The role of the dollar as a reserve currency has long been supported by three US attributes: its status as the world’s largest economy, the depth and breadth of its financial markets, and the predictability stemming from institutional maturity and respect for the rule of law.
By adopting the dollar as a medium of exchange and as a store of value, other countries have achieved significant efficiency gains while affording the US the ability to enjoy what former French president Valéry Giscard d’Estaing famously described in the 1960s as an “exorbitant privilege” — essentially, greater power to exchange its own currency for goods and services from other countries while having access to a larger pool of low-cost financing.
It is part of an implicit contract: America benefits in return for responsibly managing the system. Yet the latter aspect of the contract has been challenged in the past 15 years by the 2008 global financial crisis that originated in the US and the sudden imposition of trade tariffs in 2017.
While these events shook the dominance of the dollar, they did not fundamentally undermine it due to what can be described as the “cleanest dirty shirt syndrome”: the dollar may not be a pristine reserve currency but it is still considered cleaner than any other currency for this role.
Over the past two years, this situation has become notably trickier because of the US Federal Reserve’s mishandling of the interest rate hiking cycle and the growing emphasis on resilience in economic and business strategies. Rather than seeking to replace the dollar outright, there is now a step up in efforts to build pipes around it in the world’s trading and payment infrastructures.
China has maintained its leading role in this, strengthening initiatives to create new regional and global institutions, expanding the use of its own currency in bilateral payments and lending agreements, and revamping its Belt and Road Initiative. But it is not just China.
The tough sanctions imposed on Russia have helped spur greater country interest in arrangements that bypass the dollar. Additionally, more nations are starting to perceive it as feasible to reduce their reliance on the US currency over time. They are looking at how Russia has reorientated its trade and substituted for the dollar in both its export and import transactions, albeit in cumbersome and costly ways.
In the face of these developments, the US and its allies essentially have two options. They can work collectively to revamp multilateralism in an inclusive manner that secures buy-in from what Goldman Sachs’ Jared Cohen refers to as the “geopolitical swing states”. This would include modernising the governance, representation and operations of the IMF and World Bank.
Or they can choose to accept the short-term costs and uncertainties associated with the decoupling needed to properly de-risk. The notion of “de-risking, not decoupling” advanced last weekend by the G7 may appear appealing, but it is likely to result in an unstable middle ground rather than a viable new equilibrium.
From an economic perspective, a more inclusive multilateralism supported by a robust rule-based system undoubtedly offers greater benefits compared with the alternatives. However, it is increasingly evident that economics no longer holds the reins in driving the process of trade and international finance. There has been a fundamental shift in the relationship between economics on the one hand, and the combined forces of national security, politics and geopolitics on the other.
It is an inversion that now encourages both the de-risking and the decoupling of cross-border supply chains and cross-border payments, and it is one that the secularly weakened multilateral system cannot effectively counter without a new major effort.
© Financial Times
