Abstract: This article examines the impact of the war in Ukraine on the centrality of the US dollar in the international financial system. The potential risks of “weaponizing” the dollar as part of the sanctions against Russia made many commentators worry that this would harm the USD centrality as a reserve currency. The viability of alternative currencies is in the end limited: in uncertain times gold is gaining traction and many other currencies are more represented in FX reserves, but the US dollar dominance remains largely unchallenged, with its position in global trade and central bank reserves still secure.
The war in Ukraine has highlighted yet another limit of sovereignty that affects us all. Western countries have not only imposed trade sanctions on Russia and its allies but also frozen the Russian central bank’s assets held in Western institutions.
These measures represent a significant shift from previous sanctions, which respected the principle of central banks’ immunity, protecting them from legal challenges by other states or foreign nationals. A major debate has emerged about whether Western countries should seize (not just freeze) these assets to compensate for war damages. At the moment, this seems unlikely. Despite Russia’s aggression, many think that this would be a dangerous precedent, that may suggest that participation in the international trade system is reserved for countries ideologically aligned with the United States.
This action also underscores something that was hardly acknowledged in more peaceful times. Even central banks do not directly hold most of their foreign exchange reserves; currencies are ultimately “owned” by their issuer. Consequently, most foreign exchange reserves denominated in US dollars are held in accounts of institutions under the jurisdiction of the United States government such as the Federal Reserve of New York.
Many have highlighted the risks of “weaponizing” the US dollar, potentially accelerating a long-term of process of de-dollarization of the international financial system. The extent of the alleged reduced attractiveness of the dollar depends on the viability of alternatives, making it an empirical question. Even without extreme retaliation against Russia, some wonder if barring a major international trader from accessing US dollar facilities could harm the dollar’s centrality in the international financial system and its use as a reserve currency.
The dominance of the US dollar in international trade and finance provides several advantages to the US, such as limiting currency risk for its companies and the ability to fund its trade deficit by printing more money. This phenomenon, known as “exorbitant privilege,” was coined by French President Charles de Gaulle’s finance minister in the 1950s.
According to the IMF, the US dollar remains the predominant reserve currency, accounting for about 60% of global reserves, down from 70% in 2000. However, its decline has stabilized in recent years, as we can see in Figure 1. The euro’s share of reserves remains below the Eurozone’s proportion of the global economy, and the renminbi, despite being included in the IMF’s Special Drawing Rights (SDR) in 2016, still accounts for less than 3% of global reserves, with half held by the Central Bank of Russia. Meanwhile, the shares of other currencies, such as the Australian and Canadian dollars, the Swiss franc, and the Korean won, are rising.
Recent research (Goldberg and Hannaoui 2024 and Chinn et al. 2024) found no evidence that US financial sanctions reduce the dollar’s share in official foreign exchange reserves. However, Arslanalp et al. (2023) found that financial sanctions lead to a higher proportion of gold in overall reserves. These findings downplay the narrative that the war in Ukraine may make the international financial system more fractioned. The main movement has been from the dollar to gold or other strong currencies rather than the renminbi.
Gold, of course, is a physical asset with its own pros and cons. If stored in London, New York, or Switzerland, it can be easily sold or swapped for foreign currency but is also outside one’s jurisdiction and potentially at risk of being frozen by the international community. If stored domestically, it is harder to mobilize and subject to domestic political risks, as seen with the central bank of Libya’s gold after Gaddafi’s fall. Unless technological developments in fintech allow for the “tokenization” of gold through blockchain, gold remains a safe but cumbersome asset to trade.
As already mentioned, there is indeed a historical decline in the share of dollars in central bank foreign exchange reserves at least since the euro’s introduction in 1999. Some fluctuations in FX shares are also influenced by exchange rates. For example, the Swiss National Bank reduced its USD holdings as the USD appreciated to minimize fluctuations in the CHF-denominated value of USD reserves.
The IMF reports a decline in the renminbi’s share of FX reserves from 2.8% at the end of 2021 to 2.2% in March 2024, providing even less evidence that geopolitical turmoil is shifting the dollar’s centrality in favor of China. China is pushing for increased use of the renminbi in transactions with other governments, such as currency swaps with Latin American or African countries and transactions related to the “Belt and Road Initiative.” Its use within the SWIFT banking system has also increased since the invasion of Ukraine, though it remains a small fraction of transactions (at most 5%).
One reason for the limited impact of the war in Ukraine on the dollar is that Russia had already shifted away from the USD since the invasion of Crimea in 2014. Gopinath and Stein (2021) argue that a currency’s centrality in foreign exchange reserves is mainly due to its centrality in international trade and finance. As most international trade transactions are conducted in USD, it is logical (and in some way also mechanically necessary) for central banks to hold substantial reserves in that currency. Similarly, many developing countries issue debt denominated in USD, making the USD central to the financial system. The volume of USD-denominated bonds has increased over time, as has the amount of trade conducted in USD.
Alternative currencies do not offer similar qualities as the dollar. US government debt remains the epitome of a safe asset, with strong liquidity and safety. Chinese government debt denominated in renminbi is less than a third of US debt (7bn vs. 23bn in USD value), and access to it is not fully liberalized for international investors. Research shows that the renminbi’s share in international financial transactions has doubled, but this means it has only increased from 1.5% to 3%, which is still relatively small.
China itself, with its long history of trade surplus, holds a large fraction of FX reserves, which by definition cannot be denominated in renminbi. A quarter of dollar-denominated reserves (12bn) are held by China. To continue managing its exchange rate, China needs to hold vast amounts of USD.
In conclusion, the war in Ukraine has pushed many to wonder whether the centrality of US dollar in the international financial system was coming to an end. In reality, the US dollar’s centrality remains largely unchallenged, even if other strong currencies are gaining space. The future of international currency dynamics will depend on the evolving geopolitical landscape and the viability of alternatives, but for now, the dollar’s position appears secure.
References:
Arslanalp, S., Eichengreen, B., & Simpson-Bell, C. (2023). “Gold as international reserves: A barbarous relic no more?” Journal of International Economics, 145, 103822.
Chinn, M., Frankel, J., & Ito, H. (2024). “The Dollar versus the euro as international reserve currencies.” Journal of International Money and Finance, 146, 103123.
Goldberg, L. S., & Hannaoui, O. (2024). “Drivers of Dollar Share in Foreign Exchange Reserves.” FRB of New York Staff Report No. 1087, Rev. August 2024.
Gopinath, G., & Stein, J. C. (2021). “Banking, Trade, and the Making of a Dominant Currency.” The Quarterly Journal of Economics, 136(2), 783–830.
Johnson-Calari, J., Das, A., & Passacantando, F. (2024). The “Weaponisation” of Money: Risks of Global Financial Fragmentation. Rome: Istituto Affari Internazionali. IAI Papers, Issue 24|20, 16 pages.
Prof Emanuele Bracco
Emanuele Bracco is an Associate Professor of Economics at the University of Verona, Italy. His research spans the fields of Political Economy and Public Economics, where he has conducted both theoretical and empirical studies. Emanuele's work includes significant contributions to understanding gerrymandering, fiscal federalism, social capital, and immigration. His research not only explores the complexities of these topics but also provides insights into their broader social and economic impacts. Through his academic endeavors, Emanuele continues to contribute to the advancement of knowledge in these critical areas of economics.