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The Great De-Dollarization Wave of 2023: What Every U.S. Investor Needs to Know
The U.S. dollar’s dominance is being challenged. As countries around the world move away from the dollar, what does this mean for the average American investor? And more importantly, how can you protect your investments?
De-dollarization refers to the process where countries reduce their reliance on the U.S. dollar in international transactions, seeking alternatives. This shift has been driven by several factors:
As the U.S. faces increased tensions with major economies like China and Russia, these nations are reducing their dependence on the dollar to minimize vulnerability to U.S.-imposed economic sanctions. For instance, the U.S. has flexed its economic muscle in response to the war in Ukraine, leading to an intensified backlash against the dollar.
Russia and China’s Dedollarization Collaboration: Just days before Russia’s invasion of Ukraine in 2022, Russia and China had been actively collaborating on de-dollarization. As a result of unprecedented Western sanctions, Moscow became unable to transact in dollars and euros. Russia turned to alternatives like the Chinese yuan and gold.
However, these alternatives introduced new vulnerabilities. For instance, using the yuan makes Russia dependent on Beijing’s goodwill. Moscow has intensified its use of the yuan by increasing the yuan’s share in Russia’s reserves and switching to direct ruble-yuan trade, bypassing the dollar.
By the end of the previous year, Russia’s Finance Ministry increased the permitted share of yuan reserves in the National Wealth Fund to 60 percent. Ruble-yuan trade also saw an eighty-fold increase from February to October 2022.
Gold as an Alternative: Moscow has been accumulating gold as an alternative to the euro and dollar since its first invasion of Ukraine in 2014. Its gold holdings have nearly tripled since then. Moscow is currently holding 150,000 gold bars valued at about $140 billion, mostly stored in Russian vaults out of reach of Western asset freezes.
Russia, being the world’s second-largest gold producer, has been keen to sell excess gold in international markets. China has been a significant buyer, with gold transfers from Russia to China increasing by 67 percent in 2022. However, Russia has faced challenges in selling its gold on a global scale due to sanctions and logistical issues.
China’s Global Yuanization Ambition: China has been assisting Russia in its de-dollarization efforts since 2014. While Russia’s urgency for de-dollarization increased post the Ukraine invasion, China has a longer-term goal of competing with the dollar and advancing the yuan as an international currency. Russia serves as a test case for China, allowing the People’s Bank of China to experiment with financial and monetary policies in a controlled environment.
Declining Global Reserves
The U.S. dollar’s share in global reserves has been declining. From being the “indisputable hegemonic reserve” in 2001, it now constitutes about 59% of total global official reserves as of the first quarter of 2023.
Evidence of the Dollar’s Decline: According to the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) survey, the share of U.S. dollar reserves held by central banks fell to 59 percent during the fourth quarter of 2020, marking its lowest level in 25 years. The data shows that the share of U.S. dollar assets in central bank reserves dropped by 12 percentage points—from 71 to 59 percent—since the euro was launched in 1999.
Mechanism of the Dollar’s Decline: Exchange rate fluctuations can have a significant impact on the currency composition of central bank reserve portfolios. Changes in the relative values of different government securities can also influence this composition. For instance, during periods of U.S. dollar weakness against major currencies, the U.S. dollar’s share of global reserves generally declines since the U.S. dollar value of reserves denominated in other currencies increases. Conversely, the share increases during times of U.S. dollar strength.
Reasons for Decline: Several factors influence the U.S. dollar exchange rates, including diverging economic paths between the United States and other economies, differences in monetary and fiscal policies, and foreign exchange sales and purchases by central banks. Over the past two decades, the value of the U.S. dollar against major currencies has remained broadly unchanged. However, significant fluctuations in the interim can explain about 80 percent of the short-term (quarterly) variance in the U.S. dollar’s share of global reserves since 1999. The remaining 20 percent of the variance can be attributed mainly to active buying and selling decisions of central banks to support their own currencies.
Proponents of De-dollarization: Some emerging market and developing economy central banks are actively seeking further diversification of the currency composition of their reserves. Countries like Russia have already announced their intention to diversify away from the U.S. dollar. Despite these shifts, the U.S. dollar remains the dominant international reserve currency, but any changes to its status are expected to emerge in the long run.
Countries like Brazil, Russia, India, China, and South Africa are taking steps towards de-dollarization.
Russia’s New Currency Initiative: Last month, in New Delhi, Alexander Babakov, deputy chairman of Russia’s State Duma, announced that Russia is spearheading the development of a new currency specifically for cross-border trade by the BRICS nations. This move is a significant step towards reducing the BRICS countries’ reliance on the U.S. dollar for international transactions.
Brazil’s Stance on the Dollar: Brazil’s president, Luiz Inácio Lula da Silva, has been vocal about the dominance of the U.S. dollar in international trade. He questioned the need for all countries to base their trade on the dollar, indicating Brazil’s inclination towards exploring alternatives.
China’s Trade Agreements: As previously mentioned, China has been paying for its massive commodities purchases from Russia using the renminbi rather than the dollar. Additionally, China has signed deals to use its own currency in trade with countries like Saudi Arabia and Brazil, further reducing its reliance on the U.S. dollar.
Repercussions of De-dollarization for the U.S. Investor
A decline in global demand for the U.S. dollar could weaken its value, impacting international investments and purchasing power. The dollar’s share of allocated currency reserves has fallen from more than 70% in 2001 to 59% in 2023.
Mechanism of Currency Value: The value of a currency, like any other product or service, is determined by supply and demand dynamics. When there’s a high demand for a particular currency, its value will go up. Conversely, if there’s less demand for a currency, its value will go down.
Impact of Declining Demand: When global demand for the U.S. dollar decreases, fewer entities want to hold or transact in dollars. This reduced demand can lead to a surplus of dollars in the market, causing its value to drop. A weaker dollar means that it can buy less of a foreign currency, making imported goods more expensive for American consumers. This phenomenon diminishes the purchasing power of the dollar, meaning Americans have to spend more dollars to buy the same amount of foreign goods or services.
Real-World Implications: For instance, a weak dollar increases the cost to import oil, causing oil prices to rise. This means a dollar buys less gas, which affects many consumers. Moreover, when the dollar is weak, U.S. multinational corporations that earn a significant portion of their profits overseas can benefit. Their profits from foreign countries, when converted back to a weaker dollar, result in more dollars, boosting their bottom line. However, this can also lead to higher prices domestically as these companies might raise their prices to maintain profit margins.
Purchasing Power and Inflation: Over time, as the dollar weakens and imports become more expensive because it takes more dollars to purchase overseas goods, it can lead to inflation. Inflation erodes purchasing power as the same amount of money can buy fewer goods and services. This can have a cascading effect on the economy, affecting everything from consumer spending to interest rates.
Reduced demand for U.S. debt could lead to higher interest rates, affecting borrowing costs for businesses and consumers.
When there’s reduced demand for U.S. debt, the government might have to offer higher interest rates on its bonds to attract buyers. Higher government bond yields can lead to higher interest rates across the economy, as they set a benchmark for the minimum return investors will accept.
If the government is paying higher interest on its debt, banks and other lenders will also demand higher interest rates when they lend to consumers and businesses. This can increase borrowing costs for everyone, from individuals wanting to buy a home to businesses looking to expand.
If de-dollarization continues and the dollar loses its status as the top global currency, borrowing costs in the U.S. will probably move higher, making it more difficult to gain access to capital.
A weaker dollar could lead to increased prices for imported goods, potentially driving inflation. In a scenario where the dollar is no longer dominant, the U.S. stock market may also experience a drain in value.
Strategies to Navigate De-Dollarization
Diversify Currency Exposure
Consider investments in assets denominated in other currencies or in countries less reliant on the U.S. dollar. For instance, countries have been allocating reserves to currencies from smaller economies, including the Australian dollar, Canadian dollar, Swedish krona, and South Korean won. Retail investors, like you, can explore opportunities in foreign currency exchange (Forex) trading.
Invest in Real Assets
Commodities like gold can act as a hedge against a declining dollar. According to the World Gold Council, central bank demand for gold in 2022 soared to 1,136 metric tons, up 152% year over year and hitting the highest level since 1950. Again, retail investors can purchase gold as a hedge or even roll over their retirement accounts as a way to protect themselves from a dollar crash from de-dollarization.
Explore Emerging Markets
De-dollarization can present opportunities in emerging markets as they develop stronger local currencies and financial systems. China’s efforts to position its renminbi as a reserve currency is a testament to this, even though its share of global reserves remains under 2.5%.
The rise of cryptocurrencies and central bank digital currencies (CBDCs) offers new investment avenues. However, they come with their own set of risks and should be approached with caution.
While the U.S. dollar’s position as the global reserve currency faces challenges, its displacement is unlikely in the near term. However, as an investor, understanding these shifts and strategically diversifying can help mitigate potential risks.
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