Central banks begin to diversify US dollars

My standard joke about whether the US dollar will remain the dominant currency in the world in the future (for example, here, hereas well as here) touches on some of these topics: it is useful for world trade to have many transactions in one currency. The dominant currency at any given time has a lot of momentum, and changes in the dominant currency do not come easily. At least so far, leading candidates to replace the US dollar as the world’s dominant currency, such as the euro or the Chinese yuan, do not seem to be doing so.

But perhaps the move away from the US dollar will come in a whisper, not an explosion. Serkan Arslanalp, Barry Eichengreen, and Chima Simpson-Bell discuss this possibility in Hidden Erosion of Dollar Dominance: Active Diversifiers and Rising Prices.
Non-traditional reserve currencies»
(IMF Working Paper, March 2022, WP/22/58).

The authors pay special attention to the combination of currencies that central banks around the world hold in their foreign exchange reserves. The blue line shows the decline in US dollar holdings by central banks from 71% in 1999 to 59% in 2021.

However, the figure also shows that this depreciation of the US dollar in central banks’ foreign exchange holdings was not accompanied by a significant shift to any single alternative currency. The euro, shown by the red dotted line, rose when it was introduced in the early 2000s, but has since fallen to almost the same level. Neither the Japanese yen (black line) nor the British pound (yellow line) showed significant gains. Instead, the fall in the US dollar since 1999 has been accompanied by a rise in the value of “others.” About a quarter of this growth comes from the Chinese yuan. Other currencies that play a prominent role here are the Australian dollar, the Canadian dollar and the Swiss franc.

What motivates central banks to move their foreign exchange reserves from US dollars to these “other” currencies? The authors suggest several reasons.

First, global financial markets have become much more developed and interconnected in the Internet age, making it easier to hold small amounts of “other” currencies. They write: “But as transaction costs have come down with the advent of electronic trading platforms and now automated market making (AMM) and automated liquidity management (ALM) technologies for foreign exchange transactions, the savings associated with US dollar transactions are smaller. In addition, the expanding global network of central bank currency swap lines (Aizenman, Ito, and Pasricha, 2021) has increased the ability of central banks to access currencies other than those they hold as reserves, weakening these links between markets and functions. . ”

Second, many central banks hold large amounts of foreign exchange reserves, which in turn makes it more sensible for central banks to look around to see which currencies bring in the highest returns. In particular, lower yields on government bonds denominated in standard reserve currencies (US dollars, euros, Japanese yens, British pounds) have made it attractive to seek and diversify into other currencies.

These reasons, of course, apply more widely than central banks. It may be that the US dollar is not so much being abruptly displaced as the dominant world currency, but instead is simply being bitten off at the edges as it becomes easier and cheaper to transact with a wide range of currencies.

Here’s another issue worth considering: every time the United States uses the US dollar’s dominance in international markets as a policy tool through economic or financial sanctions, it gives other countries a reason to at least slightly move away from the dollar. US dollar as a transaction mechanism.