There’s been a lot of debate that the US dollar might lose its status as the world’s most used currency. A lot of people right now because of all this chatter they’re hearing about this for the first time, and they’re probably feeling a little bit iffy. Will the US dollar actually lose its dominance?
“The US dollar is really the only serious candidate for the world’s principal reserve currency.”
What’s a Reserve Currency?
I had the same question too, so naturally, I made this article. And the first question that I want to answer was, what the heck reserve currency analogy is. A reserve currency is a type of currency that a country will keep in its central bank, and the whole purpose of it is so that they can buy things with it and also pay off debts.
Reserve Currency Analogy
Growing up, there are popular candies at our school and many other schools around us. Now let’s pretend for a moment that I had two friends, because, well, that’s one more than I have right now. Kevin has a Snickers bar, and Claire has a Reese’s Peanut Butter Cup.
Now let’s pretend for a moment that my friend Kevin wanted to trade Claire his Snickers bar for her Reese’s Peanut Butter Cup candy, but there’s a problem. Claire doesn’t want the Snickers. In fact, the Snickers bar is just not popular at her school.
So, what Kevin could do is trade his Snickers for a KitKat and then trade the KitKat for the Reese’s that he wants. Just like candy, it operates the same way with money. Some types of money are more popular and easier to trade with, and that’s why some countries like to use certain types of money as their reserve currency. It’s just like a common denominator candy that we’re all going to use.
The Adult world
Now back to the adult world, the current reserve currency of the entire globe is the US dollar. You probably already knew that, but did you know, in fact, that central banks currently hold about 60 percent of their foreign exchange reserves as dollars, and many transactions as we’ll find out are actually conducted in US dollars.
How USD Became The World Reserve Currency
So, how did USD become the world reserve currency? First, we need to understand how the US dollar became the world’s reserve currency back all the way in 1944. Because by understanding why the world shifted away from the previous reserve currency of the world, which was the Great British Pound Sterling, we can then understand what signs to look for in case there’s ever a changing world order.
The British pound sterling started to lose its influence during World War One and shortly after World War Two. What happened was that during the First World War, the UK needed to heavily fund their war effort, which increased their own debt.
Additionally, they suspended the gold standard back in 1915 which allows them to print more currency as a result to further fund their war effort. This way, they could raise funds without having to worry about maintaining the fixed exchange rate of the British pound.
So the British actually remained off the gold standard after 1915, and they started to buy weapons and ammunition from the United States. The British would pay for these weapons and ammunition in the form of, you guessed it, gold. So the US started to slowly stockpile this gold through World War One and World War Two, and by the end of World War Two, they nearly held two-thirds of the entire world’s gold reserves.
Bretton Woods Conference
The US for the most part remained on the gold standard throughout all these years, and in 1944 there was a famous conference called the Bretton woods conference. It was at this conference in new Hampshire that 44 countries came together and signed the Bretton woods agreement.
What that agreement basically entailed was that the US dollar would become the worlds reserve currency. This was because the US had the world’s largest economy at the time, as well as two-thirds of all the gold reserves.
As a result of the Bretton Woods system, the US dollar was fixed to the price of gold, and other currencies would be fixed to the US dollar. This meant that central banks and many other international institutions abroad held large amounts of US dollars as their primary reserve asset.
Why Countries Peg Their Currency to The US Dollar
But why would countries voluntarily peg their currency to the US dollar in the first place? That’s a good question. The main reason for doing so was that it promoted stability among a lot of their own currencies, facilitating international trade, and also reducing volatility in exchange rates.
All right, so that’s the gist. The US dollar became the world’s reserve currency after World War II. Everything was fine and dandy. The US was the strongest economy at the time, plus the crap ton of gold reserves that they had.
Presudent Nixon, 1971
It was until 1971 that the US completely abandoned it. President Nixon took the United States off the gold standard in 1971 in a famous speech because what was happening was the US was spending more than they were actually bringing in. “I have directed Secretary Conley to suspend temporarily the convertibility of the dollar into gold or other reserve assets. The effect of this action, in other words, will be to stabilize the dollar.”
The United States was spending money left and right. They were spending money on the Vietnam War at the time, social programs like Medicare, and the economy just wasn’t growing as fast as in decades past. So taking the US off the gold standard meant that Nixon could prevent the dollar from losing value as well as printing more money to basically fund all the efforts that were going on.
But now the dollar wasn’t really backed by anything other than the full faith and credit of the United States government.
While this decision brought a lot of uncertainty in the international markets at the time, for the most part, countries have still latched onto the dollar as the world’s reserve currency.
How We Should Think of The US Dollar
So how should we think about the US dollar as the world’s reserve currency as of right now? I believe that there are three big criteria that we should look for when it comes to world reserve currency status, and we’ll see if the US dollar will still hold up in our lifetimes.
The first of these three criteria for a world reserve currency status is economic stability. Any world reserve currency should be backed by one of the strongest economies in the world. So that usually means having a really strong GDP as well as strong GDP percentage growth year over year.
GDP stands for gross domestic product, and it’s just a fancy way of saying how much stuff does a country make in a single year. If we add up all the money that people are spending on goods and services in a single year, we get the country’s GDP.
The higher the GDP, the more stuff that a country is making and selling, so that actually is a sign of the country doing well economically.
A country with a large and growing economy is likely to have a currency that’s going to be used in international trade and thus the world reserve currency. Of course, there are other factors to economic stability as well. So inflation is one of those numbers which the US has been having a tough time as of recent.
Current Account Balance
Another factor is the current account balance. So if the current account balance is in a surplus, that means the country is exporting more than they’re importing. If the current account balance is negative or in a deficit, that means the country is importing more than they’re exporting.
In the case of the United States, they’re currently running a deficit. In the case of China, they are running a surplus. China’s surplus could boost their world reserve currency status and make them a threat to the US dollar.
However, if you look at the data, the data currently still shows that half of international trade is invoiced in US dollars. Half of international loans and global debt are denominated in dollars. And lastly, in the foreign exchange markets, dollars are involved in nearly 90% of all transactions. Basically, the dollar still remains a pretty big deal.
The second big criteria for world reserve currency status is political. The country with world reserve status should have a strong legal system that upholds contracts with high integrity. So basically, countries will want to actually deal with them.
They should also have an independent central bank that maintains monetary policy without any political interference. Basically, you want a country or a coalition of countries that will want to be dealt with on a regular basis – aka they are reasonable and nice with other countries – so that other countries will want to use their currency.
The third criteria for a world reserve currency should be a strong military. I know it’s 2023 and that wars should be a thing of the past, but a country with a strong military usually is a global power and has global influence, thus creating more confidence for their own currency.
You want to create a predictable and stable environment for foreign investors and traders. And so, if that is ever undermined, and that undermines the entire financial system, that could threaten the world reserve currency status of whatever country holds it.
Why The US Dollar Isn’t Going Anywhere Anytime Soon
So while many people think that a changing world order is coming, there are man arguments for why the US dollar isn’t going to go anywhere anytime soon. Economically speaking, the US is the largest economy and has one of the largest stock exchanges in the world, the New York Stock Exchange, which has a market cap of 40 trillion dollars at the end of 2022. The US also leads in technology with companies like Amazon, Apple, and Microsoft, etc.
Also, the US dollar is used in 80 percent of global oil trade due to the system called the petro dollar. This system started in 1970 but basically, it stated that if you were an oil-buying country and you’re trying to buy oil from an oil-producing country, you had to pay for it in US dollars. This means that most countries are going to keep a large reserve of US dollars in their central bank so that they can trade oil internationally.
Some countries, such as China, are trying to ditch the petro dollar entirely so that they are more in favor of their own currency. And so, so far, Saudi Arabia, which is one of the biggest oil-producing countries, has said that they are open to all types of payments and they’re not just going to settle on the US dollar.
This could be a threat to the US dollar because if there’s less of a reliance on the US dollar, especially for global oil trade transactions, that could be a threat to the world reserve currency status.
However, it still remains to be seen whether or not this is a big enough threat. We’re not even seeing a really large shift yet. Right now, the petro dollar is still going pretty strong. It’s definitely something to keep an eye on.
Politically speaking, the US has strong economic and military ties with many countries in Europe, Asia, and the Middle East. The US also has strong military alliances with countries like Japan, South Korea, and all the NATO countries, for example, and this all helps to really establish the US as a dominant military and political power.
Plus, the United States spent over 1.1 trillion dollars in 2022 on military defense spending, which ranked number one in the world. So again, the US dollar, in terms of those three criteria for a world reserve status, it still remains pretty strong.
USD During Crises
Now, many people are also quick to point out that during a crisis, or perhaps a black swan event, that’s when the US dollar might be on its way out. But there is a counter-argument to that as well.
So, the dollar has been stable even in periods of crisis. For example, during the 2008 financial crisis, what we actually saw was interesting behavior. We actually saw many countries fleeing to safety in the US dollar and US treasuries. Since the US dollar is considered a safe haven currency, that’s basically what you saw. That was the actual behavior that played out during this crisis.
What’s funny to me is that the 2008 financial crisis was a black swan type event. It was created by the United States, yet other countries were investing in the US dollar. I would argue that the most vulnerable time for the US dollar to be overthrown as the world reserve currency status would be during 2008 but we saw the opposite.
According to a bulletin from the Federal Reserve in 2010:
“Total foreign acquisition of Treasury securities amounted to more than one trillion dollars in the two years since summer 2007, raising estimated total foreign holdings to nearly 3.4 trillion by mid-2009.”
Similarly, this also happened during the COVID-19 pandemic:
“As investors realized earlier this year the size of the economic shock that COVID-19 would cause, they sold riskier assets like stocks and bonds, taking safety in cash. But not just any cash, investors all over the world wanted US dollars.”
Other Countries Stats
My point is this: if the US dollar was going to be dethroned, a major catalyst would have been 2008. Alright, so what about other country stats? Countries like India, China, and the Eurozone – how do they economically stack up against the United States? Here’s a table of exactly how India, China, and the Eurozone stack up in terms of their economic metrics.
You can see that the US has a commanding lead on real GDP in 2022 and the next closest are China and the Eurozone. While the US’s GDP percentage growth in Q4 was 2.6%, which was smaller than China and India’s. We also have to take into account that the US’s GDP is about 40%t bigger than that of China’s and also 73 times the size of India’s. So basically, it’s slightly easier for these smaller GDPs to grow faster on a GDP percentage scale.
Another threat to the US dollar is Brazil and Russia, so basically part of the BRICS countries. One potential threat is that they are using their own currencies to trade amongst each other, trying to ditch the US dollar. So China has been trying to do this with Russia as well as Brazil.
However, it is important to note that the BRICS countries also face a ton of challenges themselves. For example, Brazil and Russia recently have struggled with economic recessions as well as political instability in the most recent of years. China also has some social, demographic, and economic challenges as we’re soon going to discuss.
Now, additionally, the US still has many advantages. They still have a deep and liquid financial market. They have a strong military. And also, I want you guys to look at this chart.
A dollar has the most important role in global finance, increasing in share percentage in global payments, share of international debt, and share of international loans. So while there are other countries on the horizon threatening the US dollar status as a world reserve currency, so far, the data isn’t really showing that. It’s really unclear on how long that will take.
Ray Dalio’s Changing World Order.
Ray Dalio has pointed out that, “The Decline of an Empire (The USA) and the Rise of Another One (China) has never happened before in our lifetime but they have happened many times before in a series of events called the Big Cycle lasting roughly 250 years.”
To be clear, I don’t think Ray Dalio is wrong. I do think he is right that there will be a new nation that shifts into power and wealth sometime in the future. I just don’t think it’s within our lifetimes.
Currently, the United States has been a superpower for about a hundred years now. Ray Dalio cites several factors including high US debt levels, political divide, and the rise of China as threats to the US’s power.
In terms of Dalio’s point on high US debt levels, yes, the US has a lot of debt in the United States. While the US does have high debt levels, the US dollar is still viewed as a safe haven asset and used quite a lot internationally.
Furthermore, China’s debt to GDP ratio is actually between 275% to 300% at the end of 2022, compare that to the US, which is right around 97%. China is also facing a major debt problem like the United States is, and until we see a major shift, I don’t see the world ditching the dollar just yet.
Ray’s Political Divide
In terms of Ray’s point on political divide, I would argue that yes, America does seem divided quite a lot of the time. However, America has overcome these divides time and time again in its history. It’s also unclear how much of a political divide is needed before a big shift actually occurs on the world stage.
Regarding the rise of China, the IMF (International Monetary Fund) believes that the Chinese economy will overtake the US economy by the year 2050. Other articles cite the year 2030 or 2075 as when it will happen. Until it actually happens, we won’t know for sure.
Another problem China currently faces is that “deaths outnumbered births” last year for the first time in six decades”. This means that their population could be shrinking, which doesn’t usually correlate with a growing economy because you need more workers to replace those that are retiring and passing on.
While there are definitely challenges to the US dollar, it’s likely that the US dollar will remain the reserve currency so long as we shall live, just based on the data that we have currently available to us.
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Some Other Thoughts
There are still so many strengths for the US dollar, including a deep and liquid financial market, it being one of the most used currencies in international transactions, and existing international financial systems that are rooted in the US dollar.
If the dollar does decline, I think we will see it coming from far away. So, hopefully, 10 or 20 years out. Ray Dalio isn’t wrong. I just think that the timing of this cycle is longer than we think, and we are seeing a lot of headlines and online videos that are sensational in nature.
Let me know what you guys think in the comments, and as always, Peace and Happy Hustling!