After the Fed's $5 trillion printing spree and interest rate suppression, U.S. inflation rages and the question continues to arise: When will the rest of the world give up the dollar's dominance as the world's reserve currency? If this happens suddenly, it will mean chaos, but it is happening little by little.
According to COFER data released by the International Monetary Fund at the end of March, the share of global foreign exchange reserves denominated in dollar terms fell by 40 basis points from the third quarter to 58.8% in the fourth quarter, a new 26-year low and slightly higher than the low in the fourth quarter of 2020. Foreign exchange reserves denominated in U.S. dollars include Treasury bonds, U.S. corporate bonds, U.S. mortgage-backed securities, and other dollar-denominated assets held by foreign central banks and other foreign official agencies.
Over the past 20 years, the share of the dollar since 2001 before the official arrival of the euro currency has fallen by 12.7 percentage points, from 71.5% at the time to 58.8% now.
Global foreign exchange reserves exclude assets held by central banks in their national currencies, such as Treasuries and MBS held by the Federal Reserve itself, euro-denominated assets held by the European Central Bank, or Japanese government bonds and other yen-denominated assets held by the Bank of Japan.
Back in 1977, a period before inflation raged, the dollar's share was still 85 percent. But fears that the Fed would run inflation out of control, dollar assets were dumped by the central bank, and the dollar's share of the global reserve currency collapsed, bottoming out a decade after Fed Chairman Volcker began successfully cracking down on inflation.
It took years of inflation before dollar assets were sold off, and then, after inflation was largely brought under control, it took years for dollar-denominated assets to be recovered again.
As the dollar's share of the global reserve currency declines, the share of other currencies increases and the dollar becomes less dominant as other central banks are gradually diversifying away from dollar holdings:
The ratio of the exchange rate of the US dollar to foreign exchange reserves
The value of foreign exchange reserves denominated in currencies other than the United States dollar is converted into United States dollar figures. For example, the value of euro-denominated assets held in Japan is expressed in U.S. dollars and at the current eur/U.S. dollar exchange rate to make them comparable to other assets held.
The exchange rate between the U.S. dollar and other currencies affects the size of non-dollar assets. In other words, the size of the eur denominated assets held by the Bank of Japan changes with the change of both: the change in the euro assets held by the Bank of Japan, and the exchange rate of the euro against the dollar.
However, the exchange rates of major currencies, while fluctuating month by month, have remained stable and well managed over the past 23 years, as shown by the dollar index, which tracks the dollar against the euro, yen, pound, canadian dollar, swedish krona and Swiss franc.
Today, the dollar index closed at 98.57, broadly unchanged from 1999 and 2000 levels, despite dizzying volatility in between. Those who wait for the dollar to collapse, or the euro or the yen to collapse, have to be very patient.
Over the past two decades, the impact of the dollar exchange rate on the dollar's share of global reserve currencies has been relatively small. Much of the long-term decline in the dollar share was due to the shift from dollar-denominated holdings to non-dollar holdings by central banks, but very slowly and methodically avoiding blowing down the House of Cards. In the short term, as we'll see later, exchange rates do drive things forward.
Inflation is another matter
Inflation destroys the purchasing power of the national currency. In the short term, there is no direct link between inflation and the exchange rate. For example, the dollar is currently rising sharply against the yen, but the US CPI inflation rate is the worst in the US dollar index basket, while Japan's inflation rate, although rising, remains moderate.
The euro is in trouble
The eurozone includes 19 countries with a population of 340 million. More than 20 years ago, when politicians talked about the euro, they chattered about "parity" with the dollar as a global reserve currency, trading currency and financing currency. This situation continued to develop until the euro debt crisis ended the dream of the euro as a reserve currency parity with the dollar.
The euro is already stuck in a distant second place, with a share of about 20%. The share of the rest of the global reserve currencies is small or small:
Other reserve currencies
To take a closer look at the curve at the bottom of the chart, the remaining reserve currencies compete for share, limiting the left-hand ratio to a range of 0% to 6%. This squeezed the dollar and the euro out of the market.
The yen, the third largest reserve currency, had a share of 6.0 percent after rising five years in the fourth quarter of 2020, starting to decline in the first quarter of 2021. By the end of 2021, the yen's share had fallen by nearly 7 percent, due to a 10 percent plunge in the yen's exchange rate against the dollar over the same period. In other words, all the declines in the yen's share are explained by the decline in the yen's exchange rate against the dollar.
The fourth-largest reserve currency, the pound, has remained largely stable over the past few years, but has seen a slight upward trend in recent quarters. In the fourth quarter, its 4.8% share was only slightly higher than its share in the fourth quarter of 2015.
Chinese has continued to grow in tiny increments, reaching a staggering 2.8% in the fourth quarter and up 90 basis points in two years. At this rate, it will take another 18 years for the renminbi to break through the 10 percent mark.
As the currency of the world's second-largest economy, the renminbi should have a larger share. But there are still issues with convertibility. Although it is freely convertible for trade purposes, there are still effective capital controls.
The importance of the US dollar as the main reserve currency
The role of the U.S. dollar as the world's major reserve currency has enabled the United States to run its huge twin deficits without being upset: the U.S. government's incredible public debt has soared, currently exceeding $30 trillion; And the ballooning trade deficit, fueled by 30 years of cheapness by U.S. corporate companies.
If the dollar were to be driven out of its habitat, both deficits would be harder to finance and more expensive.
It's worth noting that the fact that in recent years the eurozone has had large trade surpluses with the rest of the world, especially with the United States, suggests that an economy with a trade surplus can also have one of the highest reserve currencies, thus debunking the outdated theory that countries with large reserve currencies must have huge trade deficits.
But having a dominant reserve currency can encourage the U.S. to increase its double deficit without paying much of a price.