Reserve currency of global economy: declining dominance of US Dollar and beyond

Abstract

Since World War II, the US dollar has been the world's dominant reserve currency. It has been able to maintain its dominance for many decades fueled by the growth of the US economy and favorable geopolitics. However, in a recent couple of decades, we are witnessing a steady erosion in the dominance of the US dollar. The share of US dollar reserves held by central banks worldwide has dropped by over ~12% in the last two decades. Based on historical trends, it has been believed that the erosion of the US Dollar will be recovered by either of the three other dominant currencies of the world – the Euro, Yen and British Pound. Strikingly, we observe that the shift-out of the US dollar has been in two directions – about a quarter into the traditional currencies namely Euro and Pound Sterling, while the remaining threequarters into other non-traditional currencies. Even within non-traditional currencies, only one-third has been to the Chinese Renminbi and the remaining two-thirds into other currencies of smaller economies. This trend has been strikingly different from the history enabled by improving the liquidity of the nontraditional currencies and active portfolio diversification pursued by reserve managers. Through econometric analysis we conclude that the decline in US dollar reserves is due to three key reasons. First is reducing the importance of the size of the economy of the currency issuer country with a share of its currency in the global reserve. Second is the rapid rise in public debt of the US which has affected confidence in the US dollar. Third is a shift in the tendency of the central bankers – who are now increasingly focusing on active portfolio diversification. As the reserves held by the central bankers have increased manifold, they are now increasingly focused on generating returns from their portfolios rather than simply investing in safe assets. We also analyse whether emerging currencies like the Chinese Yuan, digital currencies and a unified BRICS currency can realistically replace the US dollar in the near future to emerge as a new dominant reserve currency. On analyzing these currencies across various parameters, we conclude that each has inherent flaws that must be addressed before it can challenge the prevailing dominant status of the US dollar. Finally, we analyse what the decline in the US dollar means for emerging economies. We conclude that a sustained decline in the dominance of the US dollar might lead to more volatility in the economy of emerging economies. However, at the same time, it also presents an opportunity for these economies as the dollar-denominated debts would eventually cost less in real terms and would help them to take an expansionary stance.