Dollar dominance—the outsized role of the US dollar in the
world economy—has been brought into focus recently as the robustness of the US
economy, tighter monetary policy and heightened geopolitical risk have
contributed to a higher greenback valuation. At the same time, economic
fragmentation and the potential reorganization of global economic and financial
activity into separate, non-overlapping blocs could encourage some countries to
use and hold other international and reserve currencies.
Recent
data from the IMF’s Currency Composition of Official Foreign Exchange
Reserves (COFER) point to an ongoing gradual decline in the dollar’s share
of allocated foreign reserves of central banks and governments.
Strikingly, the reduced role of the US dollar over the last
two decades has not been matched by increases in the shares of the other “big
four” currencies—the euro, yen and pound. Rather, it has been accompanied by a
rise in the share of what we have called nontraditional reserve currencies,
including the Australian dollar, Canadian dollar, Chinese renminbi, South
Korean won, Singaporean dollar, and the Nordic currencies. The most recent data
confirm this trend.
These
nontraditional reserve currencies are attractive to reserve managers because
they provide diversification and relatively attractive yields, and because they
have become increasingly easy to buy, sell and hold with the development of new
digital financial technologies (such as automatic market-making and automated
liquidity management systems).
This recent trend is all the more striking given the
dollar’s strength, which indicates that private investors have moved into
dollar-denominated assets. Or so it would appear from the change in relative
prices.
At the same time, this observation is a reminder that
exchange rate fluctuations can have an independent impact on the currency
composition of central bank reserve portfolios.
Changes in the relative values of different government
securities, reflecting movements in interest rates, can similarly have an
impact, although this effect will tend to be smaller, insofar as major currency
bond yields generally move together.
Taking
a longer view, over the last two decades, the fact that the value of the US
dollar has been broadly unchanged, while the US dollar’s share of global
reserves has declined, indicates that central banks have indeed been shifting
gradually away from the dollar.
At the same time, statistical tests do not indicate an
accelerating decline in the dollar’s reserve share, contrary to claims that US
financial sanctions have accelerated movement away from the greenback.
To be sure, it is possible, as some have argued, that the
same countries that are seeking to move away from holding dollars for
geopolitical reasons do not report information on the composition of their
reserve portfolios to COFER.
It is worth noting that the 149 reporting economies make up
as much as 93% of global foreign exchange reserves.
One
nontraditional reserve currency gaining market share is the Chinese renminbi,
whose gains match a quarter of the decline in the dollar’s share.
The Chinese government has been advancing policies on
multiple fronts to promote renminbi internationalization, including the
development of a cross-border payment system, the extension of swap lines, and
piloting a central bank digital currency.
It is interesting to note that renminbi
internationalization, at least as measured by the currency’s reserve share,
shows signs of stalling out. The most recent data do not show a further
increase in the renminbi’s currency share - some observers may suspect that
depreciation of the renminbi exchange rate in recent quarters has disguised
increases in renminbi reserve holdings. However, even adjusting for exchange
rate changes confirms that the renminbi share of reserves has declined since
2022.
Some have suggested that what we have characterized as an
ongoing decline in dollar holdings and rise in the reserve share of
nontraditional currencies in fact reflects the behavior of a handful of large
reserve holders.
Russia has geopolitical reasons to be cautious about holding
dollars, while Switzerland, which accumulated reserves over the last decade,
has reason to hold a large fraction of its reserves in euros, the euro area
being its geographical neighbor and most important trading partner.
When analysts exclude Russia and Switzerland from the COFER
aggregate, using data published by their central banks from 2007 to 2021, they
find little change in the overall trend.
In fact, this movement is quite broad. A paper by the IMF in
2022, identified 46 “active diversifiers,” defined as countries with a share of
foreign exchange reserves in nontraditional currencies of at least 5% at the
end of 2020. These include major advanced economies and emerging markets,
including most of the Group of Twenty (G20) economies. By 2023, at least three
more countries (Israel, Netherlands, Seychelles) have joined this list.
IMF also found that financial sanctions, when imposed
in the past, induced central banks to shift their reserve portfolios modestly
away from currencies, which are at risk of being frozen and redeployed, in
favor of gold, which can be warehoused in the country and thus is free of
sanctions risk.
This shows that the demand for gold by central banks
responded positively to global economic policy uncertainty and global
geopolitical risk. These factors may lie behind the further accumulation of
gold by a number of emerging market central banks. It is important to recall
that gold as a share of reserves still remains historically low.
In sum, the international monetary and reserve system continues
to evolve. The patterns IMF has highlighted earlier—very gradual movement away
from dollar dominance, and a rising role for the nontraditional currencies of
small, open, well-managed economies, enabled by new digital trading
technologies—remain intact.
