U.S. Dollar’s Long-Term Prospects as the Global Reserve Currency

Recent concerns about the preeminence of the U.S. dollar have been driven by:

1. the extraordinary sanctions on Russia in 2022, including cutting off its access to U.S. dollar reserves, which magnified concerns for China and other nations that are geopolitical rivals to the U.S.,
2. the ongoing trade war with China, and
3. the rapid technological development of digital assets (crypto assets).

While these developments will inevitably lead to further diversification away from the U.S. dollar, we do not believe the dollar will be supplanted as the dominant currency for global transactions and central bank reserves, and we have the following observations.

As a result of the Ukraine war and trade war with China, Russia and China are now locked into a geopolitical partnership to undermine U.S. geopolitical dominance, including the dollar’s supremacy. A consequence of this Russo-Chinese alliance will be transactions in currencies that fall outside sanctions by the U.S. However, this will be no easy feat. The U.S. dollar still monopolizes the world’s monetary system (see charts), even though the U.S. is likely to lose additional economic clout over time as other economies grow in importance.

A reserve currency must serve the three basic functions of money on a global scale: providing a store of value, unit of account, and accepted medium of exchange. A major aspect of an effective reserve currency is its ability to act as a safe haven. The U.S. is the world’s largest, most robust economy with a high degree of transparency. Importantly, the U.S. dollar is a free-floating currency and capital is allowed to freely flow into and out of the U.S. It also has the world’s most dominant military force, which includes security guarantees to many of its trading partners. Consequently, the U.S. dollar has a long history of serving all the important functions of a reserve currency while there currently is not a realistic alternative.

While China’s role in the global economy continues to grow, there are major limitations for the renminbi (RMB or yuan) as a reserve currency. It faces serious obstacles from persistent currency controls and a closed capital account. Strict capital controls limit how much foreign companies are willing to invest and borrow in yuan, outside of use in direct trade with China. China’s still-developing capital markets and strict rules on direct, onshore portfolio investments by foreigners are also significant problems. However, as China invests more at home and in other countries, financing and invoicing deals in the renminbi will grow.

While the dollar is the transactional currency globally, it is far less relevant when considering local trading blocs. The euro dominates intra-European trade, suggesting China can try to expand RMB invoicing for intra-Asian trade.

As China continues to grow and increases the share of RMB trade within its sphere of influence, the yuan will rise as an invoicing currency (see right chart). While this shift is already underway, it will most likely take years, even decades to unfold.

The biggest competitor to the dollar is the euro, which took the largest chunk out of the U.S.’s share of the global currency reserve basket in recent decades (see first chart). However, the euro share is well off its peak and the European Union could suffer a long-term loss of security, productivity, and stability from Russia’s invasion of Ukraine and the ensuing energy cutoff with Russia.

The global foreign exchange (FX) market remains concentrated in a few currencies, with the U.S. dollar dominating with a steady market share over several decades. In 2022, the average turnover per day with the dollar on one side of the transaction was $6.6 trillion, up 14% from $5.8 trillion in 2019, and in line with the change in total turnover. The dollar was involved in nearly 90% of global FX transactions, making it the single most-traded currency in the FX market. The dominance of the dollar is evident across all FX instruments and counterparties. At least 85% of trading in the spot, forward and swap markets features the dollar in one leg of the transactions.

Currently, there is no credible alternative to the dollar in the FX markets. The euro—the second most traded currency—has a share of only 31%, down from its peak of 39% in 2010. A similar trend can be observed for the Japanese yen, while the British pound has maintained a largely constant share. The shift from these major currencies has been matched by a rise in the role of emerging market economy currencies such as China’s renminbi. The renminbi’s share in global FX turnover has increased from less than 1% 20 years ago to more than 7% now. While China’s share will continue to grow along with its economic importance, the dollar will remain the dominant player in FX markets for the foreseeable future.

In addition, about half of all international debt securities and cross-border loans issued in offshore funding markets are denominated in dollars. As of the second quarter of 2022, the amount of debt and loans denominated in dollars where neither the issuer/borrower nor the lender is a U.S. resident is estimated to be 88% of total international dollar-denominated debt and 65% of total international U.S. dollar bank loans. This can be attributed to deep and liquid U.S. capital markets that will not be replaced anytime soon.

In summary, for the U.S. dollar to stop being the global reserve currency, another country’s currency would need to present itself as a superior alternative to supplant it and be so considerably superior to warrant the effort. No viable alternative exists today.