European Affairs

The U.S. Dollar: Caught between Fatal Attraction and Growing Rejection     Print Email
By Jacqueline Grapin, Founder of the European Institute

jgrapinThe short term trend for the dollar is up. The recovery of the U.S. economy, and the combination of FED tightening on one hand and easing by the European Central Bank and the Bank of Japan on the other, creates a fatal attraction for the dollar. On top of this, U.S. sanctions against Russia push Russians and ruble holders to exchange declining rubles for dollars. Overall this situation will increase the value of the dollar, making it attractive for investors but more burdensome for American exporters.

This dollar surge, however, hides a longer term trend toward de-dollarization. Monetary diversification has become a key political goal for many governments, countries, and institutions.

Since the end of World War II the word has been: “the dollar is king.” But although the value of the American currency is generally expected to increase in the near future, it is wise to anticipate that the upcoming re-balanced world will not continue to be organized around only one currency. Joining the dollar as a reserve currency are the euro, the Yuan, the ruble (in spite of its recent difficulties), the British pound and possibly others. In this process, there will be winners and losers. Demand for dollars will decrease at some point.

The euro has already become the second most important reserve currency in the world, used in 32 % of all the world international operations, while the dollar is down from its summit to 41%, and the Yuan represents 1.5 %. These proportions are not likely to remain stable. Now that China has started direct trading between the Yuan and the euro, the European currency will become the sixth major currency to be exchangeable directly for Yuan in Shanghai, joining the US, Australian and New Zealand dollars, the British Pound and the Japanese yen. The EU is the largest trading partner for China.

It is worth remembering that the original objective of creating the euro, for the Europeans, was not to create an alternative to the dollar, but rather to create a single European currency that would put an end to the detrimental variations among the various European currencies. Those fluctuations were created in large part by international reactions to the gyrations of American domestic monetary policies regarding the dollar rather than by international considerations. When the dollar went up, strong currencies like the Deutschmark would go up disproportionately, and weaker currencies would go down. The euro has achieved the goal of stabilizing the regional monetary scene. Meanwhile it has attracted interest on the part of international operators has become an international reserve currency itself.

Mario Draghi, president of the European Central Bank, recently indicated that the ECB is considering introducing a new mechanism that would include the Chinese Yuan in its basket of reserve currencies, possibly as soon as 2015. Initial amounts would be minimal, but the message is clear-- “a more important role for the Yuan makes sense since China is our third commercial partner,” he said. For the first time In September 2014, for the first time, the Yuan and the euro could be exchanged directly without passing through the dollar. China is now moving progressively toward a new status of convertible currency with the goal of increasing its international role.

The Yuan ranked seventh for global payments in August 2014 and more than one third of the world’s financial institutions have used it for transfers to China and Hong Kong.[1]

China became the largest trading nation in 2013, ahead of the U.S. By 2020 it will become the world’s largest economy. It now represents 18 % of the world GNP, slightly behind the U.S. (18%) and the euro zone (12 %). Becoming independent from the U.S. financially is part of the Chinese dream and ambition. The Yuan is already traded directly against the US dollar, the Australian and the New Zealand dollars, the Japanese yen, the Russian ruble and the Malaysian ringgit. Currently 3.8 trillion dollars of its reserves are in green backs. If the dollar went down, Chinese reserves would also go down significantly. When the dollar rises, Chinese reserves grow. Accordingly, the process of dollar independence has to be carefully managed. One way to do it is to progressively internationalize the Yuan. It represents only 2.2 % of the total volume of transactions, and ranks only ninth in the world. But substantial growth here is almost certain.

China’s trade with European Union nations grew 12 % from a year earlier to $404 billion in the first eight months of 2014, according to the Chinese customs department. That compares with $354 billion with the U.S. during the period. French and German companies lead among countries outside of greater China in the use of the Yuan according to the HSBC.

It is not out of question that the Yuan might be included in the IMF special drawing rights basket on the occasion of the upcoming reforms in this multilateral organization.

The South Korea’s central bank announced that its domestic deposits have reached 16.19 billion Chinese Yuan in July 2014, a 55-fold increase from last year, while the proportion of foreign currency deposits held in Yuan had been rising from 0.4 % in 2012 to 13.7 % at the end of 2013.

Several global financial centers are vying to be trading hubs for the Yuan, including Luxembourg, Sydney and Singapore. London is expected to expand strongly. In 2013 Yuan foreign-exchange trading reached $25 billion a day, up 50 % compared with 2012.

Considering that a third of all dollars is held abroad, this evolution will change the U.S. monetary scene significantly. In March 2014, 35 % of the 17.2 trillion dollars of US public debt was owned by foreign countries, mainly China and Japan. In addition12 % was owned by the FED which has been buying dollars on the market to keep interest rates low.

Originally dollarization was a way for many countries to escape the risks from their own currency. In 1998, the IMF revealed that more than 50 % of deposits in 7 countries under IMF “adjustment” was in foreign currencies, mostly in dollars, 30 to 50 % in a dozen other countries and 15 to 20 % in countries allowing ownership of foreign currencies.

Much of the move away from the dollar has been due to U.S. budgetary and monetary policies, that encouraged, indirectly, more international diversification.

The conflict between the U.S. and Russia over Ukraine has opened a new era when, on May 21, 2014, Russia and China signed a 400 billion dollar agreement according to which Russia will supply China with oil and gas in the future. These operations will be in Yuans and rubles. And this at a moment when a number of oil and other transactions in the Middle East are denominated in euros, not dollars. The monetary evolution in the oil sector, which was initially a powerful basis for the might of dollar, may turn out to be an important step in the world de-dollarization process. Russia’s turn to Asia not only affects the European energy scene--Europe will become more dependent on the U.S.--but it also aims at making more exchanges independent to the dollar.

The BRICS are working on a new international bank as an alternative to the IMF. Brazil and China will move to having more than a fourth of their international trade transactions done “out of dollar.” In Africa, the Central Bank of Congo has announced that as of the end of 2014 national transactions will be denominated only in CFA franc (a currency pegged on the euro).

International digital currencies will play a role in monetary system evolution. The Bitcoin is in the process of being adopted by large entities. In July 2014 Dell announced that it would accept payments in Bitcoins. In France, Monoprix, a major chain of stores said it will be ready for moving to Bitcoin payments in 2015. The German bank Fidor and the German stock exchange Deutsche Bôrse have opted for a new electronic system like Bitcoin to replace their actual accounting tools for transactions between their branches and among their clients.

As Western pressure is bringing Russia and China closer together, currencies from China, Russia, the EU are now trading each other more freely and de-dollarization is accelerating from Turkey to Argentina. At some point a return to the U.S. of large quantities of dollars can be expected (possibly calling for another FED special program of quantitative easing to absorb these liquidities before they generate a new wave of inflation in the U.S).

In this new world, geopolitical risks are becoming increasingly important factors in financial and monetary policies. With civil unrest growing on every continent and wars at tipping points, the U.S. privilege of being able to unilaterally create international money over more than two thirds of a century is becoming a mixed blessing. Some wonder whether perhaps Uncle Sam actually may want to be rid of the weight of the USD as a reserve currency. It would certainly be an intriguing strategy. And the time may come when the might of the dollar as a unifying factor is missed.

Jacqueline Grapin is Co-Chair of the Board of Directors of the European Institute.

[1]Global Research, September 30, 2014, De-dollarization: Europe and China start Direct Trading in Euros and Renminbi, by Tyler Durden