End of the Dollar?

There has been constant talk, given the current geopolitical outlook, that nations are moving away from the dollar. This Substack will analyze whether or not this is true. This seems to be a concern for many, with ongoing discussions about the end of dollar hegemony all over X and other platforms. Much of it is fearmongering around the dollar's role in global finance, so let's take a closer look at what we're actually seeing.

The most logical place to start is by analyzing the dollar's role in global reserves. Currently, the dollar accounts for a little over 50% of all FX reserves globally. We've seen a decrease in the dollar's share from its peak of around 80%, but this is largely due to the emergence of the euro and the yen in the 1990s and early 2000s. We can observe the rapid rise of the euro until the debt crisis in Europe, which severely impacted the economy around 2012, causing the euro to lose some of the ground it had gained, with many fleeing back into the dollar.

Now, the next area we must look at is something that causes a lot of confusion: the difference between the settlement of trade in one currency versus the invoicing of trade in a currency. Settlement matters a whole lot less than invoicing.

Let's start first with invoicing:

Currency invoicing refers to the currency in which a transaction's price is quoted and in which the invoice is issued. It determines the currency in which the buyer agrees to pay and the seller agrees to receive payment. The currency chosen for invoicing can affect pricing strategy, exchange rate risk, and the buyer's and seller's financial planning. For instance, if a company invoices in its home currency, it avoids exchange rate risk, while the buyer assumes it.

Let us look at an easy example:

A Chinese exporter sells goods to a U.S. company and invoices the sale in U.S. dollars (USD). The invoice specifies that the payment amount is in USD.

Now, settling:

Settling trade in a currency refers to the currency in which the actual payment is made and the transaction is completed. Settlement is the final step where the buyer transfers the payment to the seller, and this can be done in the currency agreed upon during invoicing or a different currency if agreed upon by both parties. Settlement in a specific currency involves converting the invoiced amount into the settlement currency (if different) at the current exchange rate. This process can incur additional costs and expose one or both parties to exchange rate fluctuations.

Let us look at another example:

Continuing from the previous example, the Chinese exporter is invoiced in USD, but the actual settlement may be done in Chinese yuan (CNY) if both parties agree, requiring conversion of the invoiced amount into yuan at the prevailing exchange rate at the time of settlement.

Key difference:

Currency invoicing sets the terms of the transaction (price and payment obligation), while currency settlement is the execution of the payment. Currency invoicing occurs at the start of the transaction when the sale is agreed upon, while currency settlement happens at the end when payment is made. Currency invoicing is a strategic decision that can be used to manage exchange rate risk, while settlement involves managing the risk in real-time, potentially through hedging or agreeing to settlement terms that minimize currency conversion risk.

In summary, currency invoicing determines the currency in which the transaction is billed, while currency settlement concerns how and in what currency the payment is actually completed. From the graph below, we can see that USD invoicing still dominates most trade. The EUR is next, dominating the remainder of invoicing needs. Interestingly, these invoicing currency choices tend to be influenced by geographic location.

More African countries, given their proximity to Europe, tend to invoice in EUR, whereas nations closer to the United States tend to invoice in USD.

The USD is not without its concerns, the main one being the massive rise in USD deposits globally and the impact U.S. monetary policy has on other nations. To examine this, we look at the work done by the BIS on international claims. With this data, we can analyze how currencies are utilized in international banking across countries and sectors (private and public). The issue we observe is that boom-bust cycles in banks' international claims are highly tied to the flow of dollars, as the dollar continues to play an outsized role in global finance.

Prior to the GFC (as highlighted by the BIS), "dollar claims grew by more than 10% per year on average." There is quite a bit of variation during times of crisis. If the dollar starts to see outflows, it tends to pull everyone else down with it, given the large role it plays in global finance.

Below, we can see the tracking of international bank claims versus changes in the DXY, illustrating how the strength or weakness of the dollar broadly influences increases or decreases in USD bank claims. Here, I am using the DXY as a sort of proxy for dollar flows, as the price of anything in economics is determined by the balance between supply and demand. If there is more demand relative to the supply of dollars, the dollar, in theory, should increase in value and vice versa. While this is not a perfect proxy for flows, it will be used for illustrative purposes.

Now, looking at dollar borrowing through an analysis of the cross-currency market, we see that this has declined and tends to coincide with dollar strength or weakness. If you are a bank in the USA trying to lend to a borrower abroad, borrowers usually prefer to borrow when the currency is cheap, not strong, as hedging plays an important role in this transaction. Similarly, a dollar loan from a bank in Europe to a borrower in the United States would also tend to be negatively correlated with dollar strength or weakness, as borrowing when a currency is weak or when there is a significant difference in interest rate differentials will play a huge role.

Generally speaking, the United States does not engage heavily in this type of borrowing. Instead, the role of the dollar is much larger in terms of offshore claims, as highlighted by the BIS. Nevertheless, this is an important point to note.

When examining offshore claims, we can clearly see U.S. dominance compared to other nations. While offshore dollar claims have decreased, this is largely due to interest rate differentials and reduced activity driving up U.S. claims. Nevertheless, they remain substantially higher than those of other nations, even after the decline, still making up roughly 55% of all offshore claims globally—another sign that the dollar is not in its endgame. Once interest rates start to decline and differentials begin to close, we should see this trend reverse and a rise in offshore USD claims once again.

With all of this highlighted it does not appear that we are moving away from the dollar anytime soon. Any worries about the end of the dollar are largely overblown. This highlights that the USD should continue to be denominate currency not just in global finance but in global trade.