All empires have thought at some point that they were invincible!
This somewhat provocative title, which is akin to planned obsolescence, remind us, tinged with primary Darwinism, that nothing is immutable. The Roman, the Mongol, the Ottoman, as well as the French or the British, all empires throughout the centuries have suffered the same fate! They have followed a natural cycle of birth, growth, maturity, and decline. Expressed in a more academic manner, this phenomenon is like a classic return to the mean after a two standard deviations shift.
So, what about the dominant force today, the American empire and its hegemonic dollar! It turns out that global trade is still largely dominated by the greenback. The emerging countries, led by the BRICS, whose long-term interest in emancipating from the US currency now seems unanimous, see a unique, even historic, opportunity to free themselves from the American domination and its emblem, its currency.
Let’s go over the recent steps in chronological order.
After the pandemic, as the world’s economies faced an unprecedented activity slowdown that plunged them into recession, central banks kept their key interest rates at record lows while injecting massive liquidity. The (unintended) purpose of these (joint) actions was to weaken the external value of the money to stimulate activity and generate growth to revive their respective domestic economies.
This conventional recovery or so-called “competitive” devaluation strategy was too synchronized to generate the expected effects. Opposing forces cancelling each other out and protagonists using the same weapons, the adjustment of the external value of currencies could not materialize.
These expansionary monetary policies combined with a surprisingly dynamic recovery, contributed to a rapid rise in inflation. While the price increase was supposed to be temporary, Russia’s entry into war in Ukraine, coupled with a resurgence of Covid pandemic in China, changed dramatically the balance. Thus, inflation in the prices of consumer goods and energy continued to escalate.
The start of a new war in Europe exacerbated market fears, which initiated a phase of dollar revaluation, resulting in an appreciation of the DXY (Dollar Index) of over 25% between December 2020 and October 2022. The greenback has benefited fully from the “safe haven” reflex, reinforced by the strong resilience of its domestic economy.
At the end of the autumn, the few encouraging signals on the inflation front suggested that the US rate adjustment cycle was coming to an end, causing investors to reconsider their exposure to the greenback.
Time horizons determine perspectives.
While we have generally seen an increase in the value of the greenback over the medium term (24 months), this trend has recently reversed. This particular pattern reminds us that the fundamental forces at work can differ depending on the time horizon we define. By focusing on secular influence changes, we can draw some conclusions.
Thus, if we were to measure the power of an empire:
- In terms of the relative strength, the United States could pride itself for possessing the reference currency generating the largest volume of transactions in the world. Measured through the volume of international financial and commercial transactions denominated in dollars and the level of debt issued, the dollar dominates other currencies by a wide margin. Currently, nearly 80% of foreign exchange transactions are conducted in dollars. However, the dominance of the greenback has gradually declined. This trend is due to several factors, including the economic rise of China and the use of so-called alternative currencies.
- In its ability to impose sanctions to third-party states beyond the United Nations official mechanisms provided for that purpose, the United States would take the lead with some 70 sanctions programs imposed against individuals, non-state actors or countries over the past two decades. The latest constraints imposed on Russia have had unprecedented collateral effects, pushing some governments to seriously question their dependence on the American dollar. The exclusion of Russia from Swift, the world’s leading provider of secure financial messaging services, has motivated the BRICS (Brazil, Russia, India, China and South Africa) to develop a credible alternative to the dollar. Thus, 24 countries, worried about the new restrictive measures implemented by the West, mainly the European Union and the USA, have pushed them to explore the possibility of and creating an alternative type of currency.
- In terms of World’s nominal GDP (gross domestic product) percentage contribution, the United States remains in the first place. However, China’s GDP has grown exponentially in recent decades, intensifying the trade war between the two giants. The current American supremacy should only be temporary. Moreover, when measured as a share of GDP adjusted for purchasing power parity (PPP), with a global share of 15.57% in 2022, the United States is overtaken by the Chinese economy (18.48%). These trends have been present for several years and will continue to strengthen in the future.
- In terms of the reserve currency market share within central bank balance sheets, the dollar’s share is gradually decreasing, mainly in favor of gold, the euro, the Chinese CNY and the Japanese yen. Thus, the greenback dominance is weakening and its share as a reserve currency has declined significantly, as it now accounts for only 59% of foreign exchange reserves, compared to about 70% at the beginning of the century. This trend is explained by factors such as the rise of the Chinese economy, or even the BRICS, the increasing use of alternative currencies for settling commercial transactions, and growing concerns about its long-term stability.
- In terms of military power, the United States is still in the pole position. Until now, the protection of third countries by US military forces was conditioned to their obedience to the dollar through, among other things, the purchase of US Treasury bonds, which reinforced the dollar’s dominance over time. However, the Power Index, which measures the military power of a state, now shows only a small gap between the United States and its main competitor, China (which remains only a regional power). The argument of a strong army that would represent a kind of collateral to which the currency would be attached is probably relevant as long as the measured power gap remains elevated which has been proven not to be the case anymore.
As it is often the case, the analyst’s objectivity is lost in details of no real importance. Lacking sufficient hindsight, defenders of the “dollar” empire, who imagine that it is enough to dominate one day to define it as immutable, do not necessarily spontaneously integrate into their analyses the changes that are taking place before their eyes.
On our side, and although short-term trends suggest a potential and temporary strengthening of the greenback, we believe that the long-term forces at work militate for its weakening.
Laurent Perusset, CIO