US dollar hegemony waning

The de-dollarisation trend is likely to accelerate owing to the Fed’s large-scale use of quantitative easing policies

Different countries have adopted varying measures to ameliorate the downside economic effects of Covid-19. The US, Canada and many European countries have announced huge fiscal stimulus packages with the aim to lessen the sufferings of the people and businesses hurt due to prolonged lockdowns. The purpose of the rescue measures is to put the economy back on the path of revival and growth.

Many countries have made extensive use of expansive monetary policies. Central banks in many countries have reduced key interest rates to near zero and in some countries benchmark interest rates have moved into the negative zone. Implications of these easy money policies go far beyond the immediate effects on the revival path of the economies.

The unprecedentedly liberal use of money expansion puts a question mark on the integrity and soundness of fiat money in many Western capitalist countries. Excessive increase in money supply can lead to inflationary outcomes in case the growth in real economy remains very sluggish. This can erode the value of money rapidly.

Loss of Faith

The US government launched $1.9 trillion worth stimulus package in March 2021, taking its total spending (in 2020 and 2021) to counter the pandemic to $5 trillion. The Federal Reserve has taken its quantitative easing policies to new heights. It has undertaken unprecedented measures to support the economy.

The Fed promises to buy any amount of treasury bonds issued by the US government for the purpose of financing its stimulus plans. It is the de facto monetisation of fiscal deficit. This method, guided by insights of the modern monetary theory, and referred to as ‘printing of money’, is now being used on a large scale.

The Federal Reserve has extended its bond-buying activity much beyond treasury bonds and mortgage-backed securities, which have been its traditional areas of operation. The Fed has shown willingness to buy corporate bonds, including junk bonds.

Is there a limit to the printing of money? What is the significance of soundness and integrity of money in the functioning of the modern capitalist system? It is quite likely that at some stage, people will lose faith in fiat money if money supply growth loses connection with the pace of growth of real economy. This is a phenomenon that occurs quite often in developing countries.

The advanced capitalist countries with hard currencies have so far been able to avoid this fate in the post-war period. But in the aftermath of the downturn caused by Covid-19, even the advanced capitalist economies cannot be immune from the dangers of stagnation and high inflation.

The loss of faith in fiat currencies in the advanced capitalist countries will have serious international repercussions.

Damage to Status

It is a subject of debate now that the current stance of the US monetary policy of excessive quantitative easing may cause severe damage to the dollar’s status as the world’s reserve currency.

For 75 years since the end of World War II, the status of the US dollar as the primary global reserve currency has continued virtually uncontested. About 60% of the world’s currency reserves are in dollars and the vast majority of global trade and investment takes place in dollars. In comparison, about 20% of global currency reserves are in euros.

The US has been running consistent trade and current account deficits with the rest of the world over the past four decades. The dollar’s world reserve currency status allows the US to borrow large sums of money from the rest of the world. The US has the largest external debt in the world. In September 2020, foreigners owned $21.3 trillion of US debt.

Excessive printing of money by the Federal Reserve as a response to the Covid-19 crisis is likely to instil fear among the US’ foreign lenders. This is because excessive increase in supply of money could lead to high inflation, causing a sharp decline in the value of dollar. The US government’s stimulus package running into trillions of dollars is largely being financed from borrowings from the Federal Reserve.

Changing Foreign Perceptions

Due to Federal Reserve’s policy of keeping the interest rate at a near-zero level, there has been very little participation of foreign lenders in providing funds to the US government. This is an indication of the changes in foreign perceptions of the US’ strength, which over time will cause erosion in the dollar’s hegemonic status. A recent IMF report shows that central banks around the world are reducing the share of US dollar assets of their total reserves.

In recent years, America has been very aggressive in using its currency’s power to impose sanctions on countries with whom it has any disagreement or dispute. The US has used the dollar as a foreign policy tool against certain strategic rivals such as Iran, North Korea, China and Russia.

It is true that the replacement of the dollar by some other currency as the world reserve currency does not appear likely in the near future. The TINA argument is not without merit. But there are other ways in which the domination of the dollar is coming under challenge.

In the past few years, many countries, including China and Russia, are making attempts towards de-dollarisation of their economies. These countries are diversifying their foreign exchange reserves and conducting trade transactions in other reserve currencies (such as the euro) or in their own national currencies. This trend towards de-dollarisation that has been under way for many years now is likely to accelerate because of the large-scale use of quantitative easing policies by the Federal Reserve in response to the Covid-19 crisis.

There is a discernible trend of diversification away from US treasuries into gold by central banks in several countries. The 60% increase in gold prices between 2018 and the middle of 2020 is a reflection of that development. In comparison to the US, the post-Covid economic recovery in China is likely to be much stronger, leading to a significant reduction in the GDP gap between the two countries. The shift in balance in favour of China is likely to hasten the process of de-dollarisation.

(The author is SK Dey Chair Professor, Institute of Social Sciences, New Delhi)

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