De-dollarisation: The eroding dominance of the US Dollar

Reasons Behind De-dollarisation

1] The over-dependence on a single currency exposes the nation to risks associated with fluctuations in the value of the dollar, changes in US monetary policy, and potential sanctions or restrictions imposed by the US. The US government has been running large budget deficits for years, and this has led to concerns about inflation and the value of the dollar.

2] The US has been involved in several geopolitical conflicts in recent years, including the wars in Iraq and Afghanistan. These conflicts have led to increased tensions between the US and other countries, which has made some countries less willing to use the dollar.

3] China is the world’s second-largest economy and is becoming increasingly influential in the global trade. China has been promoting the use of its currency, the renminbi, as an alternative to the dollar.

4] Cryptocurrencies, such as Bitcoin, are a new form of digital currency that is not subject to government control. This has made them attractive to people who are looking for an alternative to the dollar.

Countries seek to reduce their overreliance on the US dollar and enhance their economic sovereignty by diversifying their currency reserves and conducting transactions in alternative currencies. Reducing reliance on the US dollar enables countries to develop their financial systems, pursue economic policies aligned with their national interests, and strengthen their financial objectives. Furthermore, nations that are at odds with the US or face geopolitical pressures may seek to minimize their exposure to the dollar, reducing their vulnerability to potential sanctions or economic pressures. This shift towards a multipolar global financial system, where no single currency dominates, may lead to increased financial inclusivity and reduced vulnerabilities associated with currency fluctuations.

Challenges of De-dollarisation

The transition away from the US dollar as the world’s reserve currency, known as de-dollarisation, can be a complex and challenging process. There are a number of potential risks and disruptions that need to be carefully considered before embarking on a de-dollarisation strategy.

One of the biggest challenges is the potential for devaluation or loss of trust in the new currency. If the new currency is not seen as being as stable or as liquid as the dollar, it could lead to economic instability and hinder financial transactions. It is therefore important to build confidence and trust in the new currency before making the switch. Another challenge is that many commodities, such as gold and oil, are priced and traded in dollars. This means that shifting away from the dollar could complicate international transactions and make it more difficult to trade these commodities. This could also hamper foreign direct investment and capital flows. Countries with significant debt in USD will also face special challenges when trying to reduce their reliance on the dollar. If they suddenly move away from the dollar, their debt could become more expensive because their currency may lose value or exchange rates may fluctuate. This could lead to financial instability and make it more difficult to repay the debt.

Finally, de-dollarisation could lead to increased volatility in currency exchange rates during the transition period. Countries with less developed financial markets or limited policy tools may face greater challenges in managing exchange rate volatility. The successful management of these challenges is crucial for preserving global financial stability and sustaining economic growth. It is therefore important to carefully consider all of the potential risks and disruptions before embarking on a de-dollarisation strategy.

De-dollarization considerations for India

For developing countries like India, de-dollarisation offers potential benefits such as reduced vulnerability to US monetary policy fluctuations, enhanced monetary autonomy, and improved financial stability through the diversification of reserves. However, it also poses challenges, including increased exchange rate volatility that can impact trade, investment, and capital flows. Therefore, developing countries like India should adopt a cautious and gradual approach to de-dollarisation, considering the balance between potential benefits and risks.

Is De-dollarization a far-fetched Idea?

The United States has the world’s best financial markets, attracting participants from around the globe. The liquidity and stability of these markets create a strong network effect, making the US dollar indispensable for global financial transactions. The US dollar has long served as the dominant global reserve currency, with central banks holding significant amounts of US dollars to facilitate international trade. Shifting away from the dollar would require diversifying reserve holdings into other currencies, which carries risks and uncertainties related to the stability and liquidity of alternative currencies. Moreover, international financial institutions, such as the International Monetary Fund (IMF) and the World Bank, conduct operations and provide financial assistance in US dollars, reflecting the dollar’s global role and the established infrastructure built around its use. Any shift away from the dollar would necessitate significant structural changes and consensus among member countries.

Absence of a clear alternative to the US dollar

The Euro, Japanese Yen, and British Pound are potential contenders, but they are closely linked to the US economically and politically. Other currencies, like the Chinese Yuan, face obstacles such as capital controls and limited convertibility. Attempts at de-dollarisation through initiatives like BRICS (Brazil, Russia, India, China, and South Africa) face significant challenges. These countries have diverse cultures, politics, and economies, making consensus on a common currency and monetary policy difficult to achieve. A lack of cooperation among member countries could further hinder progress. Bitcoin and cryptocurrency-based solutions, offer potential alternatives, but they currently lack the required infrastructure. While a cryptocurrency-based system may be more feasible than a BRICS currency, significant breakthroughs and developments in decentralized finance are needed to support widespread adoption.

Conclusion

The current global financial system heavily relies on the US dollar, and despite its vulnerabilities, there is currently no clear and attractive alternative to replace it. While the US economy may be facing challenges and its supremacy may be weakening, it still maintains a strong position with credibility in the financial markets. The key factor is the availability of better alternatives. As long as the US continues to provide stability, credibility, and attractive opportunities compared to other options, the world will likely continue to rely on the US dollar. However, if a viable alternative currency emerges that offers similar advantages, the breaking point for the US dollar and its dominance could occur.

(Author is Executive Director & Chief Strategist at Acme Investment Advisors. Views expressed are completely personal. These do not represent the views of Mint.)

Updated: 15 Jul 2023, 12:56 PM IST