Rapid Erosion of USD Dominance as a Reserve Currency
Stephen Jen & Joana Freire
Extract from our "Rapid Erosion of USD Dominance as a Reserve Currency" research paper, published on the 17th of April 2023. Register for a free trial* to access the full paper.
The US dollar’s hegemony should be measured in at least two dimensions: (i) its role as the dominant reserve currency of choice (a stock concept) by central banks and (ii) its use as the primary conduit to conduct international transactions (a flow concept), either for trade or for finance. We report, for various structurally-important reasons, that the dollar’s dominance as a reserve currency has been eroding at an accelerated pace since 2022. However, its role as an international currency will not likely be challenged any time soon, despite the heightened talks of trade settlements done in non-dollars. Investors ought not be confused by these two different concepts.
- The USD is losing its market share as a reserve currency at a much faster rate than is commonly believed. After steady declines in its global market share for the past two decades, in 2022 the dollar lost market share at a pace 10 times as rapidly. Analysts have failed to detect this big change because they calculate the nominal value of the world’s central banks’ dollar holdings without considering the changes in the price of the dollar. Adjusting for these price changes, the dollar, we calculate, has lost some 11 percent of its market share since 2016 and double that amount since 2008.
- This erosion in the USD’s reserve currency status has accelerated precipitously since the start of the war in Ukraine. Exceptional actions taken by the US and its allies against Russia have startled large reserve-holding countries, most of which are from the Global South.
- While the Global South seems unwilling to continue to hold dollar assets, they do not seem to have the ability to divest from the US dollar as an international currency, particularly for financial transactions. We suspect it will be very difficult to overcome the strong network effects that have been behind the dollar’s international currency status.
- The key to topple the dollar’s throne as an international currency is predicated on the relative developments and stability in the various financial markets. If the financial markets outside the US could thrive (growing in size and becoming ever more energetic, without being unstable), and if the opposite happens in the US, the dollar could very well meet its demise. This is, however, not an imminent risk, in our opinion, though the trends are heading in that direction.
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