Greenback's reign isn't over, but cracks are showing

Business Times

3 days ago

THE US dollar remains the undisputed heavyweight in the global financial system: Central banks hoard it; global trade is priced on it; and financial markets are built around it. However, that dominance, long taken for granted, is being tested.
From shifting geopolitical alliances to evolving investment behaviour, the forces nibbling at the dollar's dominance are multiplying. There is no clear successor so far, but cracks are forming in its foundation.
For decades, the dollar has anchored the global monetary system, thanks not only to the US' economic power, but also to its deep, liquid capital markets and perceived political stability. However, these advantages are no longer absolute. International investors, once content to be heavily exposed to US assets, are starting to hedge their bets more actively.
Combine that with rising US debt, policy unpredictability and a trend toward regional currency use in trade, and the case for a weaker dollar, at least in the near term, starts to build.
Dollar's gradually diminishing role
Let us be clear: there is still no real alternative to the dollar. The euro lacks a true fiscal union and deep bond markets. The yuan remains constrained by capital controls. Even with all the talk about multipolar currencies, the dollar remains deeply embedded in how the world trades, borrows and invests.
The dollar currently makes up 58 per cent of global foreign exchange reserves, more than 80 per cent of global FX turnover and a third of global debt is issued in dollars. These are not numbers that shift quickly. Two decades ago, the dollar's reserve share was closer to 70 per cent. Central banks have steadily diversified – into the euro, yen, sterling, and the 'others' category that includes the Australian dollar, Canadian dollar and Swiss franc. Growing geopolitical tensions and trade fragmentation are only accelerating that shift.
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Trade fragmentation chips away at dollar dominance
The dollar still dominates trade between advanced and emerging economies (EM). But trade between EMs is increasingly bypassing the dollar, with more transactions being settled in local currencies or alternatives.
As at 2022, about three quarters of global trade involved advanced economies, and only a quarter of it was EM to EM or EM to China trade. That smaller slice in trade among EMs is where de-dollarisation is gaining ground. It's not enough to unseat the greenback, but it is reshaping parts of the global economy.
Structural risks from within
The bigger risks to the dollar may come from within. The US federal debt is projected to hit 99 per cent of GDP in 2024 and 118 per cent within a decade, according to the US Congressional Budget Office. This raises concerns about the long-term appeal of US government bonds (Treasuries) as the world's preferred safe asset.
Foreign ownership of Treasuries is already slipping. For years, overseas investors, especially official institutions such as central banks, held large portions of US debt. However, with slower reserve accumulation and greater diversification, foreign holdings of Treasuries and corporate bonds have fallen to about 30 per cent of outstanding amounts.
There are no signs of a broad sell-off, but the US may have to offer higher yields to keep attracting global capital as issuance continues to rise.
Hedging FX risks increasingly important
Beyond central banks and trade, a quiet shift is happening among institutional investors. Foreign investors have accumulated US$56.6 trillion in US financial assets, up from just US$2.2 trillion in 1990. That includes US$16.5 trillion in equities and another US$14.5 trillion in debt securities, with foreign direct investment accounting for a further US$16.5 trillion.
For many years, many investors – pension funds, insurance companies, sovereign wealth funds – did not hedge their dollar exposure aggressively. The dollar's historical tendency to rise in times of stress made it a natural portfolio hedge. This so-called 'USD smile' worked well for years, but it is fading.
Treasuries and the dollar have become less reliable during market stress. That has made the cost of being unhedged far more painful. As a result, we are seeing early signs of increased FX hedging activity. If this continues, it could create sustained downward pressure on the dollar through active USD selling.
Gold: diversification in uncertain times
If there is a winner from the de-dollarisation push, it is gold. Central banks, especially those in EMs, have ramped up gold purchases. The People's Bank of China, for instance, resumed gold buying in 2022 after a three-year pause.
The World Gold Council said net central bank gold purchases reached 1,045 metric tonnes in 2024. Gold now accounts for an estimated 14 per cent of global reserves, up from 8.3 per cent in 2018. Part hedge, part symbol, the appeal of the yellow metal is clear in a world of rising inflation, geopolitical friction and currency uncertainty.
What this means for portfolios
In the near term, these forces point to a softer dollar, especially if FX hedging continues to increase. Over time, the dollar is unlikely to lose its primacy, but its share in global reserves, debt markets and transactions may continue to gradually erode. Investors, policymakers and institutions would be wise to plan for a world where the dollar's leadership becomes more contested.
It is important for global investors to distinguish between cyclical and structural dollar weakness. Cyclical weakness, driven by interest rate differentials, relative US equity market underperformance or mean reversion in terms of valuations, calls for tactical repositioning away from the dollar. But structural weakness, rooted in lasting shifts in global trade, reserve composition and capital flows, would require rethinking strategic asset allocation.
For now, tactical allocation shifts would involve increasing exposure to non-US equities and local-currency bonds, or adding to gold on dips – not just as a short-term hedge, but also as a long-term diversifier. In structural allocations, the dollar remains a foundation currency, but portfolios will likely need to be tweaked in the coming years to reflect the global rebalancing of economic, trade and geopolitical shifts.
The writer is head of asset allocation at Standard Chartered Bank's wealth solutions chief investment office