Back in March, I warned that if China and Russia successfully replaced the dollar in world trade, the U.S. economy would head straight into a major fiscal crisis. My scenario was met with shaking heads and frowning faces. De-dollarization can’t happen, I was told.
Well, China just took a big step to make it happen.
The U.S. dollar has served as the international reserve currency since the end of World War II. Its role was established partly by the Marshall Plan that rebuilt Europe, partly with the so-called Bretton Woods system for exchange-rate management. In the 1970s, the dollar strengthened its position even more, when the petrodollar became the default denomination system for oil trade.
Today, the dollar accounts for almost 60% of foreign exchange reserves held by central banks around the world. Given China’s new move, that is about to change.
The dollar will not be dethroned overnight—nothing ever happens overnight in economics—but it will happen faster than most of the world’s political leaders realize.
And it will have a big impact on the economies of both Europe and America.
Back in March, I did not give any timeline in my de-dollarization analysis, noting that it is impossible to predict its timing with even a moderate sense of probability. The reason is simple: the modern world does not have enough experience with shifting global reserve currencies.
In other words, any analysis of what is to come will be hypothetical by nature. When facing a new situation, when we have no historic data to guide us, we have to rely on economic and political theory, as well as deductive analysis.
What follows, therefore, is not meant as a forecast of a de-dollarization event. Its purpose is to explain the economic mechanics involved, and what information we need to track in order to understand just how big of a threat de-dollarization actually is.
With that said, let’s see what the Chinese just did, and what its consequences may be.
Beijing creates global currency reserve
On June 25th, the Bank for International Settlements reported the creation of the so-called Renminbi Liquidity Arrangement, the RLA,
which has been developed with the People’s Bank of China (PBC), to provide liquidity to central banks through a new reserve pooling scheme. The [RLA] aims to provide liquidity support and can be utilised by participating central banks during future periods of market volatility.
Initially, six countries will participate: Chile, China, Hong Kong, Indonesia, Malaysia and Singapore. Their central banks will contribute a “membership fee” of at least RMB 15bn.
According to the South China Morning Post, the goal of the RLA is to create a financial infrastructure that “will help loosen the grip of dollar hegemony” on international trade and financial transactions. The RLA will provide liquidity security for participating central banks; the security of the system will ultimately be anchored by China, which means that its yuan (or renminbi on the international scene) will be the reserve currency of the system.
The system is not exclusively based on the yuan; participating central banks may make dollar deposits. However, since China is by far the largest economy in the system, as well as its anchor, there will be a lot more yuan in the liquidity reserve than there will be dollars. Anyone asking for a liquidity loan in dollars may come up short; ask for a loan in the Chinese currency, however, and there will be enough liquidity to provide it.
China has made an intelligent move by anchoring its system in the yuan. It incentivizes a tectonic shift in central-bank reserves in the same direction. Suppose, e.g., that the central bank of Chile runs low on foreign-currency reserves. The bank takes out a yuan-denominated loan through the RLA and is now able to continue clearing foreign transactions.
To see what happens next, let us quickly review the three ways that foreign currencies are used in an economy:
- As a store of value;
- As a means of exchange, in other words to pay for imports and exports or to clear financial transactions; and
- As a unit of account.
Now: the central bank will need yuan to repay its loan. Therefore, it needs a lot of yuan as stored value. A convenient way to do this is to incentivize exports businesses to invoice their customers in the Chinese currency. Once they get paid, they come to the central bank to exchange their yuan for pesos.
Over time, the central bank will build up more yuan in its foreign-exchange reserves—and the need for dollars will dwindle. Businesses, in turn, discover that the ample supply of yuan makes it easier, faster, and cheaper for them to get paid in yuan (as opposed to some currency where the reserves are much smaller). This aspect of the reserve currency becomes even more important in fast-moving financial transactions, where the flow of money is instantaneous and exchange between currencies need to happen immediately.
In other words, when a central bank shifts its reserve currency, the private sector will follow and make the same shift. While this does not happen overnight, once the central bank makes its move, the rest of the economy is bound to follow.
Global banking is weaponized
It would be a grave mistake to dismiss the RLA as a technical matter of finance and central banking. It is an explicit political move on behalf of the Chinese, a power play by Beijing that aims straight at the non-military heart of America’s global power. But even more important is the shockwave of consequences that will overflow the U.S. economy—and by extension Europe—once the de-dollarization effort has reached a critical mass.
Nobody should doubt the political ambition behind China’s new RLA. Explains Economic Times out of India—and listen carefully:
While tension over the Hong Kong national security law triggered heated discussions over potential China-U.S. financial decoupling in 2020, recent Western sanctions on Moscow have served as a particular wake-up call for Beijing, including the exclusion of major Russian banks from the Swift messaging system and freezing the assets of the Russian central bank.
Banks use Swift to communicate terms of international transactions. It is the nervous system of global banking; no bank can credibly participate in the global economy without Swift. Therefore, as the Economic Times points out, the Western sanctions that cut Russian banks from Swift, effectively weaponized the system. It is now a political instrument; Washington has made it so that access to Swift also means compliance with U.S. foreign policy goals.
China has long wanted to challenge the dollar’s hegemony. The Russia sanctions gave them the momentum they needed: they can now sell their own bank-reserve and Swift-replacement systems with a guarantee that those will never be weaponized.
Whether anyone will believe that is a different story; the fact is that Washington and Brussels have only themselves to blame for giving the Chinese all the selling points they needed for taking the first step toward de-dollarization.
Hence, the Renminbi Liquidity Arrangement, which of course is aimed squarely at the dollar.
This, however, does not mean that Europe will escape unharmed. Back in April, Akhil Ramesh, opinion contributor with The Hill, a Washington, D.C.-based newspaper, explained Europe’s conundrum. Ramesh referred to Russia’s invoicing for oil and natural gas in rubles as a fork in the road for Europe: accept Russian terms or “bandwagon the U.S.,” with all the de-dollarization consequences that come with that choice.
Evidently, Europe has made its choice, and its energy policy problems—replacing Russian minerals with coal from the other side of the planet—are only the beginning. If de-dollarization reaches a tipping point, the cost to Europe will be much higher than that. To see what this means, let us do a thought experiment and put some hypothetical numbers on a de-dollarization scenario.
De-dollarization by the numbers
The International Monetary Fund (IMF) publishes an excellent Currency Composition of Official Foreign Exchange Reserves (COFER) database, which covers 149 countries. It does not offer any bank-by-bank breakdowns of foreign-exchange reserves, but it does give us the numbers for the world’s aggregate reserves and their currency composition.
In the fourth quarter of 2021 the world’s central banks held $7,087 billion in their foreign-exchange reserves. This was equal to 59% of their total allocated reserves (for purposes of statistical precision, we disregard the small amount known as “unallocated reserves”). The second-largest reserves were held in euros (20.6%), with the Japanese yen in third place (5.6%).
Let us see what these numbers can tell us about the effects of de-dollarization; again, this is not a forecast, just a thought experiment to conceptualize the process.
To identify the effects of the RLA system on central-bank reserves, we need a ‘weight’ for each country. Since the IMF’s COFER database does not provide country-specific data, we have to use another variable. The best one is gross domestic product, GDP: an economy’s needs foreign exchange reserves are, roughly speaking, proportionate to GDP.
There are, of course, major individual variations, especially in terms of financial transactions (the data for which is almost entirely proprietary in nature). However, the GDP weight is good for experimental purposes.
In 2019, Chile, China, Hong Kong, Malaysia, Indonesia, and Singapore accounted for 19.1% of the world’s total GDP. The largest share, of course, is China. We assume that under the RLA system, these countries replace the dollar with the yuan in proportion to the size of their GDP.
Under this assumption, this group of countries would sell just over $1.35 trillion in foreign-exchange reserves.
This sell-off will work as a growth in the money supply; compared to the current U.S. money supply (measured as “M2” for all you monetary nerds out there), this would be a 6.25% monetary expansion. This is equal to the Federal Reserve’s money-printing in 2014.
We can easily imagine what this would do in the midst of the Federal Reserve’s effort to rein in its money supply. But this is not even the worst scenario. It is realistic, namely, that Brazil, India, Russia, and South Africa join the RLA down the road. Adding them to our previous calculations, the sell-off driven monetary expansion balloons to 8.8%.
By comparison, in 2009, the worst year during the Great Recession, the Federal Reserve expanded money supply by 8.1%.
Let us remember two things here. First, these numbers are exclusively related to central bank foreign-exchange reserves. In other words, they do not take into account the effects of financial transactions and foreign trade moving off the dollar.
Second, this is not a de-dollarization forecast. This experiment is meant to illustrate how the process could unfold, what events may happen and what we need to look for in order to understand their impact, both on America and on Europe.
Yes, Europe will be pulled in. Under a with-us-or-against-us scenario, the RLA+BRICS system could treat the euro like it treats the dollar. The sell-offs would be smaller; global foreign-exchange reserves of the euro are roughly one third of those in dollars. At the same time, the European Central Bank has been much slower than the Federal Reserve at raising interest rates and reining in its excessive money supply. The euro has also been weakened by the recent sanctions in a way the dollar has not.
Bluntly: Europe is behind the curve here.
On top of this, the euro has never quite gained the ‘safe haven’ reputation that the dollar has earned. While the American currency will lose a substantial part of that status, it could still top the euro here. If so, investor flight from Europe to America, despite de-dollarization could exacerbate the weakening of the euro.
As this experiment suggests, it is difficult to capture either the size or the time frame of a de-dollarization process. That said, the fallout for the dollar and the euro will be serious, and policy makers on both sides of the Atlantic ocean are well advised to prepare.