Originally published at Project-Syndicate | April 8th, 2022
LONDON – The freezing of much of Russia’s official foreign reserves has inevitably led some again to predict the imminent demise of the dollar’s “exorbitant privilege” as the world’s reserve currency of choice. But we should not write the greenback’s obituary just yet.
On its own, the sanctioning of Russia’s reserves will likely reinforce the primacy of the dollar as the backbone of the fiat currency system. Only if the United States were regularly to use such financial sanctions as an offensive foreign-policy weapon might a more rapid erosion in the dollar’s status occur.
True, in the past four years – a period marked by a US-China trade war and the COVID-19 pandemic – the dollar has accounted for only 40% of new reserve accumulation, compared to 23% for the euro. The Chinese renminbi’s share of new reserves has jumped to 10%, while the Japanese yen and British pound have gained ground as well.
Despite this, it is far from clear that confidence in the dollar is waning. First, global reserve growth over the past four years was a fraction of the rapid growth seen in the five years before and after the 2008 global financial crisis, reflecting reduced global imbalances. The dollar’s share of reserves has fallen from 73% in 2001 to 59% last year. But most of this decline took place in the 2000s, when reserves surged by $8.1 trillion (compared to $2.6 trillion in the last decade).
Second, the International Monetary Fund’s new allocation last year of $650 billion in special drawing rights (SDRs, the IMF’s reserve asset) artificially deflated the dollar’s share of global reserve growth during the pandemic. SDRs are based on a currency basket in which the dollar’s share is only 42%, while those of the euro, renminbi, yen, and pound are 31%, 11%, 8%, and 8%, respectively. As SDRs accrue principally to advanced economies that never use them, these shares effectively inflate the shares of non-dollar foreign reserves.
Finally, countries with strong security relationships with the US – including the vast majority of states with the largest holdings of foreign-exchange reserves – typically maintain a larger-than-average share of their reserves in dollars. As long as America’s Asian and European allies deem US security guarantees to be credible, these countries have little incentive to shift away from the dollar.
Reserve freezes are not new, but the measures against Russia mark the first time that they have been applied to a G20 country with a high degree of global trade and financial integration. For foreign investors, reserve freezes that aim to create a financial panic pose an existential threat, in terms of the potential for capital to be either lost or trapped onshore.
The potency of the sanctions imposed on Russia’s reserves stemmed not from US actions alone, but rather from the concordant steps taken by Europe and Japan. Their participation ensured de facto near-unanimity, because Chinese banks became reluctant to deal with Russia for fear of being sanctioned in turn.
But for now, the sanctions risk premium on foreign-exchange reserves realistically applies only to countries at high risk of globally coordinated measures – namely China. For the vast majority of other countries, sanctions risk should remain low. Reserve diversification will continue to make sense, but it is likely to benefit currencies of countries deemed to be “sanctions-remote.”
And while the US trade war with China and the freeze of Russia’s reserves have again raised fears of an exodus from the dollar, the question is “where to?” Strong network effects underpin the dollar’s “exorbitant privilege,” and the Russia sanctions have arguably reinforced its anchor status. All things considered, a 60/40 reserve split between the dollar and other currencies looks appropriate.
While the renminbi should continue to benefit from China’s strong trade linkages with smaller countries and commodity exporters, its challenge to the dollar is likely to suffer from greater uncertainty regarding the rule of law and the sanctions risk premium. Larger central banks may be more reluctant to hold renminbi due to Western sanctions risk and the corresponding risk that China would be forced to reimpose capital controls on foreigners. The Chinese currency should therefore remain a fractional share of global reserves.
The euro’s share of global reserves should rebound if yields return to positive territory. Recent progress in reducing the risk of a eurozone breakup is the precondition for both higher rates and a larger share in global reserves. Nonetheless, Europe still must address the issues that kept the euro’s share of reserves below 30% prior to the eurozone crisis: fragmented domestic capital markets and flawed countercyclical stabilization mechanisms.
Other countries have some risk-diversification value. But they are both individually and collectively too small to offer a credible alternative to the US, China, and Europe as a destination for reserves.
That said, one can expect lingering fallout from the freezing of Russia’s reserves. China will seek to insulate its existing reserves from potential sanctions. Commodity exporters will consider how to invest freshly minted foreign-exchange reserves stemming from the current commodity boom. And foreign investors, both public and private, will assess possible collateral damage from financial sanctions that might affect the convertibility of renminbi assets onshore.
What might eventually upend the dollar’s continued dominance? If history were to rhyme with the United Kingdom’s experience of a century ago, it would involve some combination of US financial sanctions overreach, further economic stagnation at home, and an erosion of credible security guarantees abroad. Such a scenario looks less remote than it did five years ago. But don’t bet on it happening anytime soon.
Gene Frieda: A global strategist at PIMCO, is a senior visiting fellow at the London School of Economics.