The US dollar that rose to power as the global reserve currency post the termination of Bretton Woods Agreement in 1972 is losing its allure. A recent IMF report suggests that the share of US dollar (USD) in the coffers of central banks, all over the world, is declining. The report also adds that the other Big Four currencies are not making up for the loss of dollar's share, rather central banks are diversifying their holding of other currencies.
The Big Four of currencies are the US dollar, pound sterling, Japanese yen and the euro. They comprised 98% of IMF Currency Composition of Official Foreign Exchange Reserves (COFER) in 1999, which declined to 92% in 2021. During the same period the IMF COFER of other currencies rose from almost zero to 8%.
Possible reasons for decline of US Dollar in Global Forex Reserve
The IMF research report indicated a strong negative correlation between the reserve issuer's public debt and reserve shares. This also coincides with the fact that US public debt has been trending upward for two decades, while the dollar's share has been trending down. The US took 205 years from 1776 to 1981 to amass $1 trillion debt. In the next 40 years though the US debt grew 30 times to $30.36 trillion.
For the record, global forex rose to a record $12.83 trillion at the end of 3Q21 while the US dollar's share of World Forex declined to a 25-year low of 58.9% at the end of 2020 and was 59.2% at the end of Q3 2021, according to the IMF. This implies that the rising public debt of the US is significantly responsible for the diminishing attractiveness of the dollar.
Similar effect is observed in the declining share of reserves in yen post 1988, coincident with the very strong ongoing rise in Japanese public debt.
The other variables that affect the inclination of a country's central bank to amass non-traditional currency reserves include the peg of the country's exchange rate, currency composition of external debt, direction of trade and invoicing currency.
What other currencies are being held by central banks?
Global holdings of non-traditional reserve currencies have risen from negligible levels of about $30 billion in 1999 to around US$1.2 trillion by 2021. As per IMF's Coordinated Portfolio Investment Survey, by the end of 2020, an estimated currency value of $1,070 billion (or $1.07 trillion), were held by the global central banks in non-traditional currencies, that is, currencies other than Big Four.
The Australian dollar, Canadian dollar, Chinese renminbi, and Swiss Franc accounted for 71% of reserves held in non-traditional currencies. The remaining 29% is comprised of three European currencies- Swedish krona, Norwegian krone, and Danish krone, and four Asian currencies- Korean won, Singapore dollar, New Zealand dollar, and Hong Kong dollar.
The Chinese renminbi accounts for 25% of the non-traditional currency held by central banks, globally, and its value is estimated to be of $272 billion, as per IMF. The Canadian dollar reserves are estimated to be $247 billion, comprising 23% of the non-traditional currency portfolio, followed by the Australian dollar estimated to be $217 billion, or 20% of the portfolio.
Active Diversifiers: Active Diversifiers as per IMF are countries with more than 5% of their FX reserves denominated in the renminbi and non-SDR currencies. At the end of 2020, IMF identified 46 countries as Active Diversifiers.
By the end of 2020, China emerged as the largest holder of non-traditional currencies with $198.4 billion, followed by Switzerland with $97.5 billion, and Russia with $94.7 billion held in non-traditional currencies. However, China's non-traditional currency reserve is just 6% of its total forex reserve while Russia's non-traditional portfolio is 21% and Swiss portfolio is 10% of the overall forex reserve. As per the IMF report, 10% of India's forex reserve comprised non-traditional currencies which was valued at $44.8 billion.
The report says that while the Swiss National Bank added non-traditional currencies to its strategic asset allocation, changes for other countries may be explained by their trade and financial links with non-traditional reserve currency issuers. For instance, Namibia holds a large share of its reserves in South African rand due to its peg to that currency and trade relations with South Africa. Kazakhstan and Kyrgyz Republic hold Russian ruble due to their close trade relationships with Russia. Lesotho, with 69% held in non-traditional currencies, is the largest holder of non-traditional currency by percentage share of total forex reserves. Since this tiny African nation is surrounded by South Africa, it is obvious that its major forex reserve would be the South African rand.
For instance, in case of weaker economies dominated by a strong neighbour, like Namibia, Kazakhstan, Lesotho, Latvia etc. it would be obvious for them to amass reserves in the currency of its dominant neighbouring economy.
In the same manner, the exchange peg of a country increases its propensity to gather its forex reserves in favour of the peg.
However, the motivations of portfolio diversification of some central banks are quite enigmatic. For example, the central bank of Estonia holds Australian dollars (AUD) and Canadian dollars (CAD). Malta holds about 40% of its reserves in CAD, AUD, SEK, NOK, and CHF, according to its central bank.
The emergence of Chinese Renminbi:
China, the birthplace of one of the most significant literary compositions on strategic warfare, The Art of War, by Sun Tzu, may have learned its lessons better than any other country.
Sun Tzu said - The best approach in any military operation is to gain victory by means of strategy, the next best approach is to disintegrate the enemy's alliances by means of diplomacy and the inferior method is to launch a direct attack on the enemy, storming cities and seizing territory.
Patiently and steadily, the Chinese have been asserting renminbi (RMB) by purchasing commodities, particularly oil, in RMB and using gold as a neutral settlement reserve. In 2016, the RMB became the first emerging market currency to be included in the International Monetary Fund's (IMF's) special drawing rights (SDR) basket, which had earlier been the exclusive the privilege of the Big Four.
Russia, owing to its close ties with China, is increasingly moving its monetary settlements away from the dollar and enabling payments in yuan (CNY, the monetary value assigned to RMB). Thus, strengthening the case against the dollar as global reserve currency.
Alongside increasing its dominance in world trade, China is also increasing its loans to countries in Asia and Africa by spawning long-term developmental projects.
The Cross-Border Interbank Payment System (CIPS) launched by China in 2015, as an alternative to dollar-dominated Society for Worldwide Interbank Financial Telecommunications (SWIFT), already has 1,280 financial institutions in 103 countries and regions connected to the system by January 2022, as per various media reports.
And with the launch of its sovereign cryptocurrency, e-CNY or the digital yuan, in January 2022, the Chinese have already displayed their ability for long-term planning to assert their dominance in the changing landscape of global finance.
While it is quite clear that de-dollarisation is already in motion, how swiftly it may happen and what forces will dominate global finance thereon may become clearer as the future unfolds.
