16 05 2023

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

Chinese President Xi Jinping and Brazilian President Luiz Inacio Lula da Silva, April 14, 2023. Xi held talks with Lula, who is on a state visit to China, in Beijing on Friday. Lula stated: “Every night, I ask myself why all countries have to base their trade on the dollar.” Chinese President Xi Jinping and Brazilian President Luiz Inacio Lula da Silva, April 14, 2023. Xi held talks with Lula, who is on a state visit to China, in Beijing on Friday. Lula stated: “Every night, I ask myself why all countries have to base their trade on the dollar.” Xinhua/Ding Haitao

The present international financial system centred around the US dollar is under pressure from several factors: the use of the dollar to punish other countries, the inflation in the US, the increasing US indebtedness, and the appearance of digital currencies and their potential for making international payments much faster and cheaper without using the dollar. The future is probably a fragmented and regionalised international financial system and a much reduced role of the dollar. But can it work?

To store value, Central Banks have become increasingly worried about the dollar. Both because the real value is declining due to inflation, and because of the increasing use of the dollar to punish US adversaries. As many observers have noted, there are not many alternatives. The Euro is one alternative, but it suffers from the same drawbacks as the dollar. So during the last year, Central Banks have been buying physical gold. Still, gold constitutes only 17% of Central Banks' reserves.

Contrary to what you might believe given the international tensions, the countries with the largest holding of gold as percentage of their reserves are actually EU countries and the US. They hold 53% and 66% of their reserves in gold, respectively, while Russia and China hold only 22% and 3%, respectively. The four biggest holders of gold in absolute terms are the US, Germany, Italy and France – together they hold 46% of all the gold stored in the vaults of the Central Banks. Russia is fifth and China is sixth – together they hold 11%. It is worth noting that the population in many countries is also buying gold. It is estimated that private households in India hold 24,000-25,000 tonnes of gold, equivalent to around 40% of its GDP, and that Russian households bought 50 tonnes of gold during 2022.

The demand for gold implies that the price of gold recently has reached a record level of around 65,000 USD per kilo, almost double the 2016-price. It was expected that the increasing interest rates would drive the gold price down, as no interest is earned on gold, while there is a 4.8% yield on a 1-year US treasury bond and 3.1% on a German 1-year bond. But taking into account inflation, real interest rates are still negative, so if gold can maintain its price, it is still a better investment. Furthermore, Central Banks in many countries are presently looking less at yield and more at security. For the moment, gold looks as more secure than dollar or Euro.

However, while gold is useful for a Central Bank to signal solidity and capacity to withstand adverse advents, it is not practical for international trade. A currency to be used in international trade should be easily convertible into other currencies, and while physical gold is universally valuable, it is costly to use in day-to-day transactions. Here the use of a convertible currency is more convenient.

When preparing for the post-war economy, a conference was held in 1944 in the locality of Bretton Woods with the participation of 44 allied nations, including the Soviet Union. After the chaos of the inter-war period there was a desire for stability, with fixed exchange rates seen as essential for trade, but also for more flexibility than the traditional Gold Standard had provided. The Bretton Woods system was drawn up and fixed the dollar to gold at the existing parity of 35 US dollars per ounce (today it is around 2,000), while all other currencies had fixed, but adjustable, exchange rates to the dollar. The gold standard was abandoned during the Nixon Presidency in 1971 (as the US had troubles financing the Vietnam War).

Harry Dexter White, here with John Maynard Keynes at the Bretton Wood conference. White was the US delegate, and turned down Keynes’ idea of a Bancor currency. https://commons.wikimedia.org/wiki/File:WhiteandKeynes.jpg

At the conference, the English Economist John Maynard Keynes had a more radical proposal. He proposed the creation of a new international currency, the ‘Bancor’, which should be managed by a World Central Bank, with the right to create liquidity (emit Bancors) and charged with clearing the world financial flows. This proposal was at that time turned down by the US in favour of the present dollar based system, but today his ideas have been revived. The critique against the idea of the Bancor is that as there is no international consensus about the role of a supranational World Central Bank, and as there is no way to reconcile the different interests in this context, it is unfortunately a naive, theoretical creation. Taking into account the political controversies around the US (and the European) Central Bank, the controversies at world level would be even more polarized. So I share this critique: in the present international context, it is not workable. A more pragmatic step-wise approach is needed.

For a currency to be able to facilitate international or regional trade it needs to have certain characteristics. The value of it should be relatively stable, so that more or less the same things can be bought for it even if it is stored for some time. It should be broadly accepted by the trade partners. And there should be a way to easily change it into the participating currencies. There are several proposals to create new regional or international currencies. The BRICS countries are toying with this idea, and so are Brazil and Argentina. However, this is not an easy task. The difficulties with the creation of the Euro are evidence of the challenges, and these challenges for the Euro are far from overcome yet. The creation of a new currency is more doable, however, if the level of ambition is lowered, aiming for a currency that only has the role of facilitating trade between the participant, not to substitute the national currencies. It is more like Keynes’ Bancor proposal, and it could be tied to a basket of commodities, as for example gold, silver, copper, oil and perhaps some agricultural crops, to which the participating currencies’ exchange rate can easily be calculated. However, the participating countries would need to create a Central Bank for the currency and agree on the rules for currency emission, as is the case of the IMF when issuing Special Drawing Rights. This will be a very long and complicated process, so it is not around the corner – which does not prevent the US to become nervous about the possibility.

Governor of the Central Bank of South Africa, Lesetja Kganyago, referring to the upcoming BRICS meeting in August, stated on May 12, 2023: Any move toward the creation of a single form of legal tender would spur other debates about the creation of a single central bank and where it would be situated.”

Anyway, as we have seen, the most likely outcome of the present upheaval in the international financial system is fragmentation, with or without new currencies. With a fragmented international financial system, the first challenge is to ensure that the different parts are able to work together. This will of course only possible if the present sanctions policy is not continued, as in this case the whole point is that they should not be able to work together. But suppose pragmatism wins, and there is a willingness to try to make it work. With a system dominated by bilateral swaps, markets have to be created for trading the surplus that countries may have in other countries’ central banks, so let us say a Brazilian company can sell its surplus in the Indian Central Bank swap account to another company in, say China, which needs it to pay for imports (without the need to go through a third currency as dollar or Euro). That could perfectly be done in an electronic market. But I can imagine all sorts of institutional barriers that will make this difficult in practice.

So where are we heading? Difficult to say. As we have seen in the previous articles, the US dollar is unlikely to maintain its present dominant role, so the dedollarisation is real - it is ongoing. Even so, I guess the US will do all it can to maintain the present dollar system by putting together a G7 coalition in defence of it, and then try to attract other countries to this coalition (South Korea, Australia, Norway, Switzerland etc.). Depending on the pace of the present US decoupling from China, we can then end up with two international financial systems with limited interaction between them: one centred around the US (with the rest of the Western countries, including the EU, as an appendix) and another around China. Many big countries will be caught in the middle, wanting to interact with both: India, Brazil, Mexico, Russia, Indonesia, South Africa, Nigeria, Turkey, the ASEAN countries etc. These countries will hold the key to decide the future.

Perhaps the next financial crisis can be the trigger to force a new international economic cooperation, as the G7 will then need support from other countries to overcome it, as they did during the 2008-2009 financial crisis?

So we are living in interesting times, indeed. To quote the Chinese 17th century author Feng Menlong: "Better to be a dog in times of tranquility than a human in times of chaos."


This is the third, and last, article in this series. To read the first article, click here. To read the second, click here.


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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