Even exorbitant privileges can be lost and there are a number of factors suggesting that, over time, the US dollar may be at risk of surrendering its lead, if not its role, as the world's preeminent reserve currency.
Some of these factors relate to U.S. policy decisions, others to policy decisions and developments elsewhere, but all point in the same direction. The primary reasons for the dollar's continued dominance are inertia and the lack of viable alternatives, neither of which U.S. policymakers should find comforting for the longer term.
The most obvious U.S. policy contributions to a diminished role for the dollar are from economic sanctions and protectionist trade initiatives. All else equal, protectionist policies divert trade away from the U.S., and may induce new trade partners to settle in currencies other than the dollar.
Sanctions do the same, and since they may effectively preclude dollar settlement, the implications for the dollar are more acute. In addition to the Treasury Department's list of 6,300 Specially Designated Nationals and more than 20 countries against which some type of sanctions are in place, the extraterritoriality of certain sanctions to affect persons and entities in other jurisdictions extends their reach further.
While U.S. policies have clearly pushed some countries, such as Iran and Russia, away from the dollar, officials in China and the euro zone have been actively touting their currencies as reserve and transaction substitutes.
The Chinese renminbi was added to the International Monetary Fund's Special Drawing Rights basket in 2016, joining the dollar, euro, yen and British pound, in a development the Fund said "enhances the attractiveness of the RMB as an international reserve asset." The renminbi was introduced as a numeraire in commodity markets in 2018 when crude oil futures began trading in the Shanghai International Energy Exchange.
A number of European officials have talked up the role of the euro, with European Commission President Jean-Claude Juncker telling the European Parliament in his 2018 annual program address that it is "absurd" that 80% of European energy imports are settled in dollars. France, Germany and the U.K. set up the Instrument in Support of Trade Exchanges (INSTEX) earlier this year to work around U.S. sanctions on Iran, and while it may be more politically symbolic than economically effective, INSTEX confirms that even allies will seek dollar alternatives if policy differences with the U.S. cannot be bridged.
It will be some time before the renminbi or euro poses a serious challenge to the dollar – and they may never do so – but Chinese and European policymakers will be actively looking for opportunities to expand the roles of their currencies, while the US approach toward the dollar in this regard can be characterized as benign neglect, at best.
It is difficult to directionally disentangle the causes and consequences that tie the dollar as the world's reserve currency to U.S. Treasury securities as the globally preferred risk-free asset. But it is worth considering whether a decline in the role of the dollar might be preceded by foreign investors – central bank reserve managers in particular – seeking risk-free dollar assets other than Treasurys.
It is certainly conceivable that the link between Treasurys and the dollar could break down. And if investors were to accept dollar liabilities of issuers other than the U.S. Treasury as risk-free substitutes, they would also likely consider those issuers' non-dollar liabilities similarly. However, highly rated borrowers whose liabilities could be risk-free substitutes for US Treasurys are typically sovereigns as well, and they almost always borrow in their own currencies.
There is another much smaller group of highly rated borrowers that regularly issue debt in dollars as well as other currencies – supranational institutions. State Street Global Advisors estimates that central banks hold about one-third of supranationals' debt compared with 18% of sovereign debt. Central banks hold an even bigger share of supranationals' dollar debt, suggesting reserve managers can and do separate the desire to be invested in dollars from the desire to be invested in US Treasuries.
Even so, the supranationals market lacks size, and will never come close to the Treasury market in terms of depth and liquidity, limiting its role in central bank diversification of risk-free foreign-currency assets.
Final arguments that the dollar could lose its role as the preeminent reserve currency are based on it already happening, albeit slowly.
IMF data reveal the dollar share of foreign reserves fell from a high of 73% in 2001 to 62% at the end of last year. Similarly, the World Gold Council confirms that central banks bought more gold in 2018 than at any other time since the gold standard ended in 1971, extending a string of large net purchases that began after the global financial crisis.
If the trends continue of switching from dollars to other currencies, and from currencies collectively to gold, the dollar's reserve currency status will continue to give ground, but only gradually. Global market preferences for the dollar as the currency of choice and for U.S. Treasurys as the favored risk-free asset show no signs of meaningful past or pending dramatic change.
At the same time, beyond some marginal adjustments, global central bank reserve management practices – the ultimate consideration in bestowing reserve currency status – are still centered on the dollar. Paradoxically, the most powerful forces acting to diminish the dollar's global role are US initiatives to penalize foreign transgressions of American policies and priorities.
The real paradox is that successive actions along these lines may eventually have a cumulative deleterious effect on the dollar that ultimately harms US interests much more.
—James McCormack is global head of sovereigns and supranationals at Fitch Ratings