Fed Economist Describes Scenarios for Decreasing Dollar Hegemony

The Fed economist, based on confidential data, considered three scenarios for the decline in the role of the dollar as the world's reserve currency due to geopolitical factors. One involves the loss of his dominant position,

If China, Hong Kong, as well as a number of countries in Africa, Asia, Latin America and the Middle East convert export settlements with countries outside the direct orbit of US influence into yuan , the dollar may lose its status as the prevailing reserve currency. This is the outcome of one of the scenarios that Colin Wise, Senior Economist of the International Finance Department of the Federal Reserve System (FRS), considered (RBC read his article published on October 18).

For the analysis, Wise used confidential US Treasury data on US financial assets owned by individual states (these data are published in aggregate form).

Western sanctions against the Bank of Russia, which led to the blocking of its foreign exchange reserves, have reinforced the thoughts of other governments that their dollar assets are not completely safe, the author writes. However, in reality, the widespread abandonment of the dollar due to geopolitical reasons, in his opinion, is unlikely.

How reliance on the dollar is connected to geopolitics

The role of the dollar as the main reserve currency is part of the US hegemony, which also lies in the fact that the country is the world's largest economy and has the most powerful army, the article says. It has been proven that the status of any currency is influenced by geopolitical reasons: for example, countries hold reserves in a certain currency, as they use security guarantees of the issuing country or thereby express support for the political goals and values ​​of the issuing state.

For example, both Germany and France are members of NATO, but only France has nuclear weapons. “Not surprisingly, Germany holds the bulk of its reserves in dollars compared to France,” Weiss notes. At the same time, countries that have faced financial sanctions from the US (not necessarily on reserves) are reducing investments in dollars immediately after the introduction of restrictions. This is exactly what Turkey could have done, even despite being a member of NATO, the economist admits.

The US sanctions against the Bank of Russia have heightened risk perception in all countries, but to varying degrees. States with strong geopolitical ties to the US are less concerned about this: economic sanctions tend to be imposed on non-democratic governments that violate human rights, whose foreign policy is contrary to US interests, the paper argues.

How countries are divided according to their relationship to the dollar

Weis identifies several groups of dollar reserve holders:

countries united with the United States by mutual defense treaties. These include NATO members, as well as Japan, South Korea, Brazil, etc.; countries with the status of a key ally outside of NATO. Among them are Israel, Tunisia, Egypt, Pakistan; countries associated with the United States through the import of American weapons or participation in joint exercises. These countries include, in particular, Ukraine, Hong Kong, Saudi Arabia, UAE; countries with a historically neutral status. For example, Switzerland, Ireland, Sweden; China. The economist singles it out in a separate category, since it is the yuan that is the main competitor of the dollar for world hegemony.

The first two categories account for the bulk of foreign dollar reserves, the economist estimated. As of the end of 2021, their assets in dollars accounted for about 55% of all reserves of foreign countries in this currency. This proportion has remained relatively stable over the past ten years, in the range of 50-60%, the article says. At the same time, countries that do not have a formal alliance with the United States, but receive military support from them in one form or another, have 15% of all dollar reserves in the world. The remaining 30% of dollar reserves are held by China and neutral countries (despite the fact that Finland and Sweden began joining NATO in 2022).

According to the IMF, world foreign exchange reserves in US dollars in the second quarter of 2022 amounted to 59.5% of the total, while in 2015 this share reached 66%, and in 1999 - 71%.

Three scenarios for the decline of the dollar

Weiss identifies three possible scenarios for reducing the dollar's dominance as the world's reserve currency. To estimate the scale of this process, the economist assumes that a 1 percentage point (pp) reduction in the use of the dollar in export trade invoices leads to a 0.5 percentage point decrease in the dollar in government official reserves. in favor of the yuan. Approximately 80% of export invoices (accounts for payment of deliveries) worldwide are issued in dollars, and academic studies have shown such a correlation between these parameters. Accordingly, if we assume that one or another group of countries transfers their export settlements with states that do not have geopolitical proximity to the United States from the dollar to another currency, one can estimate how their dollar reserves will decrease.

Reduction of dollar reserves by developing countries in Africa, Central Asia, Latin America, the Middle East (43 countries)

These countries are most likely to abandon the dollar because they do not have a formal military alliance with the United States, and even if they have defense ties, they build close ties with China and Russia in parallel (one such example is India). According to Wise, if exports from these states (except for supplies to NATO countries, US allies and neutral countries) are transferred from dollars to yuan, then the share of the dollar in world reserves will decrease by 6.2 percentage points, or by $800 billion. However, this will not affect its status as the most popular reserve currency. More than 40% of this amount ($800 billion) will go to Saudi Arabia and India.

Reduction of dollar reserves by 43 countries, as well as China and Hong Kong

China's desire to diversify reserves by reducing dependence on the US is no secret: the country is quite capable of reducing dollar holdings by 10 percentage points, or $320 billion, the article says. Due to the growing influence of China, Hong Kong also feels the threat of Western sanctions, which may provoke it to abandon the system of linking its currency to the US dollar (Linked Exchange Rate System, the Hong Kong dollar can only fluctuate in the range of 7.75-7.85 to the US dollar) and convert part of exports to yuan, by analogy with the 43 countries considered earlier, the article says. This will allow him to replace 170 billion dollars of assets.

Thus, in aggregate, the implementation of this scenario will reduce the share of the dollar in world reserves by 10 percentage points, or by $1.3 trillion. “This will mean that the dollar will cease to be the main reserve currency,” notes Wise.

Long term scenario

Given that the share of exports to non-Western countries is likely to increase over the years, the share of liquidated dollar reserves could also grow, the economist admits. In the case of a non-linear relationship between dollar settlements in exports and dollar reserves, a decrease by 1 p.p. the share of dollar invoices in trade leads to a decrease in the share of dollar reserves by 1.1 percentage points, the author calculated. The first scenario would then lead to a decrease in dollar reserves by 11.8 percentage points. (the largest contribution to this will be made by Saudi Arabia, India and Brazil), and the second (with the addition of China and Hong Kong) - to a decrease of 17 p.p. Even in such a scenario of a multipolar international financial system, the dollar will retain an important role - its share in global reserves will still exceed the shares of other currencies by two or more times, Wise notes.

The author emphasizes that he considers scenarios of a widespread, geopolitically motivated abandonment of the dollar to be unlikely: today too many countries have close ties with the United States and economic incentives to accumulate reserves in this particular currency. In order for the proposed scenarios to actually materialize, several fundamental changes must occur: for example, China will need to give up capital controls, and Saudi Arabia will need to abandon its national currency pegging to the dollar.

However, no one guarantees that the US will maintain its geopolitical alliances in the future. And in addition to geopolitical factors, the decline in the role of the dollar may have others - for example, the deepening of financial markets in non-traditional reserve currencies (Australian dollar, Japanese yen, etc.), the article says.

Other opinions

Wise's work was apparently motivated by sanctions against the Bank of Russia, says former US Treasury Department economist Brad Setser. “These sanctions are often interpreted as a threat to the global role of the dollar, but in reality they rather showed that diversification away from the dollar does not provide sufficient protection,” he points out (if only because the assets of the Bank of Russia in euros were also frozen).

“The dollar offers more yield (so far) and more liquidity than the yuan. In addition, diversification in favor of the yuan is also fraught with geopolitical risks for large reserve holders (Japan is not an ally of China, Taiwan is for obvious reasons, India has a border dispute with China in the Himalayas),” Setser wrote.

In the medium term, the role of the US dollar in the global financial system will decline due to the acceleration of de-dollarization processes in the countries of the world, the decline in global foreign exchange reserves, and the expansion of the use of digital national currencies - in this way, "the architecture of the global financial system will be updated," noted experts from the Faculty of World Economy and world politics NRU HSE.

In their opinion, the freezing of the reserves of the Bank of Russia as part of the sanctions pressure "created a significant precedent for the loss of confidence of the countries of the world (especially developing countries) in the US dollar."

However, UC Santa Cruz economist Michael Dooley wrote that "high-risk countries that exit the dollar bloc will have very limited opportunities to attract foreign investors." “The remaining members of the dollar bloc will only increase their integration in the capital markets and the corresponding demand for the dollar and other US assets,” he and his co-authors argued in an April article.