Is the Dollar Standard Ending?

Last month, world governments learned that property rights do not apply to foreign exchange reserves.

Recall that before Russia’s abhorrent invasion of Ukraine, the United States government froze \$7 billion of Afghanistan’s U.S.-based assets. The United States earmarked half for humanitarian aid in Afghanistan, while the balance was reserved to cover potential claims from U.S litigants who sued the Taliban for losses due to terrorism, including the attacks of September 11, 2001.

In effect, the leaders of the world’s largest economy — with a gross domestic product surpassing \$20 trillion in 2020 — seized the assets of a country with a gross national income per capita of \$500. Data from the United Nations reveal that more than half of Afghanistan’s population wasn’t even alive on 9/11.

Two weeks after the seizure of Afghanistan’s assets, the West froze the assets of the Central Bank of Russia. The implications of these decisions will take time to understand fully. However, three immediate conclusions may be drawn.

First, exporters are likely to slow their acquisition of U.S. dollar reserves going forward. This would mark an important shift, particularly for the so-called ‘emerging and developing’ economies, which have represented the marginal demand for dollars since the Asian Financial Crisis.

To wit, these countries increased their dollar holdings from roughly \$300 billion to \$2.2 trillion between 2000 and 2014 (the year for which this specific IMF data set ended), expanding their share of global reserves from approximately 25% to 50% in the process. Since then, worldwide reserve accumulation has grown to \$12 trillion.

Given the poor state of America’s finances, countries sensibly have been diversifying away from the dollar, which has declined from 71% of global reserves in 2000 to 59% last year. Now, governments must not only contend with the prospects of dilution from U.S. profligacy, but also the risks of outright confiscation.

Second, a declining demand for dollars should compel the United States to abandon its credit- and consumption-driven economy. In recent decades, exporters’ voluminous accumulation of dollars helped depress U.S. interest rates, effectively subsidizing American consumption and supporting asset prices.

A contraction in dollar demand would likely reduce asset prices, eroding the collateral for a swathe of overleveraged businesses and expanding the funding gaps plaguing retirement systems in the process. The reduced need to ‘recycle’ exporters’ dollars could also diminish the outsized role of finance in the U.S. economy and its politics, while a weaker dollar could facilitate a rebalancing toward a revitalized manufacturing base.

Third, large exporters, most notably China, will be incentivized to recalibrate their own economies in favor of domestic demand and consumption-led growth. Though this has been a stated objective of Chinese policy for years, progress has been slow-going. The West’s recent asset freezes may reinvigorate this shift with a new sense of urgency.

Many people believe that a move away from the dollar as the world’s reserve currency remains unlikely. Commentators frequently point to the lack of a viable alternative with ample liquidity and an issuer that adheres to the rule of law. After all, the euro and the Chinese yuan constituted roughly 20% and 3% of global reserves last year.

However, the probability that countries will seek out an alternative has gone up considerably. The issue is not which countries have secure, investable assets that can absorb reserves today, but rather the countries that will create them over the decades to come.

Two possibilities merit consideration.

First, what if large oil exporters and importers agree to price the commodity in another currency, intentions that China and India have floated? Regardless of global net-zero targets, the International Energy Agency projects that ‘emerging and developing’ economies will drive incremental oil demand exceeding 12 million barrels per day under most scenarios through 2030. The West’s oil imports have flatlined over 40 years and are likely to decline, whereas China, India, non-OECD Asia, and Africa are growing. These are, after all, the markets where the people are.

Second, what if a group of large commodity exporters and importers took up Zhou Xiaochuan’s 2009 proposal to resurrect John Maynard Keynes’s Bancor? The Bancor was Keynes’s concept for an international currency whose value was based upon a basket of commonly used commodities. For all the attention paid to finance and technology, it is energy — whether measured by horsepower, watts, or calories — that makes the world go round.

Prophesies decrying the eschaton of the dollar have proven rash and delusional. In a world where central banks’ property rights were observed, there was scant impetus for change.

That world resides in the past. The decision to freeze central banks’ assets may have been justifiable, but expediency has its consequences.

First submitted to FT on 21 March 2022.