Greenback is trusted in ways other currencies cannot replicate

Disruption is everywhere in the global economy. Russia’s war in Ukraine — and sweeping western sanctions on Moscow — has wrecked havoc in commodity markets. The prospects for cooperation over addressing these supply problems look limited. The turmoil is contributing to rising inflation, which is at levels unseen in a generation. Such strains in the real economy have raised questions over whether the monetary order based on the US dollar can remain unaffected.

Some change may be inevitable, but prevailing trust in the greenback will not be easily displaced. For now, the US dollar’s status as the leading global reserve currency is assured. It still makes up a majority of foreign exchange reserves and dominates trade invoicing. US Treasuries are the safe asset of choice for global markets, while the country’s institutions are still trusted and adept at managing crisis.

If threats to the dollar do emerge, they are unlikely to come from central banks diversifying some of their reserves away from US dollars, towards smaller, western currencies. This trend has been held up as evidence that the need to hold US dollars is fading as technology has made direct transfers between smaller currencies possible in ways that remove the need for the dollar to act as gatekeeper.

This may be so but most, if not all, of diversification’s beneficiaries have well-established links with the greenback. Swap lines between the central banks of these countries and the Fed in effect make these currencies nodes in a broader dollar system. Those who hold them as reserves do so in the knowledge that access to dollar funding, and — if the need arises — a smooth “flight to safety”, is practically guaranteed.

A bigger threat is that countries feeling the brunt of western sanctions might look to avoid transacting in and out of the US dollar. These countries certainly don’t trust the currency in the same way that other players in global markets do — the US has shown a willingness to use the status of the dollar as an economic weapon. The most direct alternative here is a second monetary order built through China.

Beijing’s digital currency program — which could soon enable relatively frictionless cross-border transactions — makes clear an ambition to improve the global attractiveness of the renminbi. However, while greater use of the currency might appeal to those shut out of dollar markets, its broader attractiveness as a replacement for the greenback is still questionable. China’s unwillingness to loosen its control over offshore renminbi trading is a considerable barrier to any hopes of truly competing with the US dollar.

The US cannot afford to be complacent, though. The Fed has been slow to pick up on innovations in the digital currency space. This could yet prove to be costly as other countries look to gain a first-mover advantage. A digitised rival currency which combines ease of use across borders with access to relatively deep bond markets could pose a legitimate alternative to the dollar. Europe, for example, has long been determined to broaden global use of the euro and has its own well-developed digital currency program.

Control over the global reserve currency is sought after for a reason: the seemingly insatiable demand for dollars gives the US a steady stream of funds that it can tap on demand, as well as an outsized influence over global economic affairs. These benefits mean that challenges to the dollar’s status from other ambitious issuers are inevitable. But in the game for primary “reserve status”, trust is hard won. At present, no other currencies seem ready to compete.