Global Courant
The position of the US dollar the global ranking of foreign exchange reserves held by other countries is closely monitored. Each slight decrease in its share is interpreted as confirming his imminent demise as the preferred world currency for financial transactions.
The recent drama all around negotiations on raising the limit on the US federal government debt has only fueled these predictions by “dollar doomsayers”, who believe repeated crises over the US government borrowing limit weakens the country’s perceived international stability.
But the real basis of its dominance is world trade – and it would be very complicated to turn the tide of these many transactions away from the US dollar.
The international role of a world currency in the financial markets is ultimately based on its use in non-financial transactions, especially if what is referred to in the trade as a ‘billing currency’. This is the currency in which a company charges its customers.
Worldwide network of delivery and trade
Modern trading can involve many financial transactions. In today’s supply chains, goods are often shipped across borders, and that’s after being produced using a combination of intermediates, usually from different countries.
Suppliers are also not allowed to be paid until after delivery, which means they have to pre-finance production. Getting this financing in the currency they bill makes trading easier and more cost effective.
The dominance of the US dollar may be nearing its end. Photo: Wikimedia Commons
In fact, it would be very inconvenient for all participants in a value chain if the billing and financing of each part of the chain were done in a different currency. Similarly, if most trade is billed and financed in a single currency (currently the US dollar), even banks and companies outside the US have an incentive to denominated and settle financial transactions in that currency.
This status quo becomes difficult to change because no individual organization in the chain has an incentive to switch currencies if others do not do the same.
This is why the US dollar is the most commonly used currency in transactions with third countries — the ones that don’t even involve the US. In such situations it is called a vehicle currency. The Euro is mainly used near Europe, while the US Dollar is widely used in international trade between Asian countries. Researchers call this the dominant currency paradigm.
The ease of using the US dollar, even outside one’s own country, is further supported by the openness and size of US financial markets. They are doing all right 36% of the world total or five times more than euro area markets.
Most trade related financial transactions use short-term creditsuch as using a credit card to buy something. As a result, the banking systems of many countries must be at least partially dollar-based in order to provide this short-term credit.
And so these banks have to invest in the US financial markets to refinance themselves in dollars. They can then provide this to their customers as dollar-based short-term loans.
So it’s fair to say that the US dollar has become the major global currency not only because of US efforts to boost its use internationally. It will also continue to dominate as long as private organizations involved in international trade and finance find it the most convenient currency to use.
What could dethrone the US dollar?
Some governments, such as China’s, may try to offer alternatives to the US dollar, but they are unlikely to succeed.
Transactions between governments, for example for crude oil between China and Saudi Arabia, could be denominated in yuan. But then the Saudi government would have to find something to do with the Chinese currency it receives.
Some could be used to pay for imports from China, but Saudi Arabia imports much less from China (about $30 billion) than it exports (about $49 billion) to the country.
The $600 billion Public Investment Fund (PIF), Saudi Arabia’s sovereign wealth fund, could of course use the yuan to invest in China. But this is difficult on a large scale, because the Chinese currency remains only partially ‘convertible’.
This means that Chinese authorities still monitor many transactions in and out of China, so the PIF may not be able to use its yuan funds as and when it needs them.
Even without convertibility restrictions, few private investors, much less Western investment funds, would be happy to put a lot of money into China if they are at the mercy of the communist party.
China is, of course, the country with the strongest political motives to challenge the hegemony of the US dollar. A natural first step would be for China to diversify its foreign exchange reserves away from the US by investing in other countries. But this is easier said than done.
There are few opportunities to invest hundreds or thousands of billions of dollars outside the US. Figures from the Bank of International Settlements show that the euro area bond market – a place where investors can finance loans to euro area companies and governments – is worth less than a third of that of the US.
Photo: NothingIsEverything / Shutterstock via The Conversation
Also, other major OECD economies, such as Europe and Japan, are more likely to side with the US than China in a major crisis – making such a decision is even easier when they use US dollars for trade.
It was said that states accounts for half of the world’s population refused to condemn the Russian invasion of Ukraine, but this half does not account for much of the global financial markets.
Likewise, it should come as no surprise that democracies dominate the world financially. Businesses and financial markets need trust and an established rule of law. Non-democratic regimes have no basis for establishing the rule of law and every investor is ultimately subject to the whims of the ruler.
When it comes to global trade, currency use is supported by a self-reinforcing network of transactions. Because of this, and because of the size of the US financial market, the US dollar’s dominance remains something to lose and others to gain.
Daniel Gross is a practice professor and director of the Institute for European Policy Making, Bocconi University
This article has been republished from The conversation under a Creative Commons license. Read the original article.
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