De-Dollarisation

General Studies Paper 3

Context: There’s a growing trend of countries sidestepping the US dollar (de-dollarisation) and choosing to use their own local currencies for bilateral trade.What is de-dollarisation?

De-dollarisation is a term that refers to the process whereby countries tend to reduce their reliance on the US dollar as a reserve currency, medium of exchange, and also a unit of account.

Why is the US dollar used so widely? 

• Dominance of Dollar: After World War II,the US dollar replaced the British pound as the dominating currency worldwide. In 1944, the Bretton Woods Agreement established the dollar as the world’s reserve currency. The original Bretton Woods Agreement is dead, but the dollar remains the international reserve currency.
• Trade deficit of US:  S. has been running a persistent trade deficit for decades now (in fact the last time the U.S. ran a trade surplus was way back in 1975). Theexcess dollars that the rest of the world accumulates due to the U.S. ‘s trade deficit has been invested in U.S. assets such as in debt securities issued by the US government.
• Popularity of U.S. assets among investors: The high level of trust that global investors have in the S. financial markets,perhaps owing to the ‘rule of law’ in the U.S., is considered to be a major reason why investors prefer to invest in U.S. assets.

What is Reserve Currency?

• Reserve currencies are foreign currencies held by central banks and other monetary authorities to facilitate international transactions, stabilize exchange rates, and bolster financial confidence.
• These currencies are typically characterized by their stability, liquidity, and wide acceptance in global markets, which make them attractive for holding and conducting international transactions.
• A reserve currency is also used by central banks to prepare for international debt obligations and to influence their domestic exchange rate.

Global Efforts Towards Dedollarization

• In recent years, several countries and regions have embarked on the path towards dedollarization, driven by a combination of geopolitical, economic, and strategic considerations. 
• Notable examples include China, Russia, Brazil and the European Union, each of which has taken steps to reduce their reliance on the US dollar in international transactions and financial markets.

Why are de-dollarisation attempts being made? 

• Sanctions by U.S.: The U.S. imposed several sanctions that restricted the use of the U.S. dollar to purchase oil and other goods from Russia, and this has been seen by many countries as an attempt to weaponise the dollar.
• Power to control transactions by U.S.:Since international transactions carried out in the U.S. dollar are cleared by American banks, this gives the U.S. government significant power to oversee and control these transactions.
• To end U.S Hegemony:Some countries, like China and Russia, have sought to diminish the influence of the US dollar as a means of countering perceived American hegemony and mitigating the impact of US sanctions.
• To Promote their own currency: Other countries, particularly those in the Eurozone, have pursued dedollarisation to promote the international use of their currency, the euro, in a bid to enhance their global economic standing and secure greater financial autonomy.

Challenges Towards Dedollarisation

• Threat to Global Financial Stability: As countries reduce their reliance on the US dollar, adjustments in the composition of global reserve assets may lead to shifts in capital flows and changes in asset prices.In the absence of adequate policy coordination and risk management, these fluctuations could create financial instability.
• Alternative currency:Creating a viable alternative to the US dollar presents a formidable challenge. To achieve the requisite degree of stability, liquidity, and acceptability, an alternative reserve currency must be underpinned by a robust economy, deep and liquid financial markets, and sound monetary and fiscal policy frameworks. Currently, no single currency fully meets these criteria, although the euro and the Chinese yuan have made strides in this regard.
• Increased volatility in Exchange rates: Dedollarisation could result in increased volatility in currency exchange rates, particularly during the initial phases of transition. This, in turn, could impact trade, investment, and capital flows,particularly for countries with less developed financial markets or limited policy tools to manage exchange rate volatility.

Should India Focus on De-dollarisation?

• Benefits:It could reduce the vulnerability to fluctuations in US monetary policy and enhance monetary autonomy, enabling them to better tailor policy actions to the domestic economic conditions. 
  • Moreover, the diversification of reserve currencies could provide a buffer against currency fluctuations and capital flow reversals, reducing the likelihood of financial crises and improving overall financial stability.
• Challenges:As developing countries transition away from the US dollar, they may face heightened exchange rate volatility, which could impact trade, investment, and capital flows.
  • Additionally, the development of deep and liquid domestic financial markets – a prerequisite for currency internationalisation – could prove to be a formidable challenge for countries with less developed financial systems.
  • Furthermore, the potential costs associated with the transition, such as adjustments to existing trade and financial arrangements, may be significant and could strain limited resources.

Way Ahead

• In light of these considerations, developing countries like India should adopt a prudent and measured approach towards dedollarisation. Policymakers must strike a delicate balance between the potential benefits of reducing reliance on the US dollar and the risks and costs associated with such a transition.
• While dedollarisation presents opportunities for a more diversified and resilient global financial system, it also poses significant challenges that must be carefully managed to ensure the preservation of global financial stability and sustained economic growth.
• Developing countries such as India must carefully weigh the potential benefits and risks associated with this transition.