From UPSC perspective, the following things are important :
Prelims level : SDR
Mains level : Paper 3- Diversification away from dollar
The war in Ukraine and the subsequent economic sanctions will trigger central banks to go back to their drawing boards to reassess their dependency on the greenback.
How sanctions on Russia could lead to de-dollarisation
- The imposition of sanctions and the exclusion from SWIFT by the US could trigger a faster de-dollarisation.
- The “de-dollarisation” by several central banks is imminent, driven by the desire to insulate them from geopolitical risks, where the status of the US dollar as a reserve currency can be used as an offensive weapon.
- This can also trigger a shift in the overall global forex market framework.
- The US dollar, which is the world’s reserve currency, can see a steady fall in the current context as leading central banks may look to diversify their reserves away from it to other assets or currencies like the Euro, Renminbi or gold.
How China and Russia are responding?
- Efforts are already underway for the possible introduction of a new Russia-China payment system, bypassing SWIFT and combining the Russian SPFS (System for Transfer of Financial Messages) with the Chinese CIPS (Cross-Border Interbank Payment System).
- Russia had started its three-pronged efforts towards de-dollarisation in 2014 when sanctions were imposed on it for the annexation of Crimea.
- However, these steps haven’t sufficed to effectively shield “fortress Russia”.
- China, on the other hand, aims to use trading platforms and its digital currency to promote de-dollarisation.
- China has established RMB trading centres in Hong Kong, Singapore and Europe.
- In 2021, the People’s Bank of China submitted a “Global Sovereign Digital Currency Governance” proposal at the Bank for International Settlements to influence global financial rules via its digital currency, the e-Yuan.
- The IMF has already added Yuan to its SDR (Special Drawing Rights) basket in 2016.
- In 2017, the European Central Bank exchanged EUR 500 million worth of its forex reserves into Yuan-denominated securities.
- However, the lack of full RMB convertibility will hinder China’s de-dollarisation ambition.
Why the dominance of the dollar continues and how the US benefits from its dominance
- Currently, about 60 per cent of foreign exchange reserves of central banks and about 70 per cent of global trade is conducted using USD.
- The status of the dollar was enhanced by the collapse of the Bretton Woods system, which essentially eliminated other developed market currencies from competing with the USD.
- The association of the USD as a “safe-haven” asset also has a psychological angle to it and like old habits, people continue to view the currency as a relatively risk-free asset.
- This status of the reserve currency allows the US government to refinance its debt at low costs in addition to providing foreign policy leverage.
- Additionally, sudden dumping of dollar assets by adversarial central banks will also pose balance sheet risks to them as it will erode the value of their overall dollar-denominated holdings.
Consider the question “Examine the factors that explain the dominance of the dollar in the global economy? How such dominance benefits the US?”
While the frequent use of the US dollar as a potential weapon for achieving foreign policy objectives will no doubt accelerate the process of de-dollarisation, there is still a long road ahead.
Back2Basics: What is Special Drawing Rights?
- The SDR is an international reserve asset created by the IMF to supplement the official reserves of its member countries.
- The SDR is not a currency.
- It is a potential claim on the freely usable currencies of IMF members.
- As such, SDRs can provide a country with liquidity.
- A basket of currencies defines the SDR: the US dollar, Euro, Chinese Yuan, Japanese Yen, and the British Pound.