For the past hundred years, the global financial landscape has been under the control of a single currency. In the beginning, it was the Pound Sterling, later succeeded by the U.S. dollar, which currently holds a staggering 59.02% of the Official Foreign Exchange Reserves (COFER).
The supremacy of the U.S. dollar can be attributed to its role as a linchpin that supports the majority of international trade. This role has led to the U.S. dollar becoming the most sought-after and universally accepted currency.
- The practice of heavily relying on the U.S. dollar instead of domestic currency—a practice known as dollarisation—is primarily motivated by the desire to mitigate exchange rate risks and conduct trade in a widely acknowledged currency.
- In contrast, de-dollarisation is an initiative aimed to counteract and reverse the effects of dollarisation. Several countries, including India, have initiated steps toward de-dollarisation. This movement has gained significant traction after the imposition of sanctions against Russia by Western nations.
The question remains: Is the degree of de-dollarisation being overstated, or is the dollar truly at risk of losing its unshakeable status as the world’s most recognised international currency?
Dollarisation
- Dollarisation refers to the process where a country substitutes its domestic assets, liabilities, and transactions with those of a foreign currency, primarily the US dollar.
- It can manifest in various forms, including financial dollarisation (substituting domestic assets or liabilities with foreign ones), real dollarisation (pegging domestic transactions to the foreign exchange rate), and transaction dollarisation (utilising the US dollar for domestic transactions).
- A common trigger for dollarisation is the underperformance of a country’s domestic currency, often due to factors like political upheaval or economic turmoil. These conditions may lead to volatile inflation and unstable real exchange rates, driving a shift towards dollarisation.
- Alternatively, dollarisation might occur in the context of financial market liberalisation and globalisation. The subsequent increase in capital inflow, driven by the reduction in exchange rate risk, may also lead to dollarisation.
De-dollarisation
- De-dollarisation refers to the global shift away from using the US dollar, influenced by the macroeconomic trilemma.
- This trilemma suggests that it’s impossible to simultaneously maintain capital mobility, an independent monetary policy, and a stable exchange rate—a central bank can only target two of these at any one time.
- Extensive dollarisation can render a country’s monetary policy ineffective, resulting in the erosion of seigniorage, heightened balance sheet risks, increased vulnerability to liquidity crises, and other financial perils.
- The United States dominates global financial markets, and its currency, the US dollar, is a powerful tool in its control.
- Recent trends show countries trying to reduce the US’s global influence by moving away from the US dollar and invoicing bilateral trade in their domestic currencies instead.
- Weaponisation of financial instruments, such as excluding Russia from the SWIFT system by the US and freezing its dollar assets in US banks as part of extensive sanctions, has accelerated the de-dollarization process.
How De-dollarisation Can Be Achieved
- De-dollarisation can be reached by combining several policies and actions.
- One way is to use more flexible exchange rates. This means a country can let the value of its currency change more freely against other currencies.
- Countries can also manage liquidity better to reduce fluctuations in interest rates. By doing this, they can make their domestic currencies more stable and attractive.
- Fiscal consolidation is another strategy. Here, countries, opposed to dollarisation, can limit the government’s debt that is in US dollars. This reduces their dependence on the US dollar.
- Building a deep domestic financial market is also helpful. In this market, assets are valued in the domestic currency instead of the US dollar. This helps reduce risks related to the US dollar.
- By gradually reducing reliance on the US dollar, countries can focus on their own monetary policy. This allows them to strengthen their economic structure over time.
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Recent Efforts To Challenge The Dominance Of Dollar
- Countries are finding ways to be less reliant on the US dollar. They are starting to use their own currencies more in trade.
- This change is a way to challenge the strong position of the US dollar. De-dollarisation helps them deal with any negative effects connected to the US dollar’s dominance.
- Brazil is working hard to improve its currency trade with Japan. Recently, a significant agreement was made with China. This agreement allows trading to happen using both countries’ domestic currencies.
- Indonesia has recently transitioned to a Local Currency Trade (LCT) system, aimed at de-dollarisation.
- In response to the sanctions imposed on Russia by Western countries, there is a growing movement to abandon the use of the dollar. This shift is spearheaded by China, with other BRICS nations following suit.
- The BRICS Summit on 24th August, 2023 will discuss a range of issues.
- A topic of debate might be the introduction of a common currency for BRICS nations.
- Nevertheless, India plans to abstain from such an arrangement. The reason is its significant trade deals with the US and Europe.
- India’s economy is also performing robustly among BRICS countries, which justifies its decision.
- India’s refusal to have a common BRICS currency doesn’t indicate a reluctance to decrease its reliance on the US dollar.
- In July 2022, the Reserve Bank of India (RBI) took a step towards de-dollarisation. It introduced a system for billing, paying, and settling import and export transactions in Indian Rupees (INR).
- This move became necessary because India started importing inexpensive crude oil from Russia, a country under sanctions. Russia agreed to receive payments in INR, which reduced India’s import costs.
- India aims to create systems that can bypass the dollar. It wants to strengthen the INR by settling trade in domestic currencies with multiple countries.
- Eighteen countries, including the UK, Russia, Sri Lanka, and Germany, have adopted this system. They have opened Special Rupee Vostro Accounts (SRVAs) to conduct transactions in INR.
- SRVAs are INR-denominated accounts maintained with Indian banks. These accounts directly credit or debit amounts as a country imports from or exports to India.
- The India International Bank of Malaysia recently opened an SRVA through the Union Bank of India. This step was taken to facilitate trade between India and Malaysia in INR.
Should India Pursue The Idea Of De-dollarisation?
- India recently signed Memoranda of Understanding (MoUs) with the United Arab Emirates. The MoUs aim to enhance the use of domestic currencies, the INR and AED, for bilateral trade and link payment systems.
- This move could reduce India’s reliance on foreign reserves and allow more autonomy in domestic monetary policy.
- However, a quick and complete shift away from dollarisation may not be feasible, as many countries remain committed to the US dollar due to its economic and geopolitical dominance in the past century.
- A rushed shift to de-dollarisation could destabilise the Balance of Payments (BOP), increasing the need for US dollar reserves to stabilise the currency.
Can Rupeefication Replace Dollarisation In India?
- The idea of replacing the dollar with local currencies is becoming popular worldwide. However, some people believe that this trend has been overemphasised. The decrease in the dollar’s role, especially the dollar’s share in COFER, might be due to actions taken by central banks to protect their currency.
- It could also be due to changes in interest rates. Still, it’s clear that many countries, particularly in the Global South, understand the drawbacks of using the dollar. These include problems related to exchange rates.
- The idea of “Rupeefication” is about promoting the Indian Rupee (INR) as a globally recognised currency. This implies that INR would be held and issued by foreign entities in their financial dealings.
- This can be beneficial for both private and public sectors in India. Export businesses can limit their exchange rate risks and increase their market reach if INR is accepted globally.
- The private sector could also gain more access to international financial markets and cut down borrowing costs, boosting profitability. This includes sectors outside of finance.
- The public sector could also finance its deficit by issuing INR-denominated international debt. This would save India’s official US dollar reserves.
- While managing macroeconomic and monetary policy can be challenging for a country like India dealing with domestic issues, rupeefication could actually support development.
- From a microeconomic standpoint, gradual rupeefication could stimulate the private sector and foster economic growth.
- The internationalisation of INR would only be possible when the economy is less dependent on the US dollar.
- De-dollarisation is a strategy for India, but the main focus should be gradual rupeefication, helping India to establish a global presence.
- In conclusion, gradual rupeefication can potentially replace dollarization in India, provided the economy becomes less dollar-dependent.
About COFER
The International Monetary Fund’s Statistics Department manages the Currency Composition of Official Foreign Exchange Reserves (COFER) database. COFER identifies the following currencies:
- US dollar
- Euro
- Chinese renminbi
- Japanese yen
- Pound sterling
- Australian dollar
- Canadian dollar, and
- Swiss franc
Before the introduction of the Euro in 1999, various European currencies, including the European Currency Unit, Deutsche mark, French franc, and the Netherlands guilder, were individually identified in COFER. However, all other currencies are collectively classified as “other currencies” now.
The definition of foreign exchange reserves in COFER is the same as that in the IMF’s International Financial Statistics (IFS).
Allocated Reserves refer to data on foreign exchange reserves reported under COFER.
Unallocated Reserves refer to the disparity between the overall foreign exchange reserves recorded in the IFS (International Financial Statistics) and the total reserves allocated in COFER (Currency Composition of Official Foreign Exchange Reserves).
Unallocated reserves encompass the foreign exchange holdings of countries or economies that presently provide reserve asset data for the IFS but do not report to COFER.