Did you know more than 61% of all foreign bank reserves are denominated in US dollars in 2019? It is not a surprise to anyone that the United States of America is the world's leading superpower; from its powerful military might to their dominant economy, it is safe to say that the US is one of the most powerful countries in the world. But how did they get there? How did the US Dollar become the global currency?
The creation of Bretton Woods
Let’s start from the beginning. After World War II, 44 allied countries came to an agreement and created the Bretton Woods agreement in New Hampshire. The goal? To fix the rate of exchange for all foreign currencies to the US dollar, where the United States would redeem any dollar for its value in gold. At the time, the United States was the only country largely unscathed by the war while the economies of other European countries had been severely battered. Since the US held most of the world’s gold supply and the gold-backed dollar was relatively stable, it was agreed that the US dollar would be the official reserve currency. Thus, allowing other countries to back their currencies with dollars rather than gold.
Unpegging the dollar to gold
While the United States enjoyed various benefits from being the world’s official currency, there is always the other side of the coin. The deficit spending that was used to finance the Vietnam War caused the United States to flood the market with paper money, thus depreciating the value of the dollar. With the growing concerns over the stability of the dollar, foreign countries began to demand the US government to convert their country’s dollar reserves into gold.
However, rather than allowing investors to deplete Fort Knox (United States Bullion Depository) of all its gold reserves, President Nixon made the final decision to sever the tie of the US dollar to gold. This led to the floating exchange rates (or fluctuating exchange rates) that exist today, where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies, a free-for-all if you will. Of course, such drastic measures had led to dire consequences in the US such as stagflation, a terrifying combination of high inflation and high unemployment, and high oil prices. However, thanks to brilliant economists like Milton Friedman and Paul Volker who introduced various fiscal policies, they managed to overcome stagflation and allowed the US economy to recover.
Would the US dollar be dethroned?
You may think that after becoming the world’s currency for so long and having a series of events that affected the US economy negatively, the US dollar would be replaced. After all, no king rules forever and other contenders for the world currency such as the Euro, Renminbi (also known as Yuan) or even the Russian Ruble might overtake the dollar. But surprisingly, that is not the case.
In 2007, former chairman of the US Federal Reserve, Alan Greenspan, said the Euro could potentially replace the dollar as a world currency, and his words held some form of truth to it. At the end of 2006, 25% of all foreign exchange reserves held by central banks were in Euros, compared to 66% in dollars. In addition, 39% of cross-border transactions were in Euros compared to 43% in dollars.
The EU consists of 27 countries as their members and is one of the world's largest economies, so are they the ones who would replace the almighty US dollar? Not exactly. Overtaking the world’s currency is not an overnight process as doing so would just cause a dollar collapse, and considering the world is still using the US dollar to trade, that would just destroy the global economy. As a result, because of the dependence on the US dollar, it is not in everyone's best interest to overtake it.
But that doesn’t mean other ambitious countries won’t try. In March 2009, China and Russia called for a new global currency in a G8 summit. In short, they wanted the world to create a global reserve currency that is flexible and independent from the interest of any country, thus removing any credit-based national currencies, a truly “free” currency for all. Of course, this wasn’t done out of goodwill; China who was the world’s fastest-growing economy was concerned that the trillions of US dollars it holds would be worthless if dollar inflation were to set in. As a result, China and its close ally, Russia called for the International Monetary Fund to develop a currency to replace the dollar but was promptly rejected.
However, in the fourth quarter of 2016, the Chinese Yuan became another one of the world's reserve currencies. Due to different political ideologies and ambitious goals, China has been steadily reducing its exposure to the dollar. Both China, as well as Russia, have been stocking up on gold in recent times to slowly bring down the dominance of the US dollar and weakening it gradually.
How the US dollar affects the world’s economy now?
The Covid-19 pandemic has devastated the global economy, and it has presented the flaws of a US-dominated currency. Prior to the pandemic, if large parts of the world denominate transactions in dollars, it is extremely convenient since we have established that the US dollar is the world’s most traded currency.
But during times of crisis such as a pandemic, this overdependence can be a problem because there are not enough dollars to go around. Although central banks can help with liquidity in their local currencies, in some jurisdictions, it is a bigger challenge to help businesses with dollars.
The first problem is liquidity, but the second related issue is the significant foreign exchange risk. You see, despite the hard-hit US economy, investors still want to store their money in safe havens, which are in the form of US treasuries due to its stability. The value of the US dollar has increased throughout the pandemic and it has strengthened by 5.3% against the Euro, 5.9% versus the Swiss Franc, 7.7% against the Japanese Yen, and an astounding 13.9% against the British Pound. So you can imagine the effects of non-US companies and businesses who are forced to convert their depreciating local currency to repay that much more in US dollars, and that is not accounting for the lack of steady revenue from the lockdowns imposed by the governments. With a strengthened dollar during a crisis such as this, it will negatively impact emerging market economic activity as well as international trade that is already struggling.
What would the future of the US dollar look like?
Although there were many speculations that the US dollar would be dethroned by the Chinese Yuan. The general consensus is that the US dollar would remain as the world’s global currency post-Covid-19. The fundamental strength of the US economy is that it inspires trust among investors and traders with its transparency in the financial markets and the stability of its monetary policy, allowing the US economy to thrive. As a result, investors and traders are likely to invest in the US with data-driven decision making. For these reasons, the US dollar remains the world’s most dominant currency, for now.
The story of how the US became the world’s global currency is an interesting one. How long do you think the Greenback will remain as the global reserve currency? We would love to hear your thoughts on it! And don’t forget to sign up with TranSwap to get a Global Account in the US as it not only minimises your money transferring conundrums but it also allows you to save on conversion costs!
Have a specific topic you would like us to cover next? Just let us know!
Want to save more money and time on your next global payment? You can lock in the good rates now!