Will The World Still Love Dollars After Covid?

Could the global economic disruptions of covid-19 topple the U.S. dollar’s “exorbitant privilege” as the world’s de facto reserve currency? Don’t bank on it, said a panel of leading economists who spoke remotely before the Council on Foreign Relations on Tuesday.

Economist Eswar S. Pradar, Professor of Trade Policy at Cornell University and a Senior Fellow at the Brookings Institution, explained that while other currencies like the Chinese renminbi/yuan (RMB) or even some Emerging Market currencies could figure more prominently in future trade transactions, as a global reserve there is still no real rival to the almighty greenback.

“Despite the Great Financial Crisis (GFC) beginning in the U.S., despite the U.S. taking a big hit during the pandemic…it doesn’t seem like there is much of an alternative,” Prasad said. “In times of turmoil, investors want safety, and there is only one currency that affords the safety that international investors seem to want.”

Defying expectations

Carmen M. Reinhart, World Bank Group Vice President and Chief Economist, largely concurred with Prasad’s view. She said that the dollar’s continued pre-eminence defied expectations, given the recent years’ surge in China’s contribution to global GDP.

Yet it is still preferred, she explained, as a reserve currency held by central banks, as a denominating currency for global debt rates, in setting exchange rate policies and currency pegs.

One big reason why this will probably continue, in Reinhart’s view, is that investors and financial institutions hold “greenbacks” (hard currency) as well as U.S government debt, where the liquidity and depth of the U.S. treasury market is unparalleled.

Pre-2008, she said, the prevailing perception in global financial markets was that there was a “Euro market” for sovereign debt. After the GFC, it became clear that there was no such thing as a homogeneous market for European bonds: Greek debt was fundamentally different from German debt, which again differed materially from Irish debt. This essentially fragmented nature of European debt paled in comparison to the fulsome market for U.S. treasuries.

As for the renminbi? Reinhart says that up until 2015 there was some global perception that the currency would gain ground, and that China’s rise to geopolitical prominence would be matched by a rise in financial dominance.

But, she notes, the overwhelming majority of China’s overseas lending (primarily to developing and low-income countries, where it is the world’s largest official creditor — bigger than all other Paris Club members combined) is still denominated in dollars.

Not even the covid crisis — and China’s relatively quicker emergence from the economic effects of lockdown — appears likely to upend this arrangement.

“Remorseless and unstoppable?”

Economist Benn Steil, Senior Fellow at the Council of Foreign Relations and Director of International Economics, said covid had been “largely a non-event” in terms of global financial position.

Steil noted that the U.S. Federal Reserve had effectively handled the surge in international demand for dollars — investors bought up some $450 billion bought up in U.S. treasuries at the onset of the pandemic — dusting off the “2007 playbook” and possibly showing even more responsiveness to global than to domestic dollar demand.

By the end of March, Steil noted, the Fed had extended currency swap arrangements to 15 central banks overseas, and extended half a trillion dollars in loans to foreign central banks through currency swaps, and with 170 more central banks around the world able to access Fed lending facilities using U.S. treasuries as collateral.

Steil recalled an April 2014 cover story in The Economist magazine calling the globalization of China’s renminbi a “remorseless and unstoppable” phenomenon, which nonetheless sharply reversed less than year later. In 2015, RMB peaked in terms of percentage of global payments at 2.8 percent. Within three years, that figure had reeded to 1.6 percent (coming in today at a relatively stable 1.8 percent).

“My reading is that the idea of (renminbi) internationalization was never really clear. It wasn’t that people were scrambling for renminbi because they wanted to use it for payments,” Steil said, noting that from 2005 to 2013, the currency was steadily and consistently appreciating on a monthly basis. While the People’s Bank of China (China’s central bank) was slowing that appreciation, market buying of RMB during that period was seen as a speculative, one-way bet. After 2014, these speculative inflows stopped and internationalization went into sharp reverse, as China imposed new capital controls.

Institutional framework

Eswar Pradar attributes the unmet promise of the Chinese renminbi to a couple of different factors. One is credibility: the Chinese government has committed to keeping its capital accounts open, with open capital inflows and outflows, and a market-determined exchange rate in which the PBoC does not excessively intervene. Neither commitment has proved ironclad in China.

More broadly, “what’s keeping RMB down and USD up,” Pradar explains, comes down to the institutional framework that supports the U.S. dollar as a “safe haven” currency: an independent central bank, prevailing rule of law that keeps even government actors playing by rules that they don’t like, and an institutionalized system of checks and balance.

While a case could be made that every element of this framework has been undercut in the United States over the past four years, China doesn’t have this kind of institutional framework at all.

“Maybe a unipolar world is not best of all possible worlds, but it may not be so bad,” Pradar says.

Digital yuan as domestic tool

Benn Steil noted that in the long term, there’s “no doubt” that the Chinese government likes the idea of renminbi internationalization and is taking steps to push it forward, but short-term factors push against this effort. International transactions outside China — even infrastructure projects under its Belt and Road Initiative (BRI) — are still overwhelmingly denominated in USD. And China itself often takes contradictory actions, because in a crisis like the covid pandemic, capital flows are volatile, and China often wants to encourage dollar inflows because it needs dollars itself.

What about China’s much-touted digital renminbi currency? Benn Steil sees the digital yuan as having overly domestic political and economic significance in China, reinforcing the power of the Chinese Communist Party over domestic financial transactions, weakening the power of private- and state-owned institutions in the country, and reinforcing CCP control over social interactions (such as China’s system of social credits) to compel its citizens to behave in certain ways and not others.

Antibiotic resistance

Instead, a bigger threat to dollar dominance may come from what Steil characterized as U.S. government’s aggressive use of economic sanctions to compel nations to behave in certain ways. The tool is powerful — and has been historically effective — because countries need access to dollars in order to conduct any international financial transactions.

“The problem is that the more you use this aggressive tool, the more we can expect the rest of the world to adapt, and find alternative mechanisms. Just like overuse of antibiotics, which can be very powerful, but if overused you expect bacterial to mutate and become resistant…Indeed, we are seeing the world beginning to develop other ‘antibiotics,’ in particular Iran.”

Steil notes that this aggressive sanctioning has given the European Union “enormous impetus” to begin developing an alternative international payments regime that can bypass the dollar-based payment system.

“It’s still embryonic, but again, the more we continue to use this (sanctions) tool in ways that the rest of the world finds offensive, the more we can expect the world to invest in alternatives that could, over time, begin whittling down influence of the dollar internationally,” Steil said.

Pradar agrees that U.S. sanctions — both direct and indirect (i.e., sanctions that apply to firms that do business with any entity from a country on a sanctions list) — could accelerate the rise of potentially game changing technologies like China’s Interbank Payment System (CIPS), which clears and settles services for cross-border transactions. More global transactions using alternative payment systems could then bypass dollar transactions — but still likely not threaten the dollar’s role as global safe haven of choice.