Is dedollarisation a chimaera or is it real? (I)

Written by Thorbjorn Waagstein
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A cartoon from 1905 shows U.S. President Theodore Roosevelt using his “New Diplomacy”—characterized by the phrase “speak softly and carry a big stick”—to police the world. © Library of Congress, Washington, D.C. (LC-DIG-ds-05213)

Despite much talk about the coming dedollarisation of the World Economy, the dollar continues to be the preferred currency for international trade and for building up foreign exchange reserves. There is no risk for the US that the Chinese Yuan will take over this role. But in the same way as US hegemony is about to give way to a multipolar world power system, the dollar hegemony will probably give way to a much more fragmented international financial system.

The central banks of the world hold 60% of their foreign exchange reserves in dollar, 20 % in Euro and most of the rest is Japanese Yen, Swiss Francs and British Pounds. Reserves held in Chinese Yuan constitute only 2.7%. The dollar was on one side of 88% of all foreign exchange trades in April last year, according to the Bank for International Settlements. So was is all the dedollarisation fuss about?

We have earlier discussed the motives that countries have to keep foreign exchange reserves and gold to be able to withstand adverse events and the dilemmas that come with keeping these reserves. Here we shall discuss the role currencies play in facilitating international trade.

When it comes to international trade, China is a much bigger exporter than the US. China exported in 2021 goods and services to the world with a value of 3.55 trillion dollars (USD), while the US export was 2.54 trillion, or 30% lower. Traditionally, most of China’s foreign trade has been carried out in dollar. This is now rapidly changing, as the use of the Chinese Yuan (CNY) is increasing. I n March 2023, 48.6% of all the foreign trade transactions in China were in Yuan, while 46.7% were in dollar. This is of course important for China, given the increasingly hostile US policy against the country, and the shift from dollar to Yuan is largely explained by this policy.

Does that mean that the role of the dollar will be taken over by the Yuan? No, not at all. The present universal use of the dollar was the result of the peculiar situation that arose after World War II, where Germany and Japan lay in ruins, and the economies of most of Europe, including the winning countries England and the Soviet Union, were devastated by the war. The US came out of the war with its economy intact, no bombs had fallen on its lands and its industry was churning out products as never before. Half of all industrial goods in the world were produced in the US in 1945. To avoid a post-war recession, and to counter the Soviet economic and military power, it was important for the US to maintain demand for American goods from Western Europe. So credit lines in dollars were opened for the reconstruction in Western Europe and Japan and industrial products from the US flowed into these countries. The dollar thus became the universal currency, with which one could buy whatever was needed, and hence it was accepted everywhere. Even as the American economic might has crumbled since, the dollar continues its universal role as the preferred currency for international operations.

Dresden 1945. Germany and Japan were in ruins after the war, and the economies of the winners, England and Soviet Union, were devastated, while the US was unscatched. This laid the basis for the dominance of the dollar in the post war period.

No country is today in a position as that of the US in 1945. So no single national currency will be able to take over the role of the dollar. But this simple fact should not be mistaken to mean that the dollar will continue to be the predominant international currency in the future. The only reason why bilateral trade, which doesn’t involve any US parties, is carried out in dollars (and not in local currencies), is that the international banking system is set up around the dollar, and there is a lot of inertia in this system. As it has been working reasonably well, at least for countries that are not under US’ wrath (as Cuba, Venezuela, Syria, Iran, etc.), there hasn’t been any pressing need to change it. With the increasingly hostile US policy towards China and the sanctions against Russia, where the US is using its control of dollar transactions as a political weapon, this is about to change. There are two things driving this: the increasing risk of suddenly being punished by the US, and a desire to lower the cost of international transactions by avoiding having to pass through a US bank. And a third one is coming soon: digital currencies. More on that in the next article.

Much of the discussion has been around the bank messaging system SWIFT, from which countries as Russia, Venezuela and Iran have been excluded, but this is really not the core challenge. SWIFT is only a messaging system that makes it easier for a bank to identify the bank at the other end of a transaction and to be sure it is genuine. That can relatively easily be substituted by other trusted messaging systems. The challenge is that there has to be a clearing system for these transactions.

Most countries have their own clearing systems where transactions between domestic banks are netted out and ultimately net amounts owed are transferred between the banks. As international transfers in dollars have to pass through a US bank (or a US subsidiary of a foreign bank), the clearing of these transfers are done through the national US clearing system ‘Clearing House Interbank Payments System’ (CHIPS). The Chinese Central Bank launched in 2015 its own Cross-Border Interbank Payments System (CIPS). About 1,427 financial institutions in 109 countries and regions have connected to CIPS, but it is presently very small compared to CHIPS (its transactions amounted to only 2.8% of the CHIPS transactions in March 2022). However, it is growing fast. Russia has turned to the Yuan as it has lost access to transactions in dollars and Euros, and several developing countries have agreed to carry out their trade with China in national currencies (lately including Brazil and Argentina).

To facilitate trade between two countries, a bilateral swap system is often set up between the two Central Banks. This means that there are mutual credit lines in the two Central Banks so that for example Brazilian imports from China can be drawn on the Chinese Central Bank, while China’s imports from Brazil can be drawn on the Brazilian Central Bank. These are then netted out (“swapped”) against each other. This requires of course that there is an established rate of exchange for the swap of these currencies. If there is a persistent disequilibrium between exports and imports, there is a challenge, and as China historically has had a surplus on its trade with the world, this has to be dealt with in some way or another. One way of doing it is for China to extend an official credit to the country to finance this trade deficit, as the US did after World War II. Another is to require that the difference is paid in another currency.

An example of the use of foreign exchange swap lines is Russia, which after being excluded from the dollar and Euro financial markets in 2022 has opened bilateral swap lines with many countries, among these China and India. As India has increased its imports of Russian oil during 2022, and as Russia’s imports from India have not increased, India is now running a huge trade deficit with Russia. Russia is therefore complaining that it has billions in Indian banks that it can’t use, as currency restrictions, according to Bank of Russia Governor Elvira Nabiullina, mean that Russian exporters face difficulty in repatriating Indian rupees. At the same time, some Indian companies were complaining in May last year that they had profits from their activities in Russia, which they were unable to get out of the country. It may have been solved by now (as the issue has not been mentioned since), but it shows that it is not that easy to get bilateral swaps to work, when trade is not balanced and the participating countries have cross-border capital controls. Russia has suggested that India could pay the difference in Yuan or Emirate Dirhams, but the issue seems not to have been settled yet.

It has been common to argue that China has to open up its financial markets, if it wants the Yuan to become an international currency. China seemed to be ceding gradually to this pressure from Western countries, eager to get access to the Chinese financial market. But then came the 2008-2009 financial crisis and suddenly the much lauded 'innovative and dynamic' US financial market looked much less attractive to the Chinese political leadership. China had the luck to be largely shielded from the direct effects of the 2008-2009 crisis in the Western financial system, as the link to the US banking system was limited. Even so, China was affected by the fall in demand in the Western economies due to the crisis and responded with a powerful stimulus package that helped both the domestic and the world economy. China continues to open up its financial sector to the world, but the process is gradual and it is evident that the political leadership wants to retain control over the sector.

Lehman Brothers headquarters the day of bankruptcy, 15 September 2008. The fall of Lehman Brothers was the start of the Great Recession. After that China started having second thoughts about emulating the ‘innovative and dynamic’ US financial system. https://commons.wikimedia.org/wiki/File:Lehman_Brothers-NYC-20080915.jpg

However, it has been argued that the Yuan can play an increasing role in international trade, without necessarily opening up the Chinese financial markets, as “unlimited access to deep and liquid Chinese capital markets may not necessarily be essential for Yuan internationalisation. Rather, the Yuan can acquire that role through its use in invoicing and settling China’s foreign trade and payments. China has established a global network of clearing and payments, such that it is now possible to undertake cross-border transactions in Yuan in a wide variety of different jurisdictions.” So their point is the same as the one I have been trying to make here: one thing is the use of a currency for international trade, another is the use of a currency to build up reserves to be able to withstand economic shocks. A currency can fulfil the first role, without necessarily fulfilling the second.

So what will finally come out of this? I agree with the assertion by the International Monetary Fund (IMF) that the most likely outcome is a fragmented, regionally divided international financial system. There will obviously be at least three major currency zones: The dollar zone in the US and its neighbours in the Americas, the Euro zone in the EU and its neighbours, and a Yuan zone in China and the Eastern Asian countries. But there will probably also be a patchwork of bilateral and multilateral swap agreements using local currencies, as most countries will try to diversify the risk of being attached to one foreign currency only.

In a second article we shall look at Central Bank Digital Currencies and their possible impact on the international financial system. To read this second article, click here.

To read the third and last article in this series, click here.