The global economy and political geography have experienced numerous changes in the last century. The end of the Bretton Woods system was one such major event.
Established after World War II, the Bretton Woods system fixed the value of the US dollar against gold at a rate of$ 35 per ounce. Other countries pegged their currencies to the US dollar, and the fixed swap rate determined the value of their currencies in relation to gold. The system worked well in the early post war eras; by the early 1960s, the US dollar had become overvalued, and the system came under immense pressure.
President Lyndon B. Johnson’s Great Society programs, which aimed at reducing poverty and racial inequality in the US, needed huge domestic spending. At the same time, the US accelerated its military involvement in Vietnam, resulting in a sharp increase in military spending. These factors exacerbated the overvaluation of the US dollar, leading to a growing trade deficit and the depletion of US gold reserves. As the 1960s progressed, more and more countries sought to exchange their dollar holdings for gold, resulting in a steady outflow of gold from the US.
The United States’ balance of payments deficit was not only increasing but also accelerating in the 1960s. However, the Fed was able to finance it by luring foreign central banks and private banks to purchase US Treasury bonds. These Treasury bills were the easiest way to get hold of dollars for private banks and foreign central banks to finance their companies’ international commercial activities.
In France, the Bretton Woods system was called privilège exorbitant du dollar (Dollar’s Exorbitant Privilege) as it resulted in an “asymmetric financial system” where non-US citizens saw themselves as supporting American living standards and subsidizing American multinationals.
In simple terms, the US government could print more money to finance their expenditures and debt, while other countries had to back their currencies with actual goods. This created a situation where the US could benefit from the exorbitant privilege of being able to print money at a low cost, while other countries were essentially forced to pay for it. This imbalance caused tension, and in 1965, French President Charles de Gaulle announced that France would begin exchanging its US dollar reserves for gold at the official exchange rate.
Gold has two markets. First, the official market reserved for international institutions, selling gold at a fixed price of $35 per ounce, and second, the free market for private players, where gold was more expensive. This division made it evident that the dollar was losing its trustworthiness.
Frustrated with the situation, France and Germany decided to exchange their dollars for gold that was with the Fed, which resulted in the depletion of the gold reserve. The French President Charles de Gaulle even took the bold step of chartering a World War II French warship, named the Colbert, to hasten the repatriation of the gold.
The fear that other countries might follow suit loomed large, as the Fed’s gold reserve could cover only 20% of the dollar reserves held by foreign central banks. In 1971, the United Kingdom also warned of its intention to repatriate large amounts of its gold. The situation was alarming, and a significant shift was imperative.
The situation worsened with Germany’s withdrawal from the Bretton Woods agreement, triggering a wave of panic and currency crises. By June 1971, the US had lost $22 billion in assets. In July, Switzerland exchanged $50 million of its dollar holdings for gold, and one month later, it pulled the Swiss Franc from the Bretton Woods system. France also redeemed $191 million for gold in August, sending a destroyer to New York Harbor to collect the gold from the Federal Reserve and bring it back to France.
The US government faced a moral dilemma. It could either reduce its domestic spending and military commitments, or it could devalue the dollar against gold to restore balance to the international monetary system. In 1971, President Richard Nixon chose the second option, announcing that the US would no longer exchange dollars for gold at a fixed rate. This move, nicknamed “The Nixon Shock,” effectively ended the Bretton Woods system and marked the beginning of a new era of floating exchange rates.
The US dollar remained the dominant currency for international trade and financial transactions even after the Bretton Woods system. The main reason behind this was America’s strong economy and its strong military presence all around the globe.
Another significant factor was the monetary policies of the Fed and other central banks, which resulted in the stabilization of currency exchange rates and prevented the collapse of the dollar.
These policies included managing interest rates, intervening in foreign exchange markets, and coordinating with other central banks. The US government also implemented fiscal policies to address balance of payments issues, such as reducing government spending and increasing exports.
EURO: The First Challenger to the privilège exorbitant du dollar
In the mid-90s, many economists predicted that the euro could give the dollar a run for its money. Former Fed chairman, Alan Greenspan said that it is possible for the euro to replace the dollar as a reserve currency, or at least become similarly important . And as far back as 1995, econometric analysis suggested that the euro could become the leading reserve currency, provided these two conditions were fulfilled.
(a) All EU members, including the UK, would adopt the euro by 2020.
(b) The European Union would need to create a deep and liquid financial market.
The euro has made significant progress as a currency since the 1990s, but it still hasn’t overtaken the US dollar as main reserve currency. The US dollar remains the reserve currency for finance and all major international trade. Meanwhile, the euro grapples with challenges such as the debt crisis in some European countries, Brexit, and the absence of a cohesive fiscal policy across the EU. Nonetheless, there are still financial experts who hold on to the idea that the euro may eventually give the US dollar a run for its money in the global economy.
Yuan: A Rising Challenger to the Mighty Dollar
So, there’s been a lot of buzz lately about the Chinese yuan giving the US dollar a run for its money. Apparently, lots of countries are getting antsy about how dependent they are on the dollar, especially with all the financial sanctions the US has been dishing out to places like Russia. The Covid-19 pandemic and the Ukraine war have shaken things up even more, with the dollar losing its top spot and the yuan making gains in the global foreign exchange reserves game.
Even the International Monetary Fund is talking about it. Their report, the Composition of Officials of Foreign Exchange Reserves (COFER), showed that while the global foreign exchange reserves went up to $12.85 trillion in Q3 of 2021, the US dollar’s share actually went down to 59.2%.
Now, I know what you’re thinking: the US dollar, British pound, Japanese yen, and European euro are still the big dogs, right? Well, yeah, they’re definitely still holding down the fort. But here’s the deal: in 1999, those four currencies made up a whopping 98% of world foreign exchange reserves. Fast forward to 2021, and that number has dropped to 92%. The IMF report suggests that rather than picking up the slack, central banks around the world are starting to diversify their holdings beyond the usual suspects. Things are definitely heating up in the currency world.
Another thing to note here is, share of central bank reserves.
So, there’s been a lot of buzz about the Chinese yuan challenging the mighty US dollar. Apparently, many other countries are getting antsy about their dependence on the dollar, especially with the financial sanctions that US has been dishing out to places like Russia. The Covid-19 pandemic and the Ukraine war have shaken things up even more, with the dollar losing its top spot and the yuan making gains in the global foreign exchange reserves game.
Even the institutions like International Monetary Fund are also talking about it. Their report, the Composition of Official of Foreign Exchange Reserves (COFER), showed that while the global foreign exchange reserves went up to $12.85 trillion in Q3 of 2021, the US dollar’s share actually went down to 59.2%.
Now, I know what’s going on in your mind: the US dollar, British pound, Japanese yen, and European euro are still the big guys, correct?
Well, yeah, they’re definitely still having the advantage. But here’s the kicker: in 1999, those four currencies made up a whopping 98% of world foreign exchange reserves. Fast forward to 2021, and that number has dropped to 92%. The IMF report suggests that rather than picking up the slack, central banks of the world are starting to diversify their holdings for other currencies beyond the usual suspects. Things are definitely heating up in the currency world!
Another thing to note here is the share of central bank reserves.
The yuan is increasingly being used as central bank reserves. With an approximately 25% share of bank reserves in 2020, it will be the largest non-traditional currency in global reserves. This trend towards the yuan is a significant step towards “de-dollarization” and reducing dependence on the US dollar. In 2016, the yuan was the first emerging-market currency to be included in IMF Special Drawing Rights, previously a privilege of only the big four currencies. Russia has been increasingly settling its monetary transactions with the yuan due to their growing trade and political relations. This has led to a surge in yuan’s share in Russian foreign reserves, going from 12.8% to 17.1% in January 2022. Meanwhile, the US dollar’s share plummeted from 21.1% to 10.9% over the same period.
The main challenge for the mighty dollar is that if more countries decide to trade using their own currencies, it could decrease the demand for the US dollar, potentially causing it to lose value.
Recently, China and Brazil have agreed to do financial transactions and trade in their own currencies. This means that they will no longer rely on the dollar as an intermediary, and will directly exchange yuan for Brazilian reais.
China has made the same agreement with Russia, Saudi Arabia, Iran, and South Africa. Japan and China already agreed in 2011 to trade with their own currencies instead of the dollar.
De-dollarization is not limited to China alone. Other countries are also taking steps to reduce their reliance on the US dollar in international trade and finance. India, for example, has also been moving towards de-dollarization in recent years. In 2019, the Reserve Bank of India (RBI) signed a currency swap agreement with the Bank of Japan, which allowed for the exchange of their respective currencies up to a limit of $75 billion. Moreover, India has been diversifying its foreign exchange reserves away from the US dollar and towards other currencies such as the euro, yen, and yuan. In 2020, the RBI increased its holdings of gold as a means of further diversification. India has also been encouraging the use of its own currency, the rupee, in cross-border trade with neighboring countries such as Nepal, Bhutan, Malaysia, Sri Lanka, and Bangladesh. It has been promoting the use of the rupee as a settlement currency in trade with Iran, which has been subject to US sanctions.
But the trillion-dollar question is: is it possible to topple the dollar from its throne?
The answer is yes but it is not an easy task. The American economy is the largest and most stable, making the US dollar a reliable currency for international transactions. And, the US government and financial institutions are very unlikely to surrender the advantages of the US dollar without a fight. They have a vested interest in maintaining the US dollar’s dominance, and they will likely take steps to protect it.
The main threat to the dollar is not coming from the euro, yuan, or rupee but from the US itself.
Let me explain: the dollar’s exorbitant privilege is rooted in the economic strength of the United States and the trust that the international community has in its economic system. But the economic power of the US is declining, and trust in the dollar is eroding, and there are many reasons for this.
1. The Mighty Dollar’s Weaponization:
The US has long used the dollar’s exorbitant privilege to impose sanctions, impose tariffs, or withhold access to the US financial system. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is often used as a framework to sanction countries. It has been used against Belarus, Iran, and Russia. However, it has also caused resentment and resistance among other countries that seek to reduce their dependence on the dollar and establish alternative payment systems.
2. US debt :
The national debt of the US has been rising for many years, and as of 2023, government debt accounted for 123.4 % of the country’s nominal GDP, which is roughly 31 trillion dollars. This can trigger the collapse of the dollar. The US government is spending much more than it is bringing in through taxes. Because of this, Uncle Sam is borrowing more money to cover the difference. The ever-increasing debt is unsustainable in the long run. The high level of debt may cause investors to lose confidence in the government’s ability to pay it back. As a result, the demand for US treasuries can decrease.
Once the demand for treasuries decreases, the Fed will eventually increase interest rates. This will make it more expensive for the government to borrow additional money, and it will also increase the cost of servicing the debt. If this continues, it will eventually lead to the end of the dollar’s exorbitant privileges and hyperinflation.
3. Oil politics: the Petrodollar is in trouble
In 2023, there are signals that the petrodollar may not be as strong as previously thought, and that the US may need to reassert its dominance. One major change occurred on March 29 when Saudi Arabia announced its plan to become a “dialogue partner” with the Shanghai Cooperation Organization, which is the world’s largest regional defense and political organization. Moreover, at the World Economic Forum in Davos, the Finance Minister of Saudi Arabia, Mohammed Al-Jadaan, stated that “there are no issues discussing how we settle our trade arrangements, whether it’s in the US dollar, the euro, or the Saudi riyal.” Although Saudi Arabia still uses the petrodollar, its actions suggest that it might be looking into alternative currencies. Since Saudi Arabia is the main pillar of the petrodollar, if they start to trade oil in yuan, other OPEC members will follow suit, leading to a domino effect.
4. Inflation and decline in dollar’s purchasing power
Inflation reduces a currency’s purchasing power and what it can buy. This makes imports more expensive and causes a decrease in demand for that currency. The value of the dollar drops when demand declines, which can make inflation worse. This is a vicious cycle that can cause the collapse of a currency.
If the US government continues to borrow and heavily rely on the printing of more money, hyperinflation can occur. This will cause people to lose faith in the currency and will further depreciate the dollar’s value.
The demise of the mighty dollar is no longer simply an unlikely possibility. The likelihood of the dollar’s demise is increasing due to the present economic climate, the debt held by the US government, and the growing tendency of de-dollarization. Only a few things, like inflation and a decline in purchasing power, can cause the dollar to collapse. What the dollar’s future holds is still uncertain, but one thing is certain: as the globe changes, so do the dynamics of major international currencies.