The world is witnessing a significant shift away from the dollar's dominance, and Donald Trump's recent attack on Iran, codenamed Operation Epic Fury, has only accelerated this trend. This aggressive display of force by the US administration has sparked concerns about its disregard for international law and global norms, echoing its previous actions like the on-off tariff regime and the attack on Venezuela.
In the financial realm, this shift away from the US dollar's global dominance is becoming increasingly evident. Despite strong economic growth and soaring stock prices, the trade-weighted dollar has lost 7% of its value over the past year. This decline reflects not only inflationary pressures and interest rate expectations but also a growing perception that the US policy framework is less predictable and stable than it once was.
The emergence of a multipolar system is a more likely outcome, as suggested by experts at the Centre for Inclusive Trade Policy. Instead of one currency replacing the dollar, we are seeing the development of a complex, multi-currency system. International trade continues to be dominated by the US dollar, but the use of the Chinese renminbi is on the rise, facilitated by Beijing's efforts.
However, central banks worldwide have been quietly transitioning away from the dollar as a reserve currency. The share of foreign currency reserves held in dollars has decreased from 71% in 2001 to 57% by the end of last year. This shift has been gradual, with the US Federal Reserve's role during the 2007-2008 credit crisis being a pivotal moment. By providing swap lines to selected countries, the Fed allowed central banks to exchange their currencies for much-needed dollars, effectively saving the offshore dollar system and highlighting the US's immense leverage over the global economy.
The increasing use of economic sanctions as a geopolitical tool, including freezing offshore assets and cutting off access to the SWIFT international payment system, has exposed the risks of 'weaponized interdependence,' as described by US academics Henry Farrell and Abraham Newman. Canadian Prime Minister Mark Carney echoed this sentiment at Davos, warning of the dangers of great powers using economic integration as weapons and financial infrastructure as coercion.
Washington's willingness to leverage its financial dominance has fueled the demand for alternatives to the US dollar. Technological advancements have made settlement and exchange infrastructure cheaper and faster, enabling the development of new financial structures. The European Central Bank's recent announcement to enhance its repo arrangements is an example of this, as it aims to provide a safety net for other central banks during financial crises.
The BRICS countries, including Brazil, China, India, and Russia, have long sought to reduce the dollar's dominance. While the idea of a 'Brics currency' remains theoretical, there is growing discussion about establishing financial links that bypass the US, such as creating swap lines for emergencies and making their central bank digital currencies interchangeable. As Francisco Quintana from Edinburgh Law School points out, the world is witnessing a cumulative set of similar dynamics, indicating a growing awareness of the risks associated with excessive reliance on the US.
However, the US faces potential costs associated with the diminishing dollar dominance. Recent research has highlighted a notable decline in the 'convenience yield' of US Treasuries, which is an estimate of the cost savings for the US government due to Treasuries being a favored safe and liquid asset. High US deficits and rising debt levels may contribute to this decline in trust, and the large US debt pile, projected to reach 130% of GDP in five years, could ultimately prove expensive.
Despite these challenges, US Treasuries remain a sought-after asset during turbulent times, as yields fell on Friday as investors sought refuge from software share price crashes. However, Trump's chaotic regime has given the process of de-dollarization a fresh boost, and governments worldwide are quietly building alternatives. The heavily indebted US of the future may not be pleased with the resulting global financial landscape.
