What Will Happen with the Euro? An Economic Perspective.
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Will the US Dollar Lose Global Dominance?
Information is not investment advice
The credibility of the US dollar and its banking system depends on the fact that it's considered safe and low-risk. That's why many countries around the world keep their reserves in US banks and hold US bonds in large quantities. However, if the dollar's credibility erodes because of politics, this international monetary and financial system can start collapsing.
The move of the US and its Western allies to freeze most of Russia's foreign exchange reserves has raised fears that the dollar's hegemony is being used as a weapon.
Why is the US dollar at risk?
- This kind of abuse of the dollar's dominance would backfire on the US currency. The more the US weaponizes the dollar, the more the international community will be worried that it will be hit with the same weapon in the future. This will prompt the global economy to reassess its dependence on the dollar when it comes to foreign exchange reserves.
- Goldman Sachs has warned that the dollar faces risks that may reduce its global dominance, saying some of the challenges are similar to the ones faced by the British pound before it fell from the throne. Once upon a time, the sterling was the largest reserve currency in the world.
- The brutal sanctions against Russia are based on the power of the US dollar, which is the most widely-used currency in trade, financial transactions, and central bank reserves. However, by explicitly using the dollar as a weapon, the US and its allies risk provoking a backlash that could undermine the greenback.
- The dollar's share of central bank reserves has been declining over the past years. In 2001, the dollar accounted for about 70% of foreign exchange reserves. Now, it is only about 59%, according to the IMF data.
But, why won't the dollar lose its dominance so soon?
There's no real alternative or competitor. The US dollar is the strongest reserve currency in the world. We can argue that the dollar depreciated after the crazy printing of money over the past three years and hot inflation. We can say that the world's confidence in the US as a strong partner is declining increasingly. However, you must have an alternative to exchange dollars. According to history, reserve currencies give way to each other when a more attractive currency comes along. China - today's rising power - has so far shown no reason for the global economy to trust it.
Could another currency replace the dollar?
The euro is the main alternative to the dollar, representing 20% of central banks' reserves. Still, we should be aware of the shift towards smaller currencies such as the Australian dollar, the Korean won, and, above all, the Chinese renminbi.
At the moment, the dollar index is still poised to rise after testing levels above 100. On the upside, the next big target is 103.00. The aggressive tightening cycle of the Fed is also expected to support the dollar in the medium to long term.
Chart 1: The Dollar index is on the rise since the beginning of the Russia - Ukraine war on 24/02/2022, reaching levels above 99.80.
Chart 2: The dollar's index next target is 103, last seen in 2020.
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