Alicia García Herrero (Natixis) | The US dollar has officially ruled the international monetary system since the Bretton Woods Agreement in 1944. No other currency has been able to challenge the dollar notwithstanding the ups and down of the US economy both in terms of growth but also inflation.
Notwithstanding its overall dominance, things are changing. This is particularly true for the waning share of the US dollar in the central bank holdings of foreign exchange reserves. More specifically, in the last twenty years, the US dollar has lost over 12 percentage points of market share, from 72% in 201 to 59% in 2021 (Graph 1). One could have imagined that it would have been the euro to take up that loss of market share by the US dollar since it is the currency of an economic area of a size close to that of the US and with a fully open capital account. Another potential winner could have been the RMB given China’s rapid growth in the last twenty years and its sheer size by now, being the second largest economy in the world, in US dollar terms, and the first in purchasing power terms, but with a still non-fully convertible currency.
Starting with the euro, while it did increase its market share in the first half of the 2000s, it lost what it had gained as a consequence of the European Sovereign crisis and has only started to recover recently and very slowly. The RMB has been boosted by its acceptance in the IMF Special Drawing Rights (SDR) basket since late 2015 with a 10% share. Since then, its share in central banks’ foreign exchange reserves has increased steadily but from a very low base. As of now, the RMB counts with one fourth of the share of emerging markets’ currencies and is about half way that of the yen and the British pound.
Notwithstanding the relative reduction in the share of USD in the denomination of foreign reserves, the US dollar remains dominant all other relevant roles of an international currency, such as international debt, international loans, foreign exchange turnover and, more generally, global payments as measured by SWIF transactions (Graph 2). It is in the last aspect, share of global payments where the euro reaches a share which is similar to that of the USD dollar but there have been many up and downs in the last few years and the recent trend, since mid-2021 has again been a reduction of euro-denominated cross-border transactions in favor of those in US dollar (Graph 3).
Key reasons for the euro’s international role to have remained stagnant
Based on the sheer size of the eurozone, the question is why the euro has not managed to gain market share as reserve currency. One of the key reasons is the lack of deep enough financial markets, at least when compared to the US. In fact, credit and equity markets are still national and rather small compared to the US as the euro-zone continues to be dominated by bank leading. Furthermore, bank lending has remained rather national and pan European banks have not yet emerged as much as one would have expected after a Monetary Union in 1998.
A probably even more crucial drawback is the much smaller pool of safe assets, especially since the European crisis in 2010-12, as many member states’ sovereign ratings where downgraded. In fact, as of today, the pool of euro-denominated safe assets is merely 20% of the eurozone GDP, which contrasts very negatively with the pool of risk-free assets in US dollar.
Thirdly, the lack of a single fiscal policy for the euro area also implies that there is no single ultimate backstop for the sovereign debt issued in the eurozone. On that note, the set-up of the Next Generation Fund can be considered a positive step in this direction both in terms of the amount of safe assets in euro but also as an embryo of a single fiscal policy.
Finally, and very importantly, the EU is hardly a hard power, given its dependence on the US for its security. In a word of great power competition, with a much smaller role left for multilateralism and a rule-based order, the EU will find it hard to keep its economic power, which does not bode well for the future of the euro as international currency.
What should we expect from the RMB?
Moving to the RMB one could wonder why the currency of the second largest economy in the world, which is expected to be the largest in a few years, has not been able to garner a more relevant role as international currency. The reasons are several. The most important one is the lack of convertibility. In fact, capital controls are still pervasive in China, especially for outflows and increasingly less so for inflows. Secondly, the liquidity of financial markets is still rather limited although it is improving. This is also true for the amount of safe assets, China’s sovereign bonds. All in all, the international use of the RMB remains rather limited for the size of the Chinese economy, ranking fifth globally, not only after the US dollar and the Euro but also the British Pound and the Japanese yen (Graph 4).
Still, the RMB is bound to benefit from a world of great power competition and the weaponization of the US dollar by US monetary and economic authorities, as a response to a number of external shocks. Iran is a clear case in point but, more recently, even China with financial sanctions being imposed as part of the US’ sanctions against a number of political issues, including Xinjiang and Hong Kong. Finally, Russia’s invasion of Ukraine has led to a much larger deployment of sanctions, which even include the exclusion of several Russian institutions from Swift and the freezing of Russia’s external assets denominated in US dollar as well as on other G7 currencies. Interestingly, the Central Bank of Russia had already been preparing for such eventuality since its seizing of Crimea by massively switching reserves to RMB and gold, compared to international standards. The switch to the RMB, rather than euro or other currencies from developed economies, was to be expected as the US has brought along other developed areas of the world, especially the European Union, on sanctions. This was already the case with the sanctions on Russia related to Crimea and even more so after the new G-7 sanctions have been imposed on Russia after the invasion of Ukraine. In other fact, the fact that sanctions are applied to other G7 currencies means that any shift of forex reserves to avoid potential sanctions will need to happen into non G7 currencies, which is clearly giving a boost to the demand of RMB as store of value, especially for forex reserves. This is all the more so since China has been vocal in declining to accept sanctions against Russia, considering them unilateral. Looking at the volume of RMB transactions (based on Swift data), there does seem to be a noticeable pick up in RMB transactions since the war started but it has come down since possibly because of the increasing uncertainties over the Chinese economy in the light of strict zero covid policies. In the same vein, offshore RMB deposits in Hong Kong peaked at the start of the war but they rapidly came down to their level prior to the invasion of Ukraine. Still we have seen a moderate upward trend since (Graph 5).
What to expect next?
When it comes to the future, it seems clear that the dollar will not be able to hold its exorbitant power for ever as the relative size of its economy shrinks in favor of other currencies from faster growing emerging economies. The question, though, is whether it will be the euro and/or the RMB to take the baton. For the former, there is hardly any doubt that the euro will not be able to take market share from the dollar since the size of its economy is bound to shrink, even relative to the dollar. This is also true for the yen and, possibly the British pound as Britain’s potential growth after Brexit is bound to be lower.
Instead, the RMB should continue to gain market share as it remains stubbornly low for the size of the Chinese economy. However, for the process to accelerate – it remains very slow – the RMB would need to become a convertible currency. Such scenario remains unlikely even if China has continued to open to portfolio inflows but much less has been down on outflows. Such asymmetric financial opening is bound to make it hard for the RMB to reach the market share that would be in line with China’s economic size. In addition, the Chinese economy is expected to decelerate structurally and not to continue to converge with the US economy by 2030.
Instead, other currencies from emerging economies, such as the Indian rupia, the Indonesia rupia and the Brazilian real are bound to move up in the rankings of currencies being used for international transactions. In other words, it is to be expected that the dollar increasingly less central role as the global reserve currency will be taken partially by the RMB but no fully, due to the lack of convertibility, while other currencies from large emerging economies – are expected to take part of the market share lost by the US dollar. In other words, it is very likely that we shall be moving from an international monetary system dominated by the dominant reserve currency, the US dollar, to a more multilateral one where more currencies can serve the purpose of being used international. The timeframe for such change remains long due to the stickiness of international financial markets but could be accelerated by the introduction of digital currencies, especially the RMB, as well as the evolution of the US economy relative to the rest of the emerging world. On the latter, the structural deceleration of the Chinese economy, if anything, should further slowdown the process of the demise of the US dollar as key reserve currency unless the US does even worse.
