Independence Day: Is the dollar losing its crown?

The dollar's share of allocated global foreign exchange reserves has slipped to roughly fifty-eight per cent, its lowest in nearly three decades, according to the International Monetary Fund's COFER data. An apt figure for Independence Day: the world is slowly rethinking its reliance on the American currency.

A slow drift from the dollar

Commentators predict the dollar's imminent demise every few years. The actual shift is much slower, a gradual diversification with no sign of a collapse. Emerging market central banks, unnerved by the West's use of financial sanctions as a weapon, are steadily adding physical gold and less traditional currencies to their reserves. The dollar's network effects remain formidable, but its dominance is wearing away at the edges.

The long view shows how gradual the erosion has been. At the turn of the century the dollar accounted for more than 70 per cent of allocated reserves, and the decline since then has come in small steps, a percentage point here and there, rather than in any single break. The euro, launched in 1999, took some share early on and then stalled at around a fifth after its sovereign debt crisis. The Chinese renminbi, despite years of official promotion, still makes up only around 2 per cent.

Where the reserves went

The share lost by the dollar has not gone mainly to its obvious rivals. Research by IMF economists has shown that much of it moved into what they called non-traditional reserve currencies, among them the Australian and Canadian dollars, the Korean won and the currencies of smaller advanced economies with open capital markets and reliable institutions. Reserve managers have diversified by adding a handful of small positions rather than by switching to a single alternative, which is exactly what one would expect if no challenger is ready to take the dollar's place.

Gold is the other destination. Central banks bought more than 1,000 tonnes in both 2022 and 2023, the fastest pace in decades, and the People's Bank of China added to its gold holdings for eighteen consecutive months before pausing in May. Those purchases helped drive the gold price to record highs above $2,400 an ounce this spring. Gold is not counted in the COFER currency figures, so its rise understates how far some central banks have moved away from dollar assets.

Sanctions changed the calculus

The turning point for many reserve managers came in February 2022, when Western governments froze roughly $300 billion of the Russian central bank's foreign reserves after the invasion of Ukraine. Reserves held in dollars, euros, pounds or yen were shown to be usable only with the consent of the issuing governments. Gold held in a country's own vaults carries no such risk. For central banks in countries with uneasy relations with Washington, the lesson was that reserves exist partly to be available in a crisis, and some crises may involve the West itself.

The same logic explains growing interest in settling trade outside the dollar. China and Russia now conduct much of their bilateral trade in yuan and roubles, and several countries have signed currency swap or local-currency settlement agreements. The expanded BRICS group, which added new members at the start of this year, talks regularly about reducing dependence on the dollar, although it has made little concrete progress towards any common alternative.

Why the crown stays on

The case for the dollar's staying power is strong, and it rests on plumbing more than politics. The dollar sits on one side of almost nine in ten foreign exchange transactions, according to the Bank for International Settlements, because it acts as the vehicle currency through which smaller currencies are traded. Most international trade invoicing and cross-border lending is still done in dollars. The US Treasury market is the deepest and most liquid pool of safe assets in the world, and no rival offers anything comparable. The euro area lacks a single safe bond, and China's capital controls make the renminbi hard to hold in size.

The COFER figures also move with exchange rates, which complicates any reading of them. When the dollar strengthens, the value of dollar reserves rises relative to others, and the share goes up without any central bank buying anything. A weaker dollar has the opposite effect. Some of the recent decline reflects such valuation swings rather than active selling, and some of the apparent shift can reverse without anyone changing their mind. The unallocated portion of reserves, for which countries do not report a currency breakdown, adds a further layer of uncertainty, although it has shrunk a great deal as China and others began reporting.

Sterling's long goodbye

History suggests that reserve currencies fade over decades rather than years. Sterling was the world's leading reserve currency before the First World War and remained a major one well after Britain had lost its economic lead, finally shrinking to a minor role only in the 1960s and 1970s through a series of devaluations and crises. The dollar's rise was helped by the Bretton Woods system after 1944 and survived the end of gold convertibility in 1971. Incumbency, in other words, is powerful, and it tends to outlast the conditions that created it.

The American case has its own risks. Large and persistent federal deficits, repeated confrontations over the debt ceiling and the growing use of financial sanctions all give reserve managers reasons to hedge. None of these would cause a sudden flight, but each adds to the slow push towards diversification that the COFER data record.

What to watch next

The IMF publishes COFER data quarterly, with a lag of about three months, and the direction matters more than any single reading. Central bank gold purchases, reported by the World Gold Council, show how far the move into bullion continues. The share of trade invoiced in other currencies, and any new sanctions that target a central bank's reserves, are the other signals.

The dollar will remain the main reserve currency for years to come. Its share will probably keep edging down as central banks buy gold and other currencies, with each new round of sanctions adding a reason. The practical consequence is not a dollar crisis but a slightly higher price for American borrowing over time, as foreign official demand for Treasuries grows more slowly than the supply the government needs to sell.