March 21, 2023
The US dollar has been the dominant global currency for along time, but the possibility of it losing that position becomes topical from time to time. We looked into the history and the consequence of this domination, and tried to sketch the outlines of a situation when the dollar is no longer dominant.
The US dollar has not always been dominant – in the 19thcentury it was the British Pound that played the role of a global currency. The dollar took over between the First World War and the 1950s – this roughly corresponds with the period when the US GDP overtook the combined GDP of Britain and the most significant countries of the British Commonwealth/Empire.
The relative exchange rates of the dollar and the pound were on a roller-coaster during this period (it was a turbulent period not just politically, but economically as well). But when the dust settled by the 1950s,the pound lost about 25% of its value compared to the dollar in real terms.
In recent decades, the dollar being a dominant currency was associated with relatively large current account deficits and a buildup of a large negative net foreign asset (NFA) position for the USA. Normally, a large negative NFA position means that the given country also has a large net negative net investment income in its current accounts as well. But the “exorbitant privilege” of the dollar means that this is not the case (see next chart). Despite the large negative NFA position, the balance of overseas investment income for the USA is still positive. The reason for this is twofold: the USA has a larger proportion of debt-type assets on its foreign liabilities side than on the asset side, and it can pay a lower return on similar assets than the rest of the world. You can think of the US as a giant leveraged investment fund.
Should the dollar lose its dominant position, this, and many other things would change. The dollar would probably be weaker, and the current account deficit of the USA would close. The rest of the world would demand higher returns going forward on US assets. If a new dominant currency (or currencies) emerge, those would probably be stronger than they are now. And for certain, a declining USA current account deficit would mean that the rest of the world, and most likely, the economy of the new dominant currency, would have to reduce its current account surplus.
This switchover probably would not happen in a few years, but rather in decades (if at all). But the consequences could be large. The following table shows the key findings of our hypothetical scenario modeling when the Chinese yuan became the dominant currency.