USD on its Way Out?

1. Taking a step back…

Concerns have been raised about the US dollar's hegemony as the world's reserve currency since President Nixon's decision to close the gold window in 1971. The rise of China and the growing influence of its currency, the yuan, has fueled speculation about the US dollar's future as the dominant reserve currency. Despite the possibility of reduced US dollar trade in certain regions and the emergence of regional currency blocs, the US dollar has been a hegemon for the past 80 years for a reason.

2. The US dollar's hegemony and challenges

The US dollar has been the world's dominant reserve currency since the end of World War II, thanks to the Bretton Woods Agreement, which established the dollar as the international monetary standard. Its hegemony is primarily due to the perception of the US economy's security and resilience, deep market liquidity, as well as its strong political and cultural ties to Western countries. The dollar now accounts for approximately 58% of global central bank reserves (as of Q4 2022), though it is markedly down from its 72% share in 1999, and is used in more than 75% of global transactions.

However, China's rise as a global economic powerhouse has raised concerns about the US dollar's dominance. China's GDP is second only to that of the United States, and it is the world's third largest trading nation (behind the US and the EU (and yes, the EU is not really a nation)). The Chinese yuan currently accounts for only 3% of global trade, compared to the US dollar's 75% market share. Chinese leaders have stated that they want to raise the yuan's profile as a global currency.

3. Regional currency blocs and the Yuan's ascent

Economists have observed that yuan reserves in countries with closer trade relations with China are steadily increasing. These include Brazil, Russia, Saudi Arabia and Malaysia just to name a few…

This growing influence could lead to the formation of regional currency blocs in the Eastern Hemisphere and South America, with the yuan playing a bigger role in international trade. For example, China has created the Renminbi Liquidity Arrangement in collaboration with Indonesia, Malaysia, Hong Kong, Singapore, and Chile, with each country contributing 15 billion yuan (about $2.2 billion) to the initiative. Furthermore, because of Western sanctions, the yuan has already become the de facto reserve currency in Russia, with the yuan overtaking the dollar in transaction volume.

4. A multipolar currency world

Despite the rise of regional currency blocs, the yuan's prominence, and Trump’s yelling about the end of the US dollar, the US dollar is likely to maintain its hegemony for a number of reasons.?

For starters, the United States has open markets, whereas China does not. Open markets and free capital flow are required for a currency to achieve reserve status. Therefore, China's tightly controlled economy and lack of transparency make it difficult, if not impossible, for the yuan to fully challenge the dollar's dominance.

Second, the US dollar has the world's largest currency reserves. The dollar is a more appealing option for central banks and investors due to the depth of the US financial markets and the liquidity of its assets. While the yuan's reserves are increasing, they are still a long way from matching the dollar's depth and liquidity. And even then, the US has the Fed to turn the spigots of QE and give the world the liquidity it needs.

Finally, the value of the US dollar is based on the solid foundation of a single, large market of American consumers, as well as strong historical, cultural, and political ties to Western countries. This provides stability to the dollar that other currencies, including the yuan, will likely struggle to achieve.

5. What does all of this mean?

Well, the US dollar is likely to maintain its hegemony for the foreseeable future. The dollar's resilience will be difficult to challenge for a number of reasons.

Even though the US dollar is and will be the world’s reserve currency for the foreseeable future, that doesn't mean that other currencies can't become more important and play a bigger role in international trade and finance. The current rise of the yuan, a potential BRICS currency, and other regional currencies may even result in a more balanced global financial system that is less reliant on a single currency. Though it will more likely result in polarization, sanctions, FX volatility, regional disputes, and trade wars between different trade/currency blocs...

What do you think—is the US dollar gasping its last breath?