The European Union’s announcement in September 2018 that it would begin to create a special payments channel with Iran in response to the US withdrawal from the Joint Comprehensive Plan of Action (JCPOA) once again raises the question of the role of the US dollar (USD) in the international economic order. Under the surface of discussions of alternative payment mechanisms is the legitimate question of the negative impacts of US coercive economic statecraft on the USD status as the leading global reserve currency.
Some argue that if Iran shifted to euro-denominated transactions, it could spark a broader shift within energy exporting countries that would eventually weaken the USD as the reserve currency, as well as undermine the impact of future unilateral US sanctions. William Rich of the Council on Foreign Relations and a former Treasury diplomat in the United Arab Emirates, however, argues that the proposed Europe-Iran payment mechanism is “impractical because such a process would be inefficient and costly and could not guarantee European firms protection from US sanctions, reputational damage, or Iranian misuse. It is most effective as public messaging to the Iranians that Europe is trying to resist American pressure.”
In fact, USD’s role as the global reserve currency is most affected by commercial and economic forces, not by politics. The use of sanctions has been a tremendous tool and there are certainly reasons why overuse of sanctions is problematic, but speeding up the decline of the USD as the global reserve currency is not a major concern. Most close observers are not worried about the euro overtaking the USD.
One necessary condition for a currency to be a global reserve currency is the political stability of the currency’s sponsor, which is not present in the EU at this time. Some observers are more concerned about the RMB (China’s yuan) than the euro. Adam Smith, a former senior official at the Treasury Department, emphasized that “though the USD is being challenged at the margins as yuan clearing and other localized trading processes pick up steam, its central role in global finance is currently unrivaled.”
Additionally, Brian O’Toole, a former senior Treasury sanctions official and nonresident senior fellow at the Atlantic Council, noted that “while sanctions overuse may drive other countries to set up mechanisms free of US influence, any erosion of the USD global role depends on much larger economic factors, like liquidity and velocity, than any overuse of a US policy tool.”
As the United States considers its options with respect to the murder of journalist Jamal Khashoggi at the Saudi consulate in Istanbul on October 2, the Saudis in response to US pressure could in the long term move away from USD pricing and embrace another currency, specifically the RMB, as a mechanism for denominating its oil exports. Smith also noted “despite this, the demise of [the USD’s] centrality could happen precipitously—one thing to watch for would be the willingness of major commodity producers to, as a group, price and accept payment in non-USD.”
With China’s status as the world’s largest oil importer since 2016 and the recent launch of yuan-denominated futures in Shanghai, it may seem likely that this is a reasonably plausible long-term outcome. It is still important to note that China does not stand alone in global oil markets. On its own, China may be the largest importer of oil, but China’s share of global oil consumption (13.0 percent) lagged behind the United States (20.2 percent) and even the EU’s (13.5 percent). In addition, China’s commodity futures markets are much less developed than those in the United States, with average bid/ask spreads much higher than those of New York, Chicago, or London, creating much higher transaction costs for market participants.
Most importantly though, a replacement for the RMB would introduce foreign exchange risk to the Saudis, who currently maintain a peg to the USD. While these pegs have their costs, such as in the mid-2000s when Kuwait chose to adjust its peg in response to inflationary pressures caused by the decline in its real exchange rate, these pegs have also brought stability to exchange rates, inflation expectations, and transaction costs. Though the decline in oil prices coupled with rising interest rates have brought into question the benefits of the pegs, the International Monetary Fund (IMF) executive board found in its latest Article IV Report on Saudi Arabia that the peg “continues to serve Saudi Arabia well, given the structure of the Saudi economy.”
With this in mind, it should be noted that the events of the Future Investment Initiative in Riyadh in October herald the future of Saudi economic statecraft. Despite the withdrawal of high-profile Western executives, Halliburton, Baker Hughes, Total, and other energy firms inked deals with Saudi Aramco to the tune of billions. The appearance of Kirill Dimitriev, the CEO of the Russian Direct Investment Fund, should also be noted. He was joined by a number of high-profile Russian executives, including Andrew Kostin (VTB) and Dmitry Konov (SIBUR). Even in the absence of a major move like repricing oil, it is likely that Riyadh will forge closer economic links with Russia and China.
Looking Back at History: When the USD Overtook the Pound
The consensus view is that the USD replaced the British pound as the global reserve currency in the aftermath of World War II. However, new evidence in 2017 from political economist Barry Eichengreen suggests that the displacement of the pound was, in fact, much earlier. Eichengreen contends that evidence from foreign exchange reserves, international bond issuance, and trade credit indicates that the USD achieved rough parity with the sterling internationally as early as the mid-1920s, driven by the creation of the Federal Reserve and relaxation of overseas branching regulations in 1913.
The USD receded in the 1930s due to the Great Depression, but then overtook the pound in the 1950s, becoming the sole global reserve currency in the aftermath of the pound’s devaluation in 1967. Since 1967, the latter half of the 20th century has seen innovations in financial technology that have made it easier for market participants to hedge or exchange different currencies, engendering a reserve currency environment less inclined to be naturally monopolistic.
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Michael B. Greenwald is senior advisor to the President and CEO at the Atlantic Council. He was also a former United States Treasury attaché to Qatar and Kuwait.
Image: US dollars and other world currencies lie in a charity receptacle at Pearson international airport in Toronto, Ontario, Canada June 13, 2018. (REUTERS/Chris Helgren)