Paying dividends

US dollar dominance may be challenged by rise of digital currencies

Throughout my professional life, discussions about the end of the US dollar dominance, a collapse in its price and a decline in its use, have appeared, usually during periods of turmoil in the United States. But they were always temporary. Now, as of late 2020, the role of the US dollar is nearly as preeminent as it has always been since the days of Bretton Woods, despite the fact that the US economy has seen its share of global GDP decline in the past three decades.

Yet with the novel coronavirus outbreak these possibilities are being raised once again, and on this occasion, the advent of technology and the nascent digital currencies are lending support to them.

It is undoubtedly the case that the dollar's role in today's global monetary system exceeds what is justified based on the US share of global GDP, the US share of global trade, and the US share of global capital markets. Of the three, the latter is where the dollar's persistent dominance garners its greatest strength, and it is probably because none of other potential competitors to the dollar have their own capital markets anywhere near as developed as that of the US.

The eurozone, Japan and China are the only parts of the world whose currencies might realistically challenge the dollar, but they have neither the deep liquid or diversified capital markets that can offer what the US capital market offers investors and borrowers around the world. When it comes to the price performance of the dollar's value against other currencies, it is important to not confuse this with the amount the dollar is used, although obviously a persistent and large decline in its value might itself contribute to a decline in its usage.

As for the dollar's ongoing performance against the euro, Japanese yen, renminbi, or for that matter, the UK pound, Swiss franc, Brazilian real and beyond, it will broadly speaking continue to be driven by the relative cyclical performance of the US economy versus that of other countries or regions and their relative monetary policies. Today if you look at models of purchasing power parity or more advanced versions of them, such as dynamic real exchange rates, such models today suggest the dollar is generally overvalued against most currencies, some more than others, perhaps collectively on average somewhere between 5 percent to 10 percent.

Much of this can be explained by the stronger performance of the US economy than much of Europe and Japan, and the relative stance of US monetary policy compared to these regions. Such an approach would suggest that the dollar should be somewhat weaker against the renminbi given the higher interest rates in China as well as the underlying equilibrium, and this gap might be partly due to the relatively restricted access to Chinese markets for some overseas investors. In any case, the scale of misalignment is modest, and nothing close to that existing during the 1980s when the Plaza Accord was needed to deliberately weaken the dollar, nor at the start of this century when China started to allow the renminbi to slowly appreciate. As for the dollar's dominance, it will start to reverse when the potential of other capital markets starts to offer the potential that is currently enjoyed around the world by the US financial markets and its range of instruments. The relative size of the US economy and the US share of world trade both suggest that the dollar's usage is vulnerable to a shift in the development of capital markets in other regions or nations. In this sense, continued efforts by China to allow more access to its own capital markets, both bonds and equities to overseas investors are pertinent, the same would be true in the eurozone.

There is also one other important new marginal factor which is becoming relevant and that is the development of so-called digital currencies, which the China's central bank, the People's Bank of China, is pursuing. It is trialing a digital version of the renminbi that replaces the need for cash and uses all of modern technologies to allow transactions to be undertaken in the renminbi. This is presumably attractive to Chinese authorities, as it will allow for wider usage of the renminbi. The regulatory authorities will also have stronger knowledge about the use of the renminbi, so it will be helpful to avoid unnecessary use of the currency. It is quite conceivable that a successful rollout and adoption of the digital renminbi would encourage many to start using the dollar less, especially if this made transacting in Chinese capital markets easier. Of course, if other countries, the US included, chose the same path, these attractions might be conceivably be offset, but given how powerful the US markets already are, these seem less pertinent. It will be interesting to keep following the development of the digital renminbi closely.

The author is chair of Chatham House and former commercial secretary to the UK Treasury. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.