Future of the US dollar as world reserve currency is in jeopardy

History of USD as reserve currency

The US dollar is today a world reserve currency because of two major historical events: Bretton Woods conference in 1944, and petrodollar deal made in 1971.

In July 1944 Bretton Woods agreement created a collective international currency exchange regime, which instantly made the US dollar a world reserve currency. Under the Bretton Woods system, gold was the basis for the US dollar (this is known as the gold standard) and other currencies were pegged to the US dollar’s value. The rules of Bretton Woods provided for a system of fixed exchange rates, which required that other countries would peg their currencies to the US dollar, and buy/sell dollars to keep the market exchange rates within 1% of parity. The Bretton Woods system collapsed in August 1971, after President Nixon announced a temporary (which became permanent) suspension of the dollar's convertibility into gold. By that time the Bretton Woods agreement already created a lasting influence on the international currency exchange and global trade through its development of the International Monetary Fund (IMF) and World Bank.

While the collapse of the Bretton Woods system (due to overvaluation of the dollar and loss of foreign confidence in the dollar) was quite damaging for the US economy, at the same time President Nixon has made a smart deal with King Faisal of Saudi Arabia. Nixon has promised the Saudis security in exchange for selling their crude oil only in the US dollars. Similar deals were made with the other OPEC countries and by 1975 all crude oil was sold only in the US dollars. This deal positioned the dollar as the most useful world currency and dictated other central banks to hold dollar reserves in order to buy this indispensable commodity. The dollars paid to oil-producing countries for their exports are today known as petrodollars.

The rise of the petrodollar system gave the US dollar elevated status as the dominant currency in the global economy, which led to many benefits for the US economy, including: consistent trade deficits and source of liquidity, inflow of foreign capital through petrodollar recycling (reinvestment of crude oil export revenue in the US Treasury securities), ability to finance deficit with low-interest-rate assets, and decisive influence over global economic markets.

Future of USD as reserve currency

For more than 70 years the USA has been enjoying world dependency on the US dollar, which was not only instrumental in controlling the world energy demand, but also stimulated the domestic economy by means of cheap borrowing. But, this could all come to an end as the recent developments in the geopolitical arena are seriously damaging the US dollar’s reputation and have potential to end its reserve currency status.

In February 2022 the US government started weaponizing the dollar as a sanctions instrument against Russia effectively cutting off the Russian central bank from the international monetary system. This is the most significant action ever the US Treasury has taken against an economy of this size and assets of this size.

Another wave of sanctions in March 2022 has frozen $300 billion out of $640 billion that Russia had in its gold and forex reserves. These are the reserves that Russia holds in the US dollars, while the remaining $340 billion that Russia holds in the Chinese yuan has not been sanctioned.

Although these sanctions are targeting only Russia, the other countries are watching and questioning their dependency on the US dollar and their vulnerability to similar attacks. Weaponizing the dollar as a sanctions instrument is unwise as it erodes the trust in the currency and incentivizes the countries to diversify away from the dollar. The US dollar and dollar denominated assets are being associated with significant counterparty risk.

To make things worse, the recent EU efforts to confiscate the Russian frozen assets could potentially destroy any confidence left in the western financial system, affecting both the dollar and the euro. Normally, frozen assets would be returned to the owner once the sanctions are lifted, but now the EU is looking to expropriate the Russian frozen assets and use them to finance the costly reconstruction of Ukraine.
Such an unthinkable violation of property rights, the very cornerstone of western liberal democracy, could completely destroy the trust in the western legal, economic and financial system.

While the world nations are being reminded of their economic vulnerability as their assets are potential sanctions targets and can be easily frozen by the western powers, Ukraine is calling for the United States to impose secondary sanctions on China and India for buying Russian energy. This further incentivizes these countries to urgently diversify away from the dollar (i.e. to de-dollarize).

Although de-dollarization has been happening for some time already, it was a slow process that would normally take decades. In the current geopolitical environment this process is speeding up significantly. Countries like China, India, Saudi Arabia, are hastily reducing their dependence on the US dollar.

Even if de-dollarization is picking up pace, it may take years for the US dollar to lose its dominant place in the global economy. There are several reasons why the countries can’t de-dollarize instantly. Firstly, the US dollar is still a world reserve currency and countries need dollars to purchase essential commodities, which are predominantly priced in dollars. Another reason why the world is hooked on dollars is the ease of making transactions. Both the US dollar and the EU euro are the most transactable world currencies.

China, Saudi Arabia and even Japan are steadily reducing their exposure to the US Treasury securities (check https://ticdata.treasury.gov/Publish/mfh.txt). Their dollars are now buying gold, which can’t be sanctioned by the western powers. Stockpiling of gold reserves by the central banks is a trend that is worth paying attention to. China, Turkey and Saudi Arabia are buying gold instead of the US Treasury bills, which is a form of diversification away from the dollar.

The recent China-Brazil bilateral trade agreement is another example of de-dollarization efforts. All central banks hold dollar reserves in order to trade with other nations. However, when China and Brazil agree to trade in their own currencies, they are simply bypassing the US dollar as an intermediary.

Besides, this is not an isolated case. China has similar agreements with Russia, Pakistan and several other countries.

BRICS currency might be a flawed idea, nobody knows for sure, but this idea is out there and it just might become reality. There's a possibility that the BRICS currency will be backed by gold. We should remember that the US dollar was also backed by gold in 1944 when it became a world reserve currency. There are some advantages of the gold standard. For example, it prevents inflation as governments and banks are unable to manipulate the money supply (e.g. overissuing money).

The end of the petrodollar system

Very important instrument that makes the US dollar world's most useful currency is the petrodollar system, which should be evaluated in the context of global de-dollarization.
Saudi Arabia, traditionally a provider of raw materials, is now seeking a more active role in shaping global events. Since the establishment of the petrodollar system, the Kingdom has had close ties with the United States, but now it’s looking to strengthen its relationships with other countries, particularly in Asia. For example, last year the Saudis have shown determination to prioritize their own interests even if it’s damaging the relationship with the USA.

In October 2022, OPEC announced the biggest cut to oil production since the start of COVID pandemic. This came at the wrong time as the collective west is already suffering from the record high inflation fueled by the high energy prices. Instead of listening to the USA and increasing production, the Saudis are prioritizing their oil revenues.

The US-Saudi relations have reached an all-time low, but the United States can’t do much to punish the Saudis. The US leaders are aware that the Saudis hold the petrodollar card in their hands, which is of significant importance for the US economy. Because of this the US government can’t sanction the Saudis in any meaningful way. In the past, there were attempts to pass the NOPEC bill to which the Saudis threatened to ditch dollar oil trades. Ultimately, the petrodollar system isn't essential for their oil business as the majority of Saudi Arabia's oil is consumed by Asia.

Although the Saudis use petrodollar as a leverage against the US foreign policy, they know that ditching petrodollar prematurely could be devastating for their security. We all know what happened to Iraq after they switched their oil sales to euro in 2001.

The recent application of Saudi Arabia to join BRICS is a significant development. The Saudis could potentially bring additional economic and political influence to the bloc, because of its vast energy resources. BRICS block is an independent international organization encouraging commercial, political, and cultural cooperation among the BRICS nations (Brazil, Russia, India, China, and South Africa). The BRICS have a combined area of about 26.7% of the world's land surface and 41.5% of the global population. With 32.1% of global GDP, the BRICS have already surpassed the combined GDP of the G7 nations.
If BRICS decides to build up its membership with Saudi Arabia, it could shape a bilateral currency exchange deal under which the BRICS countries would not have to buy oil in dollars. This could spell the end of the petrodollar system and petrodollar recycling. A breakdown of the petrodollar system would be a real game changer and it could significantly accelerate the ongoing de-dollarization.

The government of Saudi Arabia has officially agreed to join the Shanghai Cooperation Organization (SCO) as a dialogue partner. With this move the Saudis aim to strengthen their economic partnership with their Asian neighbors. It becomes overwhelmingly obvious that they are distancing themself from the west and pivoting towards Asia. Besides, the SCO is not only an economic alliance but also a security organization, which might give the Saudis security guarantees that could protect them against the potential US retaliation (in case of abandoning the petrodollar system).

To conclude…

Because all commodities are priced in dollars, the US dollar has been the most useful currency and enjoyed a special status in the global economy for the past 7 decades. Central banks of other countries must hold dollar reserves in order to be able to buy commodities. This dependency on the dollar creates an environment in which the United States has decisive influence over global economic markets.

The US dollar and the EU euro are today the most transactable world currencies.
Weaponizing the dollar (along with the euro) as a sanctions instrument damages the trust in the currency and creates awareness of the counterparty risk associated with dependence on the US dollar, which in turn incentivizes countries to diversify away from the dollar (i.e. to de-dollarize). Due to ongoing de-dollarization efforts the US dollar could lose its dominant position on the global stage. This doesn’t mean that the US dollar will become worthless and disappear, it only means that the US economy will be on a more equal footing with the rest of the world.

Whether one believes that the de-dollarization is real or not, the following themes are worth paying attention to: foreign holdings of the US Treasury securities, accumulation of gold reserves by the central banks, bilateral trade agreements, Saudi Arabia joining the BRICS block, emergence of the BRICS currency.