The US dollar has ruled the international monetary system since the Bretton Woods Agreement of 1944. No other currency has been able to challenge the dollar notwithstanding the ups and downs of the US economy both in terms of growth but also inflation.
Nevertheless, despite the dollar’s overall dominance, things are changing. This is particularly true for the waning share of the US dollar in the central bank holdings of foreign exchange reserves. More specifically, over the last two decades, the US dollar has lost over 12 percentage points of market share, from 71 percent in 1999 to 59 percent in 2022. One might have expected the euro to benefit from this loss since it is the currency of an economic area of a size close to that of the United States and with a fully open capital account. Another potential winner could have been the yuan given China’s rapid growth over the last 20 years and its sheer size. It is now the second largest economy in the world, in US dollar terms, and the first in terms of purchasing power, but with a still non-fully convertible currency.
Starting with the euro, while it did increase its market share in the first half of the 2000s, it lost what it had gained as a consequence of the euro crisis and has only started to recover recently and very slowly. The yuan has been boosted by its acceptance in the Special Drawing Rights—an international reserve asset also known as the SDRs—since late 2015 with a 10 percent share. Since then, its share in central banks’ foreign exchange reserves has increased steadily but from a very low base. As of now, the yuan has a one fourth share of emerging markets’ currencies, about half that of the Japanese yen and the British pound.
Notwithstanding the relative reduction in the share of dollar in the denomination of foreign reserves, the US currency remains dominant in all the other relevant roles of an international currency, such as international debt, international loans, foreign exchange turnover, and, more generally, global payments as measured by SWIFT transactions. It is in the last aspect, the share of global payments, where the euro has reached a share that is similar to that of the dollar but there have been many ups and downs in the last few years and the recent trend, since mid-2021 has again been a reduction of euro-denominated cross-border transactions in favor of those in dollars.
A Stagnant Euro
Based on the sheer size of the eurozone, the question is why the euro has not managed to gain market share as a reserve currency. One of the key reasons is the lack of deep enough financial markets, at least when compared to the US. In fact, credit and equity markets are still national and rather small compared to the US as the eurozone continues to be dominated by bank lending. Furthermore, bank lending has remained at the national level and pan-European banks have not yet emerged as much as one would have expected after monetary union in 1998.
A probably even more crucial drawback is the much smaller pool of safe assets, especially since the eurozone crisis of 2010-12, when many member states’ sovereign ratings where downgraded. In fact, as of today, the pool of euro-denominated safe assets is only 20 percent of the eurozone GDP, which contrasts very negatively with the pool of risk-free assets in US dollars.
Thirdly, the lack of a single fiscal policy for the euro area also implies that there is no single ultimate backstop for the sovereign debt issued in the eurozone. On that note, the establishment of the Next Generation Fund can be considered a positive step in this direction both in terms of the amount of safe assets in euros but also as an embryo of a single fiscal policy.
Finally, and very importantly, the European Union is not a hard power, given its dependence on the US for its security. In a world of great power competition, with a much smaller role left for multilateralism and a rules-based order, the EU will find it hard to hold on to its economic power, which does not bode well for the future of the euro as an international currency.
What to Expect from the Yuan?
Moving to the yuan, one might wonder why the currency of the second largest economy in the world, which is expected to be the largest in a few years, has not been able to achieve a more relevant role as an international currency. There are several reasons for this. The most important one is the lack of convertibility. In fact, capital controls are still pervasive in China, especially for outflows and increasingly less so for inflows. Secondly, the liquidity of the financial markets is still rather limited although it is improving. This is also true for the amount of safe assets, China’s sovereign bonds. All in all, the international use of the yuan remains rather limited in the context of the size of the Chinese economy, ranking fifth globally, not only after the dollar and the euro but also the pound and the yen.
Still, the Chinese currency is bound to benefit from a world of great power competition and the weaponization of the dollar by the US monetary and economic authorities, as a response to a number of external shocks. Iran is a clear case in point but, more recently, China has also been subjected to US sanctions on a number of political issues, including human rights violations in Xinjiang and Hong Kong.
Finally, Russia’s invasion of Ukraine has led to a much larger deployment of sanctions, including the exclusion of several Russian institutions from SWIFT and the freezing of Russia’s external assets denominated in US dollars as well as in other G7 currencies. Interestingly, the Russian central bank had already been preparing for such an eventuality since Russia’s seizure of Crimea in 2014 by massively switching reserves to the yuan and gold, compared to international standards. The switch to the yuan, rather than the euro or other currencies from developed economies, was to be expected as the US has brought along other developed areas of the world, especially the European Union, on sanctions. This was already the case with the sanctions on Russia related to Crimea and even more so after the new G7 sanctions were imposed on Russia following the invasion of Ukraine in February 2022.
The fact that sanctions also applied to other G7 currencies means that any shift of foreign exchange reserves to avoid potential sanctions would need to be into non-G7 currencies, which is clearly giving a boost to the demand for the yuan, especially for forex reserves. This is all the more so since China has been vocal in declining to participate in sanctions against Russia, considering them unilateral. Looking at the volume of yuan transactions (based on SWIFT data), there did seem to be a noticeable pick up in such transactions after the war started but it has since come down possibly because of the increasing uncertainties over the Chinese economy in the light of its strict zero-COVID policies. In the same vein, offshore yuan deposits in Hong Kong peaked at the start of the war but they rapidly came down to their level prior to the invasion of Ukraine, although there has since been a moderate upward trend.
What to Expect Next?
Looking forward, it seems clear that the dollar will not be able to hold on to its overwhelming dominance forever as the relative size of its economy shrinks in favor of other currencies from faster growing emerging economies. The question, though, is whether it will be the euro and/or the yuan that take on the baton. In the case of the euro, there is hardly any doubt that it will not be able to take over the dollar’s market share since the size of its economy is bound to shrink, even relative to the dollar. This is also true for the yen and, possibly the pound as the United Kingdom’s potential growth after Brexit is bound to be lower.
Instead, the yuan is likely to continue to gain market share as it is currently stubbornly low in relation to the size of the Chinese economy. However, for the process to accelerate—it remains very slow—the yuan would need to become a convertible currency. Such a scenario remains unlikely even if China continues to open to portfolio inflows but much less has been done on outflows. Such asymmetric financial opening is bound to make it hard for the yuan to reach a market share that would be in line with China’s economic size. In addition, the Chinese economy is expected to decelerate structurally and not to continue to converge with the US economy by 2030.
Instead, other currencies from emerging economies, such as the Indian rupee, the Indonesian rupiah, and the Brazilian real are bound to move up in the rankings of currencies being used for international transactions. In other words, it is to be expected that the dollar’s increasingly less central role as the global reserve currency will be taken partially by the yuan but not fully, due to its lack of convertibility, while other currencies from large emerging economies are expected to take part of the market share lost by the dollar.
In other words, it is very likely that we will move from an international monetary system dominated by the dominant reserve currency, the US dollar, to a more multilateral one where more currencies can serve the purpose of being used internationally. The timeframe for such change remains long due to the stickiness of international financial markets but could be accelerated by the introduction of digital currencies, especially the yuan, as well as the evolution of the US economy relative to the rest of the emerging world. Within this context, the structural deceleration of the Chinese economy, if anything, should further slow down the demise of the dollar as the key reserve currency unless the US economy does even worse.
Alicia García Herrero is Senior Research Fellow at Bruegel and Adjunct Professor at Hong Kong University of Science and Technology.
