Regardless of who you speak to, most people likely understand (or at least accept) that the US Dollar (USD) is the world’s most important currency. Most people also likely understand (or accept) that the USD is the world’s most important reserve currency.
Despite how important the dollar is to the US and the world, there is surprisingly very little mainstream consensus about where that power comes from and whether that power can be sustained. There is also a growing consensus that the Chinese RMB is likely to overtake the USD in the coming years as a reserve currency.
Capital Flywheels believes that the power of the USD and the status of the USD as the world’s preeminent reserve currency is stronger than people perceive, despite what the media may say. This power is derived from the significantly stronger network effects that have built up around the USD, which all prior reserve currencies lacked.
For example, there have been no shortage of media coverage suggesting that the dominance of dollar is about to end for various reasons…
Here’s CNBC:
Even exorbitant privileges can be lost and there are a number of factors suggesting that, over time, the US dollar may be at risk of surrendering its lead, if not its role, as the world’s preeminent reserve currency.
Source: CNBC
Here’s the South China Morning Post (a publication based in Hong Kong, owned by Jack Ma, founder of Alibaba):
The bottom line is that reserve currencies come and go. The status of the US dollar as the world’s No 1 currency is not carved in stone, even if Washington might think that. Admittedly, there is currently no viable fiat currency alternative, and that includes the renminbi, but that doesn’t mean US dollar hegemony can’t erode just as sterling’s did.
Source: SCMP
Even the well-regarded hedge fund manager, Ray Dalio, is sounding the alarms:
In my opinion, we’re near the end, in the late stages, of our reserve currency system – it’s a fiat monetary system. Not only do we have negative rates, but we’re going to have much bigger deficits … and that’s not half the story. Because the larger story is the unfunded liabilities.
Source: Ray Dalio via CCN
While there are certainly risks, and history proves that no reserve currency can last forever, the USD’s current positioning is very different from prior reserve currencies. The differences primarily stem from how global trade and economies have evolved through history combined with the changing role that currencies play in our lives.
To understand these changes, we have to rewind the clock to understand how the world looked before the concept and need of “reserve currencies” arose…
The World Before Globalization
To start, we have to go back 1000-2000 years to when the world was a much less globalized place. While countries conducted some trade with each other, most trade was conducted internally / domestically. Most countries were largely required to be self-sufficient because without the transportation / engine revolution (e.g. cars, trains, planes), buying stuff from far away was simply not a realistic arrangement.
In such a world, the purpose of currency is largely to facilitate internal trade. The only thing that matters is that the currency is widely accepted and available domestically. In other words, currencies have internal / domestic network effects. People use a specific currency because other people use the same currency, too.
While the world mostly operated this way for most of human history, currency dynamics become much more complex when you start bringing other countries into the picture. This is because other countries have their own currencies, too. When country A buys something from country B, country B will end up with currency from country A. However, currency from country A is not usable within country B…therefore country B would not want currency from country A unless it can be used to buy something from country A as well. This is the concept of reciprocal international trade. This system only works when both countries have something to offer. If one of the countries does not have something to offer, then trade becomes very difficult unless there is a common currency.
Historically, this was less of an issue not because every country produced useful goods for trade, but because every country had / produced gold. And gold was / is a globally desired good.
These dynamics played out similarly across all bilateral trade relationships historically and likely played an important role in linking currencies to widely accepted metals like gold and silver. In this regard, gold was the world’s first reserve currency, and even today, central banks around the world hold gold reserves in order to lend some credibility to their currencies.
Emerging Global Empires
Starting around 500 years ago, the modern conception of reserve currencies started to take shape. The first major currency to assume global reserve currency status in a big way was the Dutch gilder. This was enabled through Dutch dominance of global trade on the backs of the Dutch East India Company, which also coincidentally was a major military force / power around the world. With the rise of the Dutch empire, the Dutch was able to push the gilder as a common currency across many countries within its empire. Conceptually, the Dutch turned a large portion of the world into a common, semi-domestic market. As we explored above, currencies become complicated only when there are multiple countries involved. However, the rise of global empires beginning in the 15th Century also meant that many countries were forced to integrate into common, single markets.
This view is further supported by the fall of the gilder from reserve currency status the moment the Dutch ceded global dominance of trade and military might to the British empire. Similarly, once Britain ascended to the top both commercially and militarily, the British Pound became the world’s reserve currency.
When the US ascended to the top both commercially and militarily following World War II, the USD also became the world’s reserve currency much like its predecessors.
Since all reserve currencies historically lost their status as reserve currencies when military and commercial might receded, it’s not a surprise why there are so many people willing to call the end of USD dominance. While the US remains strong financially and militarily, it’s also clear that China will soon eclipse the US financially and has the potential to challenge the US militarily. Already, most countries in the world count China as the top trading partner, ahead of the US, despite the US having a somewhat larger economy than China.
While history suggests that the downfall of the USD is inevitable and will happen soon, the world has also changed materially from the 15-19th Centuries, and these changes make dethroning the USD much harder than people think.
A Changed World / Digital Dollars
The first major change to consider is that the world is much more globalized and interlinked than ever before. Historically, countries would only trade with their neighbors, which meant maybe just a handful of trading partners. However, today most countries are integrated into global supply chains and hence are linked with dozens or more trading partners.
Visually, trade has evolved from essentially hub-and-spoke to point-to-point networks.
This is a very important change because it means the currency dynamics have become much more complex. In a hub-and-spoke world, currency dominance is determined simply by dominance in trade. If a single country dominated trade globally, then most countries would, by definition, need to hold that currency in order to facilitate trade with that country.
However, while China dominates global trade through a hub-and-spoke model today, global trade has become much more of a point-to-point network than 500 years ago. For example, two hundred years ago, Brazil would have only traded with its physical neighbors and Portugal / Spain, but today, Brazil likely trades with several dozen countries. Even if China is Brazil’s single largest trading partner, global trade has become much more diversified than in the past where one or two trading partners could realistically represent all international trade.
Conceptually, a point-to-point model has materially stronger network effects than a hub-and-spoke model. The USD is currently the reserve currency in a world that has evolved into a point-to-point model, and the network effects under this model makes USD much harder to remove compared to reserve currencies in the past. This is because while China (or any other rising power for that matter) may be the largest trading partner for over 150 countries in the world, the number of bilateral, point-to-point trading relationships is much larger (several thousands). Even if China convinces most countries to use RMB to do trade with China (many transactions are still done in USD even when it involves China), there are many, many more trade relationships that China would have to change from afar. For example, convincing Brazil/Argentina trade to use RMB instead of USD. For example, convincing Indonesia/Singapore trade to use RMB instead of USD. The truth is the world has become a much more integrated network and all currencies exhibit internal network effects…while China may have some influence over the acceptance of RMB in its own trade relationships, becoming a reserve currency will require changing the behavior of other trade relationships that do not involve China. And the number of these relationships is far larger than China’s own.
The second and more important change to realize is that international trade is no longer done with physical currency but rather digital currency. Capital Flywheels believe too many people get lost in macro concepts and ideas to realize that at a micro-level, changing a reserve currency is becoming harder and harder to do. Centuries ago, if Europe wanted to buy tea from China, you literally have to send cargos of money (or gold or something of equivalent value to barter with). This model is not fit for the modern world because it involves too much friction. Global trade would be incredibly hard to do if everyone needed to physically put money into a plane or ship and send it to their overseas suppliers (imagine the amount of time it would take to physically count all the trillions of dollars involved in global trade).
Global trade today is actually done digitally. This may seem obvious to you, but the method in which this is conducted is not obvious and is very important. When a US company, for example, buys from a supplier in China, the US company will have their bank digitally wire the money to the supplier’s Chinese bank. Seems simple. But how and when does the Chinese bank actually get the physical bills? Does the US bank therefore still need to put the bills onto a plane and send it over? At what point does the physical transfer of money happen? And if the physical transfer of money still needs to happen, how does “digitally wiring” something reduce friction vs how the world worked before?
The answer is it never physically happens!
I’m going to repeat that: The physical transfer of money never actually happens.
Capital Flywheels believes this is one of the greatest misunderstandings (even amongst finance professionals) about how the global currency system works. People seem to think money actually physically moves around and that if any country can simply change what currency is moving around, they can eclipse the USD.
But since the ascendancy of the USD to global reserve currency status, all global trade involving USD actually only involves money moving around within the Federal Reserve’s vaults. When a US company buys from a Chinese supplier, the US company tells their US bank (with money held at the US Federal Reserve) to wire money to the Chinese bank. But the Chinese bank will never actually get the money in China. The money is actually wired to the Chinese bank account at the US Federal Reserve. The money never physically moves. It is just digitally transferred from one Federal Reserve account to another.
This is an incredibly powerful arrangement because it adds another layer of network effects on top of the existing network effects of the underlying currency.
In this existing system, if Brazil wants to trade with the UK, they simply need to use the US Federal Reserve (and SWIFT payment network) to wire money to the UK accounts. This saves Brazil the headache of figuring out how to physically send money to the UK.
This system has been incredibly powerful in accelerating globalization and international trade ever since the end of World War II because it dramatically reduced trade friction and standardized world trade around one currency and a common set of laws that most countries were okay adhering to. In the above example, the UK is happy to accept on faith that Brazil can pay for its purchases (even without physical delivery of money), because the US Federal Reserve can vouch for (and see) whether Brazil actually has the necessary funds in their Federal Reserve account.
There are a lot more important nuances to this, but the bottomline is that the USD has dual network effects that now make it very, very hard to break, even if it eventually loses trade and military dominance. In the old world, global trade was hub-and-spoke centered around a dominant power. In that world, military and trade relevance is the dominant factor underpinning the power of a currency. But in our current contemporary world, the dominant factor underpinning the power of the USD is actually frictionless globalized trade enabled by network effects.
Why China Wants an Alternative
Given that most international trade actually doesn’t involve anything more than moving some digital numbers around at the Federal Reserve, you can probably start to understand how much power the Federal Reserve has over any country that uses the USD.
Why is it that the US can sanction a country like North Korea or Iran and cause overnight collapses in their economies?
This is because sanctioning a country prevents that country from accessing or using the Federal Reserve accounts. This means that a sanctioned country not only needs to figure out how to trade by physically sending money to a trading partner (which involves a lot of friction), the sanctioned country actually won’t even have access to any USD they’ve held at the Federal Reserve. Because almost all USD trade globally are conducted at the Federal Reserve, the Federal Reserve also has the power of transparency over most financial transactions globally (they happen literally at the Federal Reserve).
This is increasingly a concern for China because, despite their dominance in trade, most of their international trade is still done in USD, which means they need access to the Federal Reserve.
More importantly, while many people point to China’s $3 trillion of reserves as a sign of strength, most of these media pundits are clearly not taking into account that that money doesn’t sit in China…most of that money is sitting at the Federal Reserve. While China has $3 trillion of reserves, they may not have access to it if the relationship snaps.
This table below shows China’s holdings of US Treasuries that are held at US-based custodians (i.e. custodians with accounts at the Federal Reserve). China currently holds about $1.1 trillion at the Federal Reserve. On top of this, China’s reserves also include several hundreds of billions of US agency mortgage debt as well as US equities that are all also held at US-based custodians. Roughly 2/3 of China’s $3 trillion of reserves are within US borders.
Source: US Treasury
For decades, countries have been calling for the end of the USD repeatedly. Sometimes, even from our own allies such as the French in the 1960s. However, the world today is very different from the world before. Much like the tech networks that dominate our own social lives today, the USD has built several overlapping network effects that are very hard to break. Much to the dismay of most countries around the world, the USD is likely to retain its dominance for longer than people expect, and luckily for the American public, sustaining USD hegemony is probably one important and hopeful thing since not much else is going right in this country…
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