In recent years, there has been a growing trend towards dedollarisation. This refers to the shift towards non-US dollar currencies in international trade instead of the dollar. This trend has accelerated in the wake of the Covid-19 pandemic and the associated economic challenges, as countries seek to reduce their dependence on the US dollar. One area where this trend is particularly relevant is in the oil and gas industry, which has traditionally been dominated by the US dollar. Earlier this year, France completed an LNG gas trade using the Chinese Yuan. Another gas trade in yuan between China and UAE was also completed. In this article, we will explore the implications of dedollarisation for the US and the wider global economy.
How USD became king
The US dollar has been the world reserve currency for nearly a century, meaning its the primary currency for global trade. It achieved this primarily due to two significant developments: the Bretton Woods Agreement and the establishment of the petrodollar system by OPEC.
In 1944, representatives from various nations gathered in Bretton Woods, New Hampshire, to design a post-World War II international monetary system. Under the agreement, the US dollar was chosen as the anchor currency, with other currencies pegged to its value.
In the 1970s, the Organization of the Petroleum Exporting Countries (OPEC) introduced the petrodollar system. OPEC members agreed to price oil exclusively in US dollars and accept payment only in dollars. As oil became an essential commodity globally, countries had to acquire dollars to purchase oil, increasing the demand for the currency. The US’s strong economic performance and stability has helped it retain its position as the world’s reserve currency.
The impact of dedollarisation on the US
Dedollarisation has begun, albeit in a small way. In January 2023, the EU launched a pilot project to test the use of the euro in transactions with non-EU countries, as alternative to the US dollar. The dollar accounted for 70% of foreign exchange reserves at its peak but has now fallen to 59% (link). This has significant implications for the US and some of the main drawbacks are discussed below.
As other countries shift away from the US dollar, the demand for dollars decreases, which could lead to a decrease in the value of the US dollar relative to other currencies. This could result in higher inflation in the US and increased borrowing costs for the US government, which would have to pay higher interest rates to attract investors and service its debt.
Dedollarisation can potentially weaken the US’ ability to impose sanctions on other countries. Currently, the US leverages the dollar’s dominant position to enforce economic sanctions by limiting access to the US financial system. If countries reduce their reliance on the dollar, they would be less vulnerable to these sanctions. It would be more challenging for the US to exert the same level of influence and coerce compliance from other nations. Dedollarisation could lead to the development of alternative payment systems and financial networks that bypass US institutions, diminishing the effectiveness of US sanctions and limiting its ability to shape global economic behaviour.
Another drawback for the US of dedollarisation is that it may be unable to print money to service its debt. Currently, the US owes most of its debt in dollars but in a worst case scenario the Federal Reserve can just create more dollars. It can borrow in its own currency at lower interest rates than foreign countries. If mass dedollarisation occurs and demand for US Treasury bonds decreases, borrowing costs may rise, leading to higher interest payments and potentially straining the US government’s ability to finance its deficits.
Furthermore, the US can currently devalue its currency to end up paying less in real terms. Imagine the US borrowed $100 billion from Germany with an exchange rate of €1 to $1. Here, Germany lent the dollar equivalent of €100 billion. If the US then devalues its currency to an exchange rate of €1 to $2, then pays back the $100 billion in dollars, Germany would receive just €50 billion but the $100 million debt would have been paid. Devaluation comes with its own problems of course and is not done lightly or regularly. As mentioned, a weakened currency makes imports more expensive and can drive up inflation and borrowing costs. But it remains a notable economic lever and this lever is dependent on widespread use of the dollar.
The pros of dedollarisation for the rest of the world
While dedollarisation may have negative implications for the US, it also has potential benefits for the rest of the world. One of the main advantages of dedollarisation is that it reduces the exposure of countries to fluctuations in the US dollar. When countries conduct international trade in US dollars, they are subject to the whims of the US economy and its monetary policy. By using non-US dollar currencies, countries can reduce their dependence on the US and increase their economic autonomy.
Another potential benefit of dedollarisation is that it can increase trade between countries. When countries use their own currencies in trade, it can make it easier and cheaper to conduct transactions, as they do not need to convert their currencies into US dollars. This can lead to increased trade and economic cooperation between countries, which can have positive economic and political implications.
The cons of dedollarisation for the rest of the world
Despite the potential benefits of dedollarisation, there are also some drawbacks to this trend. One of the main concerns is that it could lead to increased currency volatility, as countries shift away from the stable US dollar to other currencies. This could result in increased exchange rate risk and make it more difficult for countries to conduct international trade.
Another potential concern is that dedollarisation could lead to a fragmentation of the global financial system. If countries conduct trade in their own currencies, it could create regional financial systems that are less integrated with the rest of the world. This could make it more difficult for countries to access global financial markets and could limit their economic opportunities.
Taking all into account, the implications of dedollarisation for the global economy are multifaceted. While there are potential benefits and drawbacks to this trend, a significant shift away from the US dollar could reshape international trade, economics and politics. As more countries explore alternative currencies and payment systems, it will be important for policymakers to carefully consider the implications for their country and the wider global economy and work to ensure that any potential drawbacks are mitigated.
We must note that we are still a long way from a genuine move away from the dollar. No other currency is as liquid as the dollar and there’s no clear competitor. The dollar was involved in 88% of global FX transactions last year and in 2020, Dollar-denominated debt outside of the US hit $12.6 trillion, a new record. Governments though the prospect of dedollarisation poses a significant threat to the status quo but this threat is certainly not imminent and may not materialise.