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What happens if the US$ is replaced as the world reserve currency?
The international financial arena is characterized by the prevalence of the US dollar as the world’s reserve currency. Nonetheless, historical precedent indicates that the status of reserve currencies can undergo transformation over extended durations, with substantial shifts rarely occurring suddenly. Below are potential outcomes in the event of a gradual erosion of the dollar's prominence as the leading global reserve currency:
· economic consequences
Throughout history, changes in the status of reserve currencies have typically unfolded over extended periods rather than abrupt shifts. If the dollar's prominence were to wane, the US could potentially encounter decreased capital access, elevated borrowing expenses and a reduction in stock market valuations. The dollar's role as the global reserve currency has enabled the US to sustain considerable trade imbalances and government expenditures; a move away from the dollar could necessitate substantial economic adaptations.
· uncertain replacement
Delving into predictions regarding the potential successor to the dollar as a global reserve currency poses a formidable task. Potential candidates encompass the euro, Chinese yuan or innovative financial frameworks, such as those supported by precious metals or digital currencies. Nevertheless, transitioning to a fresh global reserve currency would demand significant alterations in global political dynamics and financial structures.
· investment strategies for a ‘de-dollarized’ world
Though a sudden termination of the dollar's reserve currency status remains unlikely, there exists a discernible chance that its primary position in global trade may slowly diminish. To ready themselves for such a prospect, investors should contemplate broadening their investment portfolios to mitigate potential vulnerabilities tied to a declining dollar. Diversifying across an array of asset categories, industry sectors and geographic areas offers a protective shield against instabilities in currency markets.
· overcoming home-country bias
Numerous investors exhibit a propensity for what is known as “home-country bias”, directing a significant portion of their investments towards their own country. Historically, such a concentrated focus on US assets has yielded favourable outcomes. Nevertheless, previous financial crises have underscored the significance of spreading investments internationally. In an environment where the dollars’ worth diminishes, possessing assets valued in alternative currencies such as euros, yen or those from emerging markets can constitute a wise approach.
· focus on emerging markets
In a hypothetical situation where the dollar's influence wanes, emerging economies such as China and Brazil could experience noteworthy upticks in the valuation of their currencies and assets. The technology sector, closely tied to the US economic landscape, might encounter difficulties whereas industries such as manufacturing and fundamental materials could ascend in significance within a de-dollarized environment. It could be advantageous to explore prospects within emerging-market economies that revolve around these sectors.
· inflation hedge
As the value of the US dollar encounters downward pressure, an important consideration arises: the prospect of a notable uptick in inflation within the American economy. In response, investors might explore the strategy of diversifying their portfolios by including investments in energy resources, precious metals and real estate holdings. These asset categories not only function as a safeguard against the depreciation of the dollar but also serve as a protective measure during periods marked by rising prices or geopolitical uncertainties.
Certainly, challenges exist as regards replacing the US dollar as the world reserve currency; the recent BRICS conference in July 2023 hinted that there might be changes in how we view this currency. But here is the scoop: at this gathering of Brazil, Russia, India, China and South Africa (BRICS), the idea of having a common currency among themselves did actually not arise. This tells us that there are some fairly significant hurdles to overcome in order to replace the US dollar as the world’s reserve currency. In theory, having a common currency sounds great as it could make trade between countries easier by moving from one-on-one deals to a group system, which means less reliance on the good old US dollar. But the official word from the summit was about boosting the use of local currencies in global trade. The strengthening of banking networks was even discussed to enable BRICS members to move money around between countries. However, what was not discussed was the new-fangled means by which to make cross-border payments, such as using digital currencies issued by central banks. Bilateral clearing can become tricky, especially when dealing with trade imbalances is involved. Converting your local currency into a currency that everybody agrees on (probably the Chinese renminbi in this case) can be a real puzzle. And what do you do with all the extra funds from these one-on-one deals? You need to cache it and invest it in your own local currency, which adds a whole new layer of complexity when you are juggling trade surpluses and deficits. An example of this was when some Russians selling oil ended up with a hoard of Indian rupees which then had to be turned into renminbi, and finally, were swapped out for US dollars. And that rollercoaster ride impacted the value of the renminbi! China is a big player here, playing banker by swapping its currency for the other BRICS members' currencies and lending them cash. China it seems increasingly are akin to the lender you go to when things get rough, similar to the IMF. We have also witnessed this happen since Russia invaded Ukraine and Western banks’ lending to Russia ceased. The Chinese stepped in and according to the FT, lending to Russia in the last 14 months went from $2.2billion to $9.7billion.
Whilst BRICS nations may wish to reduce their reliance on the US dollar, they have a number of other challenges to face. And the fact that they are not even talking about having a common currency tells us that moving away from the US dollar as the world's reserve currency is not going to be easy. However, change is on its way and it would be prudent to pay close attention to the global payment infrastructure providers such as Swift and Mastercard. Swift has demonstrated the capability of its infrastructure to facilitate the seamless transfer of tokenised value across various public and private blockchains and according to the official press release, although tokenisation is still in its early stages, a significant percentage of institutional investors (97%) believe it holds the potential to revolutionise asset management and bring positive changes to the industry. Swift’s press release stated: “We’ve now tested that solution in a sandbox environment with 18 central and commercial banks. Participants expressed strong support for the solution’s continued development, noting that it enabled seamless exchange of CBDCs, even those built on different platforms. Our experiments have shown the critical role that Swift can play in a financial ecosystem in which digital and traditional currencies co-exist.” Meanwhile earlier this year, Mastercard announced its “Multi-Token Network (MTN) to facilitate broader mainstream adoption of blockchain and digital asset technologies for businesses and consumers in a manner that is intended to preserve the integrity of today's regulated financial system.”
Latin Americans happy to use digital payments
Source: Mastercard
The world of finance and global economics is transforming at a rapid pace, even the US dollar’s role as the world reserve currency is no exception. Amidst the ongoing global financial transformation driven by digital innovations, several notable trends are emerging. Firstly, there is a notable uptick in interest surrounding digital payment methods, including cryptocurrencies, tokenised deposits, stablecoins and CBDCs, which offer the promise of impacting and disrupting conventional financial systems. Nevertheless, it is vital to acknowledge the associated risks and uncertainties tied to regulations. Secondly, a broader movement toward digitizing various assets, both tangible (such as stocks and real estate) and intangible (including healthcare data and digital shopping) is unfolding, so ushering-in improved transparency and accessibility across diverse markets. Lastly, the future role of the US dollar as the world's primary reserve currency appears uncertain in this digital transformation era. Examining historical precedents, it is clear that shifts in reserve currency status are gradual processes rather than abrupt changes. Whilst the prevailing influence of the US dollar remains steadfast, it is evident that alternatives are currently under active consideration. The ascent of digital assets and the growing curiosity surrounding decentralized financial frameworks introduce fresh dimensions to these deliberations. The worldwide financial terrain is undergoing ongoing transformations and so the ability to adapt, diversify and engage in strategic foresight becomes more imperative for governments, investors and institutions alike as they navigate the shifting demand for alternative forms of payments.