The Dollar’s hegemonic properties are bad for global financial stability and Fed Policy
By: Henri Kouam
Tags: Invoicing, Financialstability, FX, Usd, Global Trade

The U.S. dollar is the main reserve currency across the globe. According to the IMF, the dollar comprises 61.3% of global FX reserves, with the Euro, British Sterling, and Japanese yen trailing far behind. Furthermore, global trade amongst countries tends to be cleared in dollars as it equally benefits from the unit of account and ease of convertibility. Furthermore, the U.S. equally have control of the SWIFT system, through which most financial transaction across the world is cleared. One can, therefore, understand why the U.S. dollar holds unprecedented hegemonic properties. Finally, global commodities are equally prices in dollars, with substantial implications for government revenues for commodity exporters such as Algeria, Chad, Cameroon, Saudi Arabia, etc.

What are the global implications of the Dollar’s hegemonic properties?

When the dollar appreciates, debt-servicing costs for developing economies automatically increase, their currencies depreciate and inflation shoots through the roof. I find in an earlier paper that reserves are equally adversely affected by the dollar-dominance that has come to characterize the global trading system. In the context of COVID-19, 1/3 of African countries at high risk of debt distress benefited from debt postponement by creditors from multilateral institutions. Furthermore, during periods of macroeconomic volatility, these economies cannot rely on high value-added exports that can insulate growth over the long run. Not only does this mean such economies see their FX reserves depleted, but the risk of a currency or banking crisis also grows significantly. Take Turkey in 2018, which saw its reserves depleted leading to populist calls from its President for citizens to sell the dollar.

On the one hand, the Fed has always served as an anchor to the global economy, but the dollar’s hegemonic properties compromise the attainment of the inflation target. This is exacerbated by advanced economies FX that have remained stable over the last ten years, reducing the transmission from the currency to inflation outcomes; the story is much different for emerging markets such as Russia, China, South Korea, and South Africa, whose economy and trade is increasingly pointing east and equally depreciate synchronously when the dollar appreciates.

For most U.S. policymakers, analysts and experts, keeping the dollar’s hegemonic properties are indispensable to its soft power. This might not be the case for the FED who has cut interest rates to unprecedented lows to stimulate the economy, keep inflation expectations anchored, and achieve its mandated inflation target. The Fed is, of course, justified in its aggressive monetary policy stance even as the timing of a mixture of tools can be used to achieve no-mandated goals in tandem. Whilst the execution of such policy comes with grave risks to macroeconomic and financial stability over the long run. However, monetary policy has come to play an indispensable role in the real economy via the signaling mechanism that determines the response function from capital financial markets. However, even as stock markets have rallied, the real economy has remained battered by COVID-19 and unemployment has remained unfortunately high. However, if the dollar was less global in nature, one can argue that the Fed would perhaps achieve its inflation target whilst using other tools to blunt the adverse effects of COVID-19.

Monetary policy could stay more expansive and less effective

In the post-Bretton Wood years, monetary policy has been indispensable to supporting economic growth and price stability. However, it will become increasingly salient to advanced economies in the coming decades as a tool to stimulate and counteract the event-driven financial crisis. However, if a bond and dollar-bias persist, it is challenging to anticipate a scenario where inflation converges back towards the 2.0% target without monetary policy becoming increasingly expansive. In the last decade, the FED’s balance sheet has grown by X% to X in 2021. While there are no limits to how far the banks’ balance sheet can grow, but it is not clear that monetary policy can grow increasingly useful once it reaches the zero lower bound.

On the one hand, one argues that the signaling mechanisms and tweaks to the conduct and implementation of monetary policy can serve as an anchor for the economy during periods of financial stress. The dollar cannot lose its hegemonic properties without significant implications for its foreign policy. However, the benefits to the domestic economy and monetary policy, in particular, will be substantial as the Fed will readily affect its inflation target, while its balance sheet and the cost to overall monetary policy will remain muted. Admittedly, Market forces, not policymakers can drive the transition away from the dollar towards other currencies. I argue that such an outcome will reduce the pressure on external balances for developing market economies, whilst improving the functioning of monetary policy in the U.S. Rather than allow a growing balance sheet to contend with de-anchored inflation expectation and below-target inflation, signaling tools from DM central banks can serve as a backdrop for better FX management.

The U.S. will continue to benefit from the SWIFT for the better part of the next decade, this should suffice in displays of soft power. In the interest of price, financial stability, and a less bloated balance sheet, reducing the dollar’s salience in global trade and financial markets will be instrumental and addressing the spillovers from global imbalances and commodity-linked depreciation cross developing market economies. Meanwhile, by diversifying reserve holding, the dollar’s safe-haven properties will be triggered to a lesser extent during periods of macroeconomic volatility. This need not be problematic for the dollar that is unlikely to see a big sell-off but should rather benefit from a gradual transition towards non-dollar currencies in global trade and financial services.

The dollar cannot lose any one of its hegemonic properties without risking financial stability and its global hold on power, but a slow and gradual diversification away from the green bank bodes well for global financial stability and will facilitate the attainment of the Fed’s explicit inflation target. Some view the dollar’s global hegemony as counterproductive and purely in foreign policy terms, but this is misguided and fails to contextualize the role of the dollar in achieving domestic macroeconomic objectives. A weaker dollar, playing a less significant role in the global economy will achieve both domestic macroeconomic and financial stability, whilst reducing the negative impact of global imbalances during periods of macroeconomic volatility.

The displacement is inevitable, but what will the trigger be?

In a recent article on Project Syndicate, Nobel Laureate Dr. Nouriel Roubini argued that several currencies have been displaced in recent history. This was the case with Spain in the sixteenth century, the Dutch in the seventeenth century, France in the eighteenth century, and Great Britain in the nineteenth century. The question isn’t the likelihood of COVID-19 triggering a broad-based flight from the dollar, but rather the ability of the dollar to serve as the global financial anchor amidst alternatives across the East.

China has already created and implemented a Digital Currency Electronic Payment System, which has been piloted in four regions, namely Beijing, Tianjin-Hebei, Yangtze River Delta, and Guangdong as well as Hong Kong Macau Area. However, this is currently limited to China alone and it is not clear that the renminbi will be linked to a digitized counterpart that facilitates convertibility. Over the long run, China will demand that its partners across the World begin invoicing trade int he Chinese Renminbi, which could lessen the dollar’s hegemony over the long run. Over 44% of EU trade was invoiced in the Euro in 2019, which suggests that both market-led and structural trends will occasion less dependence on the dollar.

COVID-19 has shown the salience of the dollar on global trade and financial markets, but a number of triggers such as U.S. — China trade tensions as well as structurally-driven market trends could reduce the post-Bretton woods reliance on the dollar. While no one event will trigger such a move, it is not likely that the dollar’s dominance will persist in the new world order.

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