The US dollar has enjoyed a coveted status as the world’s reserve currency ever since World War II (and to some extent, even before).
What does this mean? In short, it means the US dollar is the preferred currency for a variety of purposes, including:
Being held as currency reserves at central banks and major financial institutions.
Being used to complete international transactions.
Being used to purchase and trade a number of commodities, particularly oil.
Typically, central banks, financial institutions, and businesses with reserves of US dollars hold a portion of these in cash, while the remaining are held in the form of US Treasury bonds.
As a result of the dollar’s status as reserve currency, the United States government and its citizens have enjoyed a number of benefits, including lower transaction costs and borrowing costs.
But despite the dollar’s long track record as global reserve currency, there’s no guarantee that this will always be the case. In fact, data from the International Monetary Fund (IMF) shows that the percentage of currency reserves held in US dollars has been on a general decline since the late 1990s.
This trend, known as de-dollarization, is one of the key macroeconomic forces that we believe is contributing to our transition into a secular market regime driven by high inflation.
Below, we define de-dollarization, take a closer look at how the dollar became the world’s reserve currency, the factors driving de-dollarization in recent years, and the effects that this might have on investors.
What Is De-dollarization?
De-dollarization is an ongoing process that sees the global financial system moving away from the US dollar as the primary reserve currency.
In practice, this means that:
Central bank reserves are holding fewer US dollars, in exchange for a greater percentage of other currencies.
More bilateral trade agreements are being signed in which the dollar is not the primary currency.
Key commodities, including oil, are increasingly being purchased with currencies other than the US dollar.
A Brief History of the Dollar As Global Reserve Currency
Before the Dollar: The British Pound
Throughout the 1800s and early 1900s—up until the start of the First World War—the British pound acted as the de facto global reserve currency. This was thanks in large part to the important role played by Britain and its colonies in international trade.
All of this began to change when war broke out in 1914, however. In order to finance the war, many countries involved decided to suspend their use of the gold standard. This meant that their currencies could no longer be exchanged for gold. The decision effectively devalued many global currencies.
Knowing that following suit would threaten the pound’s standing as the world’s reserve currency, Britain refused to abandon the gold standard, and instead relied on large amounts of debt in order to finance the war.
In the aftermath of the war, however, Britain struggled to effectively manage its economy while constrained by the gold standard. In 1931, the country chose to abandon the standard, paving the way for the US dollar to replace it as the global reserve currency.
Enter the Dollar
The transition from pound sterling to US dollar as the world’s reserve currency happened gradually, and then all at once. This occurred for a number of reasons.
First, while many European countries abandoned the gold standard in order to finance the first world war, the United States did not. This lent a semblance of stability to the dollar that other currencies did not have.
Second, the United States emerged from World War I largely unscathed, especially when compared to the vast destruction seen by European countries (in terms of economic activity, infrastructure, and, of course, human life).
And third, when World War II broke out, the United States did not enter the fray directly until 1941 (two years after fighting began). Until that point, the US indirectly supported the Allies with weaponry and other essentials—which were typically paid for in gold. By the end of the war, this meant the United States had the largest gold reserves in the world.
With international gold reserves (aside from the US) depleted, a return to the gold standard after the war would be impossible. But a dollar-denominated system would be feasible, as the US dollar was still backed by gold.
In what would become known as the Bretton Woods agreement, 44 Allied countries devised a new system of foreign exchange. As a result of this 1944 agreement, the currencies of signatory nations would be pegged against the US dollar instead of directly against gold. In place of the gold reserves they would previously have held, these nations would instead come to hold dollars—which could be exchanged for gold.
Threats to the Dollar as Reserve Currency
During the following decades, the United States enjoyed this status largely unchallenged.
That began to change in the 1960s. This was due in part to an increase in spending by the United States from its involvement in the Vietnam War. Perhaps more important, however, was the fact that this period saw the emergence of both Germany and Japan as global manufacturing superpowers threatening the dominance of the United States—a fact that weakened the dollar.
Because the US dollar was pegged to gold, countries that exported goods to the United States for dollars would then exchange those dollars for gold, leading to a large outflow of gold and a diminishing reserve.
In order to stem this outflow, then-President Nixon would close the “gold window,” and effectively remove the United States from the gold standard in 1971.
You may be wondering: If abandoning the gold standard proved to be the death knell for the British pound’s standing as the world’s reserve currency, how is it that the dollar was able to cling on?
The answer lies in oil.
A deal struck between the United States and Saudi Arabia—the leader of OPEC—in the 1970s essentially mandated that global buying and selling of oil needed to be completed in US dollars. Thus, while the dollar may no longer have been considered “as good as gold,” it was considered to be “as good as gold for oil.”
A new term, petrodollar, emerged to speak to this evolution.
As a result of the deal, every oil-importing country in the world needed dollars in order to buy oil. They got these dollars by exporting goods to the United States and being paid in dollars, which they would then use to buy their needed oil. Any dollars that remained after the oil was bought would be used to buy US Treasury bonds, stocks, and real estate.
What’s Changing Now?
Since the early 2000s, the percentage of currency reserves held by central banks dedicated to US dollars has been on a steady, albeit gradual, decline.
In the late 1990s and early 2000s, approximately 78% of all foreign currency reserves consisted of US dollars, according to data compiled by the International Monetary Fund (IMF). Today, the dollar accounts for just 58% of all foreign currency reserves, while the euro accounts for just over 20%.
The remaining 22%? That’s split among an increasing number of currencies, including the Japanese yen, Chinese renminbi, Australian dollar, and Canadian dollar.
This decline has coincided with a number of developments.
As China’s economic might and influence continue to grow, the country has taken deliberate efforts to move away from a dollar-denominated economic system. Since 2011, China has made agreements with a number of countries—including Russia, Japan, Brazil, and Australia—to trade in national currencies instead of dollars. Likewise, India and Russia have entered a similar agreement with each other.
Additionally, a number of international payment systems have emerged in recent years as potential challenges to the US-backed SWIFT. These include:
The Chinese CIPS
The European INSTEX
The Russian SPFS
The dollar’s hegemony is even being challenged on the energy front. In March of 2022, in response to western sanctions over its actions in Ukraine, Russia has effectively forbidden “unfriendly nations” such as the United States and Europe from purchasing gas in any currency other than the Russian ruble. In the same month, it was revealed that China was attempting to make a deal with Saudi Arabia allowing for oil to be purchased using Chinese renminbi.
While the dollar still accounts for the vast majority of all international currency reserves, the factors discussed above have all worked to reduce its standing as the world’s reserve currency over the course of the past 20 years. Today, a world in which the dollar does not enjoy reserve currency status looks a lot more plausible than it did just a few years ago.
Why Investors Should Care About the Threat of De-Dollarization
If the dollar were to indeed lose its status as the world’s reserve currency, it would trigger a number of negative effects for U.S. residents. For starters, it would make it more expensive for American consumers to purchase foreign goods and services. Moreover, it would also make it more difficult for the Federal Reserve to get a handle on inflation.
Why? It all goes back to the fact that central banks hold their excess dollar reserves in the form of US Treasury bonds. Fewer dollars held in reserves means fewer buyers of Treasury bonds. Selling Treasury bonds is one of the Fed’s most potent tools for removing cash from the economy, which subsequently cools inflation.
But that only works so long as there are ample buyers. If not, the Federal Reserve will have to choose between allowing the bond market to crash–which would cause a severe recession–or stepping up to buy the surplus Treasury bonds itself–which would exacerbate inflation.
As of December 2021, an estimated 33% of US federal debt was considered to be “foreign holdings,” i.e., held by foreign investors or foreign central banks. Of this, approximately 54% was specifically held by foreign governments. That means that roughly 18% of all US federal debt is held by foreign governments.
Removing them from the market (or reducing their share of debt purchases) would have a major impact on the bond market—and, really, all aspects of American life.
While it’s far from certain that the dollar will be supplanted as the world’s primary reserve currency, it is a risk that investors should consider.
De-dollarization, alongside other macroeconomic forces, can dramatically influence the performance of your investment portfolio over time. It’s crucial that your portfolio accounts for these risks and factors.
Here at Allio, our portfolios are designed by Wall Street veterans with an understanding of the macroeconomic forces that influence the global and domestic economy.