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Demise of the Reserve Dollar?

3 Nov 2020 | World Economy


It must not be forgotten that today’s practices in domestic and international commerce trace their origins back to those first fundamentals adopted to escape the limitations of barter. Equally, that the Greek and Romans developed, then applied these principles on more significant scale than was to be repeated for nearly a millennium. If medieval Europe’s banking system mark the beginnings of more contemporary practices, it was Britain’s leadership in global Industrialisation that led them to maturation. Essential to the latter was the universal adoption of the gold standard—replacing silver for many countries including the United States—in turn paving way for dominance by the pound sterling.

In order to appreciate where these dynamics are changing in the twenty-first century—and their significance—we must understand the pragmatics that underscored the sine qua non of this original reserve currency:

  1. Economic dominance.
  2. Largest trading nation.
  3. Unchallenged military power.
  4. Global transactions capability.
  5. Communications infrastructure.
  6. Political transparency.
  7. Rule of law.
  8. Net creditor status.

We must also appreciate that each of these elements evolved over time to propel the pound to its unique role and have never been fully replicated nor achieved since. So, while many of the elements listed above undergird the reserve dollar, clear differences do exist. The latter—most especially the move into a totally fiat currency—are critical to understand since they distill into something the far more vulnerable; strength built on perception. Esse est percipi. In 2020 the dollar dominates because the dollar dominates. It is this element based on residual carryover that marks both strength and Achilles' heel. Central here is the ecosystem of the dollar as a stable, cross-border payments system. This is what gives the dollar it’s power, and it is what will end that power. Encouraging the latter is the fact that the system is neither neutral nor benign.

As a de facto monopoly it gives the United States government: 

  • Leverage to use the system financial transactions as a political weapon.
  • Unearned trading privilegessuch as the ability to run otherwise unsustainable balance of payments deficits.
  • The ability to transfer the down-side of quantitative easing to third countries. 
  • Most central banks have no choice but to buy dollars to keep their currencies from appreciating. 

Considering the original reserve currency requirements covered in our opening section. The first quarter of the twenty-first century marks an era in which America has lost its previously overwhelming dominance in economic size, trading significance and comparative military might.  

We suggest this is now evolving into systemic weakness. The US dollar has lost 12 per cent of its value against leading currencies since April 2020, but what makes this decline rather different from previously sharp undulations are the underlying structural shifts which suggest this is going to become a systemic and on-going trend. This threatens a key asset of the dollar, stability. This is real enough given the $7 trillion of quantitative easing (currently equal in value to half of all the gold ever mined) now threatening potentially significant inflation. What amplifies the global impact of this danger are the major structural differences between the pound as dollar as reserve currencies. The latter currently accounts for 58 per cent of all central bank assets, when the pound held a similar proportion in 1952 it did so in a time when 70 per cent of these assets were held in gold. In 2020 that figure is more than reversedwith obvious implications for the dollars vulnerability. While, with political will the impact of these challenges could be delayed, a more immanent threat comes from the potential of digital and blockchain technologies to evolve into a politically neutral, stable, cross-border payments system outside the dollar. 

It is this potential in particular, that is driving the interest of China and other nations in pursuit of the digital currency option. We especially note:

  1. Chinas developmentand now adoptionof digital and blockchain technologies is entering a period of rapid and exponential growth.Tactical in nature, it is part of the countrys aim to become the dominant economic global power by 2049, concomitantly taking leadership in a number of advanced technologies.Current trajectories suggest they will be the worlds first fully digital economy. 
  2. An intermediate goal is Chinas reported design of an East Asia stablecoin" as a regional alternative to the dollar would protect against unwelcome US political interference, as well as potentially increasing cross-border commerce in the region. 
  3. Blockchain technologies are fluid in the sense they can operate both in centralized and decentralized ecosystems; with compete transparency or complete privacy. This duality reflects a wider, inherent elasticity, reflecting blockchains’ extraordinary capacity to evolve beyond its initial remit and purpose. China will seek to utilize aspects of these to pursue avenues of local control, regional and global advantage. 
  4. Numerous press reports suggest that a roll-out of a digital RMB is immanent. This perception is reinforced by the China Construction Banks acknowledged experimentation with digital wallets earlier this year. Given the high level of political will, it seems reasonable to expect that the technology will be implemented for commercial use by Spring 2021, dovetailing into the launch of Chinas next Five-Year Plan; Chinas most tactical and ambitious yet. 
  5. Flowing from digitization a number of major benefits are anticipated for the Sino economy, including ledger transaction verification, fraud reduction, the closing of regulatory loopholes and a reduction in tax evasion. The result will strengthen both local economic confidence and growth, and give the country an increased edge over global competitors. 
  6. Chinas systematic pursuit of these technologies is nowhere more evident than in the number and quality of blockchain related patents the country has secured over the past decade; more than double those coming from the United States. The importance of dominating blockchains global infrastructure provision is clearly understood. Simultaneously it strengthens Chinas role in the the global commercial ecosystem, while reducing third country political interference. 
  7. Ambitious and well-funded anticipation in these technologies by Americas Google and Amazon makes a point in itself. 
  8. Equally to be noted are the blockchain infrastructures China is developing in Paris, Sydney, Sao Paulo, Singapore, Tokyo, Johannesburg, Los Angeles and San Francisco, by-passing traditional avenues and creating large savings in transaction costs running into hundreds of millions of dollars. 
  9.  As with advanced cellular communications, the West finds itself unexpectedly behind the curve in these technologies, and now struggling to catch up. Mindful of the challenges represented by the era of COVID management, both to the commercial sector and Government macroeconomic policies, China is determined to press home its advantage. 
  10. Finally, it needs to be clearly stated that the digital yuan is not intended to replicate nor compete with bitcoin or other cryptocurrencies as it is something altogether different; a system of payment not an asset. 

Notwithstanding Chinas successes, it is evident that the dollar is set to remain the dominant global reserve currency for some time, but that ending its dominance is far from impossible. The lesson of sterling is that once in situ it takes a sustained and relentless flow of unfavorable circumstances to dislodge it. Seven years after the Second World War sterling still accounted 60 per cent of global reserves, with the dollar a poor second at 30 per cent. In the end it was a combination of the 1968 devaluation and the 1970s oil crisis that witnessed the pounds fraction of total foreign currency reserves fall from a third to less than three per cent in ten years. Conversely, the dollar escalated to 80 per cent before falling back to 60 per cent, a figure which seems to reflect its natural equilibrium since.  

The lessons of history can only teach us so much, however. Considering the factors, we cited as the bed-rock of reserve currency status, it is clear that while China possesses economic strength and trading dominance, it lacks convertibility, the transparency of Western jurisprudence (and thus confidence) and most critically of all, a truly global commercial infrastructure. By analogy this is like having a train but no rails upon which it can run.  

Chinas hopeand determined ambitionis that the principles underlying cryptocurrency, blockchain and digital-fiat technologies are going to provide an alternative highway. Theoretically, the chances of this happening sooner or later are very high, and sudden changes in world events can make theory a reality in a hurry when expediency demands it. That other leading economies are pursuing similar policies to China in these regards makes a point in itself.  

As to what we can conclude, at the very least we are seeing a move away from traditional global transaction infrastructures, and while the dollars’ demise as the global reserve currency seems exaggerated, China may successfully create an alternative based on collective, hegemonic alliances, relieving it of many of the perceived downsides of the dollar's dominance.