The United States of America and the US dollar have been a pillar of dominance for decades. However, internal problems such as infamous fiscal and monetary policies, plus external pressures from political and economic rivals have exposed the global superpower’s weaknesses. While the USD is still a major player in the forex market, calls for de-dollarisation are making investors anxious about the greenback’s fate.

In this article, we’ll go through what de-dollarisation is, which markets could be affected, and what it means to traders.

What is de-dollarisation?

De-dollarisation is a global movement by nations to limit the use of the US dollar as the global reserve currency and medium of exchange for international transactions. For example, crude oil exports from Saudi Arabia to China are priced in US dollars. For China to complete the transaction, they need to sell their national currency (Yuan) to purchase US dollars, placing selling pressure on the Chinese Yuan and increasing the value of the US dollar. The idea behind de-dollarisation is to remove the US dollar as the transaction currency of choice and instead deal directly in Chinese Yuan or Saudi Riyal.

To determine the effects of de-dollarisation, we need to first look at the role of the USD in the global economy. This will also allow us to correctly identify the potential consequences of the dollar’s erosion due to the de-dollarisation movement.

The role of USD in the global economy

The US dollar is considered the world’s reserve currency since 1944. A reserve currency is a foreign currency held by central banks worldwide and used for international transactions such as world trade and global investments. This means that most countries have large dollar reserves, making the US dollar an essential factor in a nation’s economy. The prominence of the US dollar in global reserves is significant; as of 2021, the dollar constituted approximately 59% of the world's allocated foreign exchange reserves, according to the International Monetary Fund (IMF).

The US dollar is also the world’s most used invoicing currency. An invoicing currency is the currency used for international transactions. A country must first exchange its local currency for USD to trade with another country.

As per our example above, if Japan wants to buy metals from Australia, it cannot use yen to pay. It must first exchange yen for the US dollar. The US dollar's dominance in international trade, particularly in transactions involving countries like Japan and Australia, is highlighted by its role in Australian exports. According to the Australian Bureau of Statistics, between 2015-16 and 2020-21, the proportion of Australian merchandise exports invoiced in US dollars (USD) increased by 6.3 percentage points to 87.8%, while those invoiced in Australian dollars (AUD) decreased to 9.9%.

Also, according to Eurostat, in 2020, 48.1% of all goods and 79.95% of petroleum and petroleum-related products imported into the EU from non-member countries were invoiced in US dollars.

How did the USD become the international reserve currency?

The US dollar hasn’t always been recognised as the global reserve currency. The Greek drachma, Roman denari, Venetian ducat, the Spanish silver dollar, and the UK pound sterling are some previously globally recognised currencies. The reason for these currencies being able to dominate during their time is because each empire’s currency dominated the world economy and culture at their respective time.

When other countries or people traded with these empires, they often retained the profits they generated in the empire's currency rather than exchanging them.

By the end of World War 2, the US was virtually unscathed, helping it become the world’s biggest economy - generating roughly 50% of the world's GDP. Even today, most of the world’s biggest firms are US-based, and they demand payment in US dollars. Only 4 out of the 20 biggest firms by market cap (in late 2023) were not from the USA.

Source: https://www.whytes.ie

But there are also more direct reasons why the US dollar is today’s main reserve currency. In 1944, with the global economy recovering from the war, 44 Allied nations met to create the Bretton Woods system. This agreement involved countries like the United States, Canada, Western European countries, Australia, and Japan. This required them to peg their currencies to the US dollar. For these countries to peg their currency to the US dollar they needed to hold USD, in order to be able to supply their local banks and users.

The dollar itself was convertible into gold at USD 35 per troy ounce. This system, however, was not a traditional gold standard where all currencies were valued in gold, but rather a fixed exchange rate system with the dollar as a central reference.

On August 15, 1971, US President Richard Nixon ended the dollar's convertibility into gold, marking a shift to fiat currencies, which are government-issued and not backed by physical commodities. This move prompted a gradual shift from fixed exchange rates to floating rates, where market forces determine the value of currencies.

Despite these changes, the US dollar remained the world's primary reserve currency, maintaining its pivotal role in international finance and trade.

Why are there calls for de-dollarisation?

The global movement for de-dollarisation is led mainly by world leaders and business figures who are alarmed by the power that the US holds over world trade. Even a single rate hike by the Federal Reserve can plunge the global markets into chaos, with other currencies also feeling the effect.

Security concerns are also behind the de-dollarisation movement. Russia, for instance, has actively called out the US Treasury for weaponising the US dollar against non-allies. These statements come after the United States and over 30 allies and partners imposed heavy sanctions on Russia in response to its unprovoked invasion of Ukraine, squeezing Russia’s foreign exchange reserves.

One notable organisation that has been making waves towards de-dollarisation is BRICS, an intergovernmental alliance between emerging superpowers Brazil, Russia, India, China, and South Africa. BRICS have entered into bilateral trade agreements with each other and their respective central banks to reduce their dollar reserves and rely more on local currencies.

For example, China and Brazil made headlines on 29 March 2023 when they announced that they would stop using the US dollar as an intermediary currency when trading. This could serve a massive blow to the US dollar as China is one of its biggest rivals for the global market share. At the same time, Brazil is the biggest economy in Latin America. Russia and India followed suit, using Russian rubles and Indian rupees in international trade.

There are also talks of BRICS establishing a common currency to take over the USD as the global reserve currency. Historically speaking, there have been multiple attempts to replace the USD, but none has come close to success. There are a lot of challenges that BRICS, or any other organisation, will face before they can effectively replace the US dollar.

What is the data telling us?

The global shift from the US dollar as the dominant reserve currency is a gradual process. In 1999, approximately 71% of international reserves were held in USD, which declined to about 59% by 2021. This trend indicates a gradual de-dollarisation, although the US dollar still plays a significant role in the global economy.

Several factors are contributing to the continued dominance of the US dollar. One of the primary reasons is the prevalence of US firms in international markets, with many requiring payments in USD. Additionally, the depth and sophistication of the US financial markets, alongside robust commodity trading infrastructures, make the dollar a preferable option.

Other significant currencies face challenges that hinder their potential as viable alternatives to the USD. For instance, China's currency, the Renminbi, is not fully convertible due to solid capital controls, and the currency itself is not free-floating. Moreover, doing business in China is hampered by legal, political, and language barriers. With Russia, due to its involvement in the Ukraine conflict, is notably ostracised from international financial systems.

Whereas Brazil and South Africa, face high inflation and economic volatility, and are also unlikely candidates for reserve currency status. Japan's Yen, while a significant currency, is less appealing due to the heavy involvement of its central bank in the bond market, leading to days with minimal trading activity in the Japanese treasury market, which undermines its attractiveness as a haven for savings.

As for the Indian Rupee, it's not widely considered a potential reserve currency due to several reasons:

While a large and growing economy, it still needs the scale and global financial integration comparable to economies like the US or the Eurozone. The depth and liquidity of India's financial markets are also relatively limited compared to these economies.

The Indian Rupee is not a fully convertible currency, which is a fundamental requirement for a reserve currency. India also faces fiscal deficits, inflation, and regulatory uncertainties that could deter international investors.

The Indian economy is still developing, with significant parts relying on informal sectors, which adds to the unpredictability and risk factors associated with the Rupee.

For a currency to be a reserve currency, there needs to be immense trust and stability associated with it, which currently, the Indian Rupee does not universally command.

The Euro has also been touted as a possible reserve currency. Yet, just a few years ago, there were talks of Greece leaving the Euro, and with more anti-EU parties gaining prominance in Europe, investors are unlikely to want to hold a currency that could potentially disintegrate. With the EU economic area also slowing down and an ageing population, it doesn’t look like a viable reserve currency.

Looking towards the future, it is natural to assume that China will become the next leader, given its size. According to the World Population Prospects 2022, published by the United Nations Population Division, China is projected to have a population of 771.3 million by 2100, while the United States is projected to have a population of 393.9 million by 2100.

If the average Chinese resident earned the same as the average US resident, the Chinese economy would be 1.95 times bigger than the US economy – making China an obvious reserve currency candidate. Yet, as mentioned above, many changes are required before that can happen. And maybe the most significant change required is for them to turn into a democracy, something that is not likely any time soon.

Effects of de-dollarisation in the global markets

With the dollar being so widely interlinked with the global markets, the continuation of the de-dollarisation movement and any moves within it could increase market volatility on a global scale. Here are some of the potential effects of de-dollarisation on the global markets:

Forex

The biggest risk of de-dollarisation is that the value of the USD drops in value as people sell the USD and move into other currencies. A lower-valued USD would also increase inflation in the USA and, in the worst case, create a catastrophic situation if confidence is lost, as the US would be spending more than it earns. Borrowing as a percentage of GDP is 103.4%.

In 2022, the Euro was the second biggest currency reserve held at roughly 20.5% and likely the short-term winner.

In the long run, and following changes to their capital control and economy, the Chinese yuan is a likely winner.

Cryptocurrencies

Cryptocurrencies emerge from the belief that traditional fiat currencies are flawed and that governments often exert excessive control over individual finances. This viewpoint gains momentum in scenarios where high inflation occurs or government actions restrict financial freedom, such as imposing a €10,000 limit on cash transactions in the EU or the financial controls seen in Cyprus. Cryptocurrencies are often touted as a solution in these contexts, offering an alternative to government-regulated monetary systems.

Amidst these developments, the cryptocurrency market is regaining attention as a viable investment option. Major cryptocurrencies like Bitcoin and Ethereum have shown resilience and growth as they gain acceptance among more institutions as possible alternatives to fiat currencies.

Stocks

The US stock market has strong relations to the dollar but it’s not as straightforward as you might think. Some companies would rather have the dollar depreciate than appreciate. Let’s look at the two scenarios.

When the dollar appreciates, US companies that import raw materials, energy or commodities to manufacture goods and services will feel the blow on their balance sheets. If de-dollarisation continues, the purchasing power of the dollar decreases. This means manufacturers will have to spend more to buy the same amount of materials, putting significant pressure on profit margins.

Stocks and indices tracking companies that publish worse-than-expected earnings reports often find themselves in a downward trend.

On the other hand, if the dollar depreciates, US companies that export goods and services will fare better. The inflow of foreign currencies traded against a weaker dollar will mean companies have higher profit margins. At the same time, American goods and services will become more affordable in the global market, creating massive appeal for US products.

Check out how to trade stocks with CFDs here.

Gold

The potential political and economic fallout from de-dollarisation will likely push anxious investors to turn to gold for protection. Gold bugs have for years been using the high US spending and inflation as a reason to get more people to buy gold.

Also, seen as a safe-haven asset, gold shines the most during a crisis. Should nations completely abandon the greenback, it’s safe to say that there will be a window where gold rises in value before investors embrace the USD’s replacement.

The decreased dependence on the US dollar will significantly impact the financial markets, presenting CFD traders with various opportunities to go long or short on various instruments.

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