Dollar Dominance and Its Role in the Financial Diplomacy


Dr. Karan Thagunna (KATHMANDU, 10 October 2022) – Financial diplomacy is characterized by the effective management of financial relations at the international level through which states manage their foreign relations and make decisions. It represents a subset of economic diplomacy, which has progressed more slowly. Indeed, financial diplomacy employs several actors whose objective is to carry out the negotiation and decision-making process, serving to improve the financial system and develop its insertion in international finance. The International Monetary Fund and the World Bank represent the most dominant and influential institutions in the search to achieve financial diplomacy to their missions of orientation and economic and financial governance.

In the context of financial globalization, we hear more and more about these financial relations controlled by financial diplomacy which aims, through the attempts of governments, to establish stability in the absence of an international commercial regulatory framework. To better understand international economic and financial relations, it is necessary to clarify the role of non-ordinary diplomatic actors such as ministries of finance, central banks, and companies, the banking sector as well as diplomatic forums such as the World Economic Forum, G8 or G20.

The international role of a currency can be measured by its usage as a medium of exchange. The dollar’s central role in world financial markets reflects both the currency dominance by the American leadership and the absence of reasonable alternatives. Currency dominance has also been a linchpin in America’s efforts to shape a global order around free markets and democracy while serving as a foundation for the sustained growth of a more integrated global economy. The U.S. dollar is overwhelmingly the world’s most frequently used currency in global trade. An estimate share over the period 1999-2019, the dollar accounted for 96 percent of trade invoicing in the Americas, 74 percent in the Asia-Pacific region, and 79 percent in the rest of the world. The only exception is Europe, where the euro is dominant.

A key function of a reserved currency is as a store of value which can be saved and retrieved in the future without a significant loss of purchasing power. One measure of confidence in a currency as a store of value is its usage in official foreign exchange reserves. As shown in Figure below, the dollar comprised 60 percent of globally disclosed official foreign reserves in 2021. This share has declined from 71 percent of reserves in 2000, but still far surpassed all other currencies including the euro (21 percent), Japanese yen (6 percent), British pound (5 percent), and the Chinese renminbi (2 percent). Moreover, the decline in the U.S. dollar share has been taken up by a wide range of other currencies, rather than by a single other currency. Thus, while countries have diversified their reserve holdings somewhat over the past two decades, the dollar remains by far the dominant reserve currency.

Source: federalreserve.gov

Financial Diplomacy and Dollar Dominance

“Great powers have great currencies,” wrote the Nobel Laureate Robert Mundell, and it seems uncontroversial that global influence and global money are intertwined. Indeed, if the military strength and economic wealth of the United States underpin the dollar’s central role, America’s global influence is enhanced because its currency dominates trade, finance and sovereign reserves. In the extreme, the United States has been known to leverage its military strength on behalf of economic interests—and indeed, the dollar itself. At different times, for example, Japan, Germany and Saudi Arabia have been reminded that U.S. security guarantees warranted their financial support when the dollar came under strain. Alternatively, during the Suez Crisis (1956-57), the dollar’s dominance allowed the United States to force a British military withdrawal under threat of triggering a run on sterling.

Yet much of the dollar’s influence stems directly from the prestige of America’s institutions and trust in its intentions. Military and economic power support the dollar’s dominant share of trade and investment, but faith in U.S. political institutions has bolstered its role as both a reserve currency and a safe haven. In a world of imperfect choices, other countries have come to rely on the U.S. record of building rules-based financial institutions, proposing agendas for policy coordination and shaping progress toward open markets. This has been the story of the postwar Bretton Woods institutions, U.S. engagement in debt relief negotiations and the response to financial crises.

Benn Steil and Robert E. Litan wrote in Financial Statecraft (2006): The Role of Financial Markets in American Foreign Policy that in 1970, some 90 percent of cross-border money flows were related to the trade of goods and services, while in the early 2000s some 90 percent are for investments or swaps or futures or a financial purpose unrelated to trade.

Financial diplomacy begins with the coordination of macroeconomic policy, investment regimes and banking regulation, but dollar dominance has given the United States a privileged role in a broad field of negotiations including debt restructuring, battles against terrorism and cross border crime. Most notably, targeted financial sanctions have dramatically bolstered political leverage to isolate countries like Venezuela over human rights or Russia over cross border disputes and issues. Washington has sometimes failed to capitalize on all these tools due to poor political leadership or bureaucratic dysfunction, but that may make its accomplishments all the more remarkable across two broad areas. First, U.S. financial diplomacy has been the dominant voice in setting the rules and institutions that reinforce the openness and stability of the global financial system, and consequently support world economic prosperity. Second, the dollar’s dominance has opened conversation on a range of matters that raise global standards and improve cooperation beyond finance.

The scope of financial diplomacy is tricky to distinguish from broader applications of economic power, which are often deployed in commercial channels through higher or lower trade barriers or outright embargoes. If the impact of offering or withholding commercial benefits has become diluted in an integrated world of many alternative suppliers, however, the importance of financial tools has grown. While America’s economic power rose through the twentieth century with its commanding share of global GDP, its financial leverage grew far more sharply over the last three decades.

War in Ukraine and Weaponization of USD

With the outbreak of the war in Ukraine, Western countries have imposed all-rounded sanctions on Russia. This, in turn, has had an impact on the global economic, trade, and financial systems, raising concerns in the market and academic circles about the adjustment of the global financial system. One of the main issues being debated is the status of the U.S. dollar.

Gita Gopinath, First Deputy Managing Director of the International Monetary Fund (IMF) warned that financial sanctions against Russia by the West could gradually weaken the U.S. dollar’s role in the world, leading to further fragmentation of the international monetary system. Analysts such as Goldman Sachs economist Cristina Tessari said the actions of the United States and its allies to freeze Russia’s central bank’s foreign exchange reserves have sparked fears that countries may begin to ditch the dollar due to concerns about the power that the United States could muster thanks to the dominance of the currency.

Kenneth Rogoff, a Harvard University economics professor, said in an interview with Bloomberg that the dominance of the dollar could end within 20 years. The reason is that the U.S. and its allies have launched sanctions due to the Russia-Ukraine war, restricting Russia’s access to the dollar-dominated global financial system. This “weaponization of the dollar” will instead stimulate the acceleration of alternative solutions. Rogoff believes that the U.S. blockade or freezing of the foreign exchange reserves of the Russian central bank is undoubtedly a historic development. The preeminence of financial sanctions on Russia by the U.S.-led Western world could accelerate changes in the international financial system to compete with the U.S. dollar. While this certainly would not happen overnight, what could have taken 50 years may now only take 20 years to realize, said Rogoff.

 

Challenges to the Dollar’s Dominance

Near-term challenges to the U.S. dollar’s dominance appear limited. In modern history there has been only one instance of a predominant currency switching—the replacement of the British pound by the dollar. The dollar rose to prominence after the financial crisis associated with World War I, then solidified its international role after the Bretton Woods Agreement in 1944 (Tooze 2021). However, over a longer horizon there is more risk of a challenge to the dollar’s international status, and some recent developments have the potential to boost the international usage of other currencies.

Increased European integration is one possible source of challenge, as the European Union (EU) is a large economy with fairly deep financial markets, generally free trade, and robust and stable institutions. During the COVID-19 crisis, the EU made plans to issue an unprecedented amount of jointly backed debt. If fiscal integration progresses and a large, liquid market for EU bonds develops, the euro could become more attractive as a reserve currency. This integration could potentially be accelerated by enhancements to the EU’s sovereign debt market infrastructure and introducing a digital euro. Additionally, the euro’s prominent role in corporate and sovereign green finance could bolster its international status if these continue to grow. However, even with more fiscal integration, remaining political separation will continue to cause policy uncertainty.

Another source of challenges to the U.S. dollar’s dominance could be the continued rapid growth of China. Chinese GDP already exceeds U.S. GDP on a purchasing power parity basis (IMF World Economic Outlook, July 2021) and is projected to exceed U.S. GDP in nominal terms in the 2030s. It is also by far the world’s largest exporter, though it lags the United States by value of imports (IMF Direction of Trade Statistics, 2021-Q2). There are significant roadblocks to more widespread use of the Chinese renminbi. Importantly, the renminbi is not freely exchangeable, the Chinese capital account is not open, and investor confidence in Chinese system and institutions is yet to grow like US and EU countries. These factors all make the Chinese renminbi—in whatever form—relatively unattractive for international investors.

A shifting payments landscape could also pose a challenge to the U.S. dollar’s dominance. For example, the rapid growth of digital currencies, both private sector and official, could reduce reliance on the U.S. dollar. Changing consumer and investor preferences, combined with the possibility of new products, could shift the balance of perceived costs and benefits enough at the margin to overcome some of the inertia that helps to maintain the dollar’s leading role. That said, it is unlikely that technology alone could alter the landscape enough to completely offset the long-standing reasons the dollar has been dominant.

Conclusion

The IMF’s latest study report shows the “dollar dominance” appears in its weight in global markets. The US dollar’s share of foreign trade invoicing and international debt issuance and non-banking transactions is well above what the country’s shares of international trade, international bond issuance, and cross-border borrowing would suggest. There are mainly four gravitational factors favor the continuation of the dollar’s central position in international financial markets, in trade invoices and payments, and in public and private foreign exchange reserves – call it “network – complementarity and synergy – effects.” The relative expansion of the other currencies depends on how successfully they manage to offset those factors.

First, the more extensive installed base for dollar-denominated transactions favors the currency. Second, no other monetary system offers an equivalent volume of “investment-grade” government bonds as the United States does. Third, it is also worth noting that “non-traditional currencies” were favored by a partial search for returns in reserve management. The fourth gravitational in favor of the dollar would be the absence of regulations restricting liquidity and asset availability, including capital controls. Despite the sanctions already applied in cases such as Iran, Venezuela, and Russia, there is a difficulty here for Chinese bonds compared to those in dollars and the other three major currencies.

In sum, absent of any large-scale political or economic changes which damage the value of the U.S. dollar as a store of value or medium of exchange and simultaneously bolster the attractiveness of dollar alternatives, the dollar will likely remain the world’s dominant international currency for the foreseeable future. Hence, the dollar’s dominance and its impact on global financial institutions will remain in the days to come. Financial diplomacy will increasingly be weaponized by the United States and its allies on various global stages and forums; however, alternative currencies such as digital crypto can achieve global acceptance sooner.

References

Boz, E., C. Casas, G. Georgiadis, G. Gopinath, H. Le Mezo, A. Mehl, and T. Nguyen (2020). “Patterns in Invoicing Currency in Global Trade.” IMF Working Paper No. 20-126.

Tooze, A. (2021). “The Rise and Fall and Rise (and Fall) of the U.S. Financial Empire.” Foreign Policy https://foreignpolicy.com/2021/01/15/rise-fall-united-states-financial-empire-dollar-global-currency Accessed August 13, 2021.

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