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The Tell: Rise of ‘nontraditional’ reserve currencies diminishes dollar’s dominance

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The U.S. dollar’s status as the dominant global reserve currency shows few signs of waning, despite a flurry of challenges from Russia and China as MarketWatch reported this week.

But if the dollar does eventually cede its status as the most popular currency for central bank reserves, international trade and bank deposits, then this latest data point will likely be remembered as a milestone.

On Thursday, the International Monetary Fund reported that the percentage of international currency reserves denominated in dollars has fallen below 59% to a new low of 58.81%.

Source: IMF

To help put this in context, it’s worth noting that the IMF has been collecting data on international reserves since 1995. Since there are no reliable data on international reserves before then, it’s likely that this new low is actually the lowest concentration of dollar holdings in international reserves since the collapse of Bretton-Woods in the early 1970s.

The latest update dates back to the fourth quarter of 2021.

As the dollar’s role in foreign currency reserves has receded, central banks around the world have been diversifying into a number of different international currencies. Analysts have argued that this could be construed as a positive for the dollar’s continued dominance, since the international community has yet to coalesce around a single challenger currency.

Instead of diversifying into euros or the Japanese yen
USDJPY,
-0.21%
,
central banks have instead favored a smattering of smaller rivals, including the South Korean won
USDKRW,
-0.10%

and the Swedish krona
USDSEK,
-0.76%

– along with the Australian
USDAUD,
-0.80%

and Canadian dollars
USDCAD,
-0.35%
.

Currencies of smaller economies accounted for three-quarters of the recent shift away from dollars, as the IMF illustrates in the chart below:

Source: IMF

According to the IMF’s blog, this is the rationale for favoring smaller currencies.

“These currencies combine higher returns with relatively lower volatility. This appeals increasingly to central bank reserve managers as foreign exchange stockpiles grow, raising the stakes for portfolio allocation.”

“New financial technologies — such as automatic market-making and automated liquidity management systems — make it cheaper and easier to trade the currencies of smaller economies.”

What’s more, central bankers can rest assured that these currencies won’t experience much instability since they benefit from bilateral swap lines with the Federal Reserve, which bolsters confidence in their ability to retain their value compared with the dollar.

In some cases, the issuers of these currencies also have bilateral swap lines with the Federal Reserve. This, it can be argued, creates confidence that their currencies will hold their value against the dollar.

Another plausible explanation: these “nontraditional” reserve currencies benefit from open capital accounts and a strong track record of sound and stable monetary policy.

The importance of maintaining an open capital account highlights another interesting feature of the latest IMF data: while the Chinese yuan
USDCNY,
-0.26%

has seen its share of global reserves grow, the increase has been comparatively lackluster, with Russia alone accounting for nearly one-third of all foreign renminbi reserves.

Source: IMF

While there has been some increase in the share of reserves held in renminbi, the Chinese currency accounts for just 25% of the shift away from dollars in recent years.

To be sure, the dollar’s share of international reserves remains well above half, and its dominance in global trade is even greater. The dollar accounted for 96% of trade invoicing in the Americas, 74% in the Asia-Pacific region, and 79% in the rest of the world during the 20 years between 1999 and 2019.

In terms of market performance, the dollar
DXY,
-0.42%

has also continued to dominate thanks to an attractive interest rate differential and safe haven flows: one popular gauge of the dollar’s value touched its strongest level since 2002 earlier this year.

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