In February 2022, the United States imposed unprecedented financial sanctions on Russia, most notably by restricting the flow of foreign exchange reserves of the Russian central bank in order to undermine Russia's ability to stabilize its economy and finance. It is widely believed in the international community that the financial sanctions will significantly reduce the attractiveness of US dollar assets. However, judging from the actual data from February 2022 to the end of 2023, the dominance of the US dollar as a reserve currency has risen instead of falling.
First, the trend of the US dollar's status
From the perspective of the unit attributes, the function of the US dollar as a denominated currency has indeed been affected by sanctions, but the appreciation of the US dollar has made up for part of the losses. Under the influence of US financial sanctions, the convenience of the dollar has decreased. Countries have increased trade and settlements in non-dollar currencies, setting off a wave of "de-dollarization". However, it should also be noted that since March 2022, with the Fed's interest rate hike, the US dollar index has continued to rise, and the US dollar has appreciated by more than 20% against other currencies, increasing the real value of dollar-denominated debt and assets. This means that in the function of dollar-denominated currencies, the increase in debt valuation partially compensates for the loss in trade denomination.
From the perspective of the medium of exchange, the US dollar has increased its share in international payments and foreign exchange transactions, grabbing most of the euro share. According to the Society for Worldwide Interbank Financial Telecommunication (SWIFT) Global Currency Payments data, the US dollar accounted for 47.54% as of December 2023, significantly higher than the pre-sanctions level of 38.85%. At the same time, the share of the euro fell sharply to 22.35% from 35.36% before the sanctions. In foreign exchange trading, the US dollar and the euro also show a trend of trade-off. Clearly, the geographical proximity of Russia and Ukraine to Europe presents a significant risk premium for the euro. The British pound, a traditional safe-haven currency, has also moved in line with other European currencies after the escalation of the Ukraine crisis. As a result, the dollar reaps a share of major Western currencies such as the euro, which in turn boosts its comparative advantage.
From the perspective of asset allocation attributes, the share of the US dollar in the global foreign exchange reserve currency has increased slightly, and has expanded its advantage over other major Western reserve currencies. Before the United States tightened sanctions against Russia, the US dollar's market share in global foreign exchange reserves had fallen to 58.8% in the fourth quarter of 2021, a 26-year low. However, after the United States strengthened sanctions against Russia, the proportion of the US dollar in global foreign exchange reserves showed an upward trend, and the proportion of the US dollar in global foreign exchange reserves rose to 59.74% in the second quarter of 2022, increased again to a high of 60.1% in the third quarter, and remained at about 59.46% for the whole of 2023.
Second, the reason for the trend of the US dollar
Financial sanctions inevitably pose a national security threat to the target country, which makes the countries that support the US sanctions feel more secure. From the perspective of international security, countries and actors that feel insecure because of U.S. financial sanctions have different currency choices than those that feel more secure because of U.S. financial sanctions.
1. U.S. allies have accepted the dollar's "security premium" and strengthened the dollar's international status.
First, defense commitments have increased the attractiveness of the dollar. Countries that benefit from military protection have an incentive to hold and trade the currency of the country providing military protection as a way of providing economic support. 2022 data shows that about three-quarters of U.S. security assets held by foreign governments are already held by countries with some military ties to the United States. Second, geopolitical mechanisms drive demand for the dollar. As geopolitical conflicts negatively affect countries' willingness to maintain economic interdependence, governments have focused more on subordinating international economic relations to geopolitical relations. Third, military power plays an important role in shaping confidence in a currency that is not likely to depreciate sharply, is safe and liquid. U.S. military hegemony provides an umbrella for the dollar, and other countries that do not enforce sanctions but largely agree with their targets are willing to store value in currencies that guarantee security and liquidity.
(2) The "de-dollarization" caused by the implementation of financial sanctions by the United States has not yet formed economies of scale, and the impact on the status of the US dollar is insufficient.
First, countries interested in "de-dollarization" cannot avoid the financial costs of "de-dollarization". Second, it will take time for many countries to implement their "de-dollarization" strategies. Although the government level of countries that have adopted the "de-dollarization" strategy is firmly implementing the "de-dollarization" initiative, it is difficult to credibly implement the "de-dollarization" at the corporate level in the short term. Third, countries that "de-dollarize" have different goals and different sense of urgency. These countries have neither a consensus nor the same sense of urgency to prioritize "de-dollarization", which hinders the formation of a systematic and cohesive "de-dollarization" trend in the short term.
(3) The stability of the US dollar in global foreign exchange reserves can reverse the trend of its role as a medium of exchange, a means of payment, and a measure of value.
The U.S. dollar accounts for about two-thirds of global foreign exchange reserves, and it still has an overwhelming advantage. The stability of the U.S. dollar as a reserve of value can derive other monetary functions, and then reverse the decay trend of the U.S. dollar as a unit of account and a means of payment. The cyber externalities of the US dollar have increased the resilience of the US dollar to shocks.
3. Long-term impact outlook
(1) Countries that have imposed joint sanctions with the United States have shifted from focusing on security to attaching importance to the economy.
The excessive expansion of U.S. sanctions could hurt the economic interests of allies, weaken their support for current and future financial sanctions, and then affect the stability of the U.S. financial sanctions alliance. At the same time, uncertainty about U.S. security support for allies has risen. It is becoming increasingly expensive for the United States to maintain its military superiority, and domestic budgets limit military spending. More importantly, the U.S. defense commitment will change with its strategic advancement and other security policy changes, which will have a different impact on the countries in the alliance, further increasing the uncertainty of the U.S. defense commitment to its allies.
(2) In the long run, "de-dollarization" countries may form market-oriented economies of scale due to the convergence of choices.
First, "shared grievances" and "baselines of common interests" may lead to consensus among "de-dollarized" countries. In the face of geopolitical uncertainty, it is imperative for many countries to diversify their risks and reduce their exposure to exogenous shocks and exchange rate fluctuations, which has created a baseline of common interests among all countries subject to the privilege of the dollar, which could lead to the rise of joint initiatives to "de-dollarize". Second, the political and economic capacity of "de-dollarization" countries will support the robustness of "de-dollarization" initiatives. Russia is in the best position to unite other economies negatively affected by dollar fluctuations and use a broad path of "de-dollarization". India is unlikely to play a clear role in the broader "de-dollarization" initiative, but it will help other countries reduce their dependence on the dollar by supporting initiatives to promote the use of local currencies in trade and development finance. China has always prioritized the stability and equality of its system, which is why its diverse vision of the system is more attractive to its followers. Third, the increase in the number of "de-dollarization" participants will lead to professional division of labor, learning effects, and cost sharing.
(3) Changes in the power of the two sides or four scenarios that trigger changes in the status of the dollar.
Scenario 1: The U.S. financial sanctions alliance is solid, "de-dollarization" is still in a state of solitary combat, and the international dominance of the U.S. dollar will not be threatened. In the absence of a large number of investment options to replace the US dollar, the global monetary system still uses the US dollar as the dominant international currency for a long time due to the inertia of finance and the externality of the trading network.
Scenario 2: The U.S. financial sanctions alliance is solid, "de-dollarization" forms economies of scale, and the "campization" of the international monetary system may occur. In this case, the contours of the two areas will become more and more apparent. The two spheres will use different technologies and operate under different political, social, and economic norms, splitting the international monetary system into a dollar-dominated Western camp and a non-dollar-dominated non-Western camp.
Scenario 3: The U.S. financial sanctions coalition is becoming looser, and "de-dollarization" fails to form economies of scale, and the "fragmentation" of the international monetary system may occur. Political fragmentation could lead to higher trade barriers or stronger financial protectionism, posing a greater risk to global connectivity. Investors frequently rebalance their portfolios across currencies can create chaos in the international monetary system.
Scenario 4: The U.S. financial sanctions alliance is becoming looser, and the economies of scale of "de-dollarization" are growing, and the international dominance of the U.S. dollar will be shaken. Unilateral "de-dollarization" could pave the way for broader economies of scale, where non-dollar financial facilities between countries could interact and generate benefits, and could also be linked to create alternative non-dollar institutional and market mechanisms that better serve their interests and ideas. As a global public good with broader support, it could divert global financial flows from existing systems.
This paper prefers the evolution of the international monetary system in Scenario 4. Over time, the wartime unity of the United States and its allies will inevitably be challenged. While "de-dollarized" countries are unlikely to form security-focused alliances, convergence in choice can create value together, leading to market-based, scal-up arrangements. The continuous accumulation of "de-dollarization" means that the inflection point of the decline of dollar hegemony is real, and its direct consequence is the decline of the United States' ability to use sanctions against its strategic opponents, which in turn will destabilize the ability of the United States to enhance its political and economic values and maintain its soft power advantage in the global system.
Source: "China Institute of Contemporary International Relations" WeChat public account
Author: Ma Xue
Editor: Hu Liang
[Statement: This number is an official public welfare account to serve the decision-making of governments at all levels, enterprises and institutions, and this article is reprinted for the purpose of conveying more information. If there is a source labeling error or other inaccuracies, please contact us. We will correct it in a timely manner. Thank you]