Breaking Dollar Dominance - Chapter 1: Demystifying The Dollar

Breaking Dollar Dominance - Chapter 1: Demystifying The Dollar

By Jtodd | The Zone | 3 Apr 2020


Check out my other article  "Traditional Savings are Dead, So Now What?"

 

If you've kept up with global economic and monetary trends, you would know that the Dollar has a unique position in the global economy. Many experts have deemed the Dollar the "World Currency", but how and why did the Dollar come to occupy this space? There have been many articles written on the topic, and none seem to paint a clear picture, so I've decided to go through the primary data myself and see what I could come up with.

 

What I've concluded through my digging is what any professor will tell you on the first day of any introductory economics course. The answer: demand, demand, demand, demand and more demand. But where exactly does the high demand for Dollars come from? In this article I break down the sources of that demand in 5 parts: trade, commodity markets, debt, investment, and banking reserves/foreign exchange markets

 

 

1.   The United States Dollar and Trade

 

It's fairly common knowledge that the United States economy is the World's largest with a gross domestic income (GDP) that by most recent numbers is roughly 24% of total global output.  Based on 2017 estimates the United States is a top three global exporter (eclipsed only by China, and the entire European Union). With the United States occupying a top trade spot it's no wonder that demand for the greenback is so high. You see, when countries wish to import US goods they are required first to purchase US Dollars using their foreign currencies, or rely on their Dollar reserves in order to complete those transactions. Since the US based companies do their accounting in Dollars (i.e. pay their taxes, employees, rent, etc) this only makes sense. 

Moreover, the Dollar is also the most widely used invoicing currency for international transactions. According to bizfluent.com, an invoicing currency is defined as "The currency that a business uses to charge its customers [and it] represents the way of measuring the price for an order."  The Bank For International Settlements reports that the US Dollars use in global transactions is 4.7 times its share of global imports, and 3.1 times its share of global exports. 

 

  

2.   The United States Dollar and Commodity Markets

 

It is a well established fact that the global commodity market is dominated by the Dollar. Everything from soft commodities (wheat, corn, soy) and hard commodities (Industrial metals, energy products) to precious metals (gold, silver, platinum) are denominated in Dollars. That means that the US Dollar is the De Facto currency for exchange of global commodities. The most notable of these currencies is of course oil.

Oil is the lifeblood of the global economy. Think for a second how many of your daily consumables are produced locally. Either goods are imported from other countries (I'm looking at you China) or in the case of the US or EU from another state.  As of 2019, a whopping 68% of the GDP of the United States was personal consumption expenditure. This means that the US domestic economy (and the global economy by proxy) would come to a screeching halt without access to oil for transport or to power the US service industries.

Carrying over from the previous topic, the European Union as whole is the largest global importer of oil in the world, and the overwhelming majority of those imports are conducted using the Dollar.

 

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3.   The United States Dollar and Debt

 

While it is true that the United States has one of the largest public debts to GDP in the world, those that hold that debt have an incentive to keep the value of the Dollar high. The largest foreign holders of US public debt are China and Japan. According to The Balance, both countries wish to keep the value of the Dollar above the value of their own domestic currencies, in order to keep exports affordable. 

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In addition to the public debt of the United States, a large percentage of other countries' public debts are denominated in Dollars. To get an idea for the numbers I dug through the World Bank statistics and here is what I found:

The Dollar Composition of Public Foreign Debt

Russia: 95%   Brazil: 96.4%  China: 83.5%  India: 82.5%  Turkey: 69.6%

Low Income Countries: 66.7%  Low/Middle Income Countries: 73.5% 

Lower Middle Income Countries: 73.5%  Upper Middle Income Countries: 76.5%

East Asia/Pacific: 79.6%  Europe/Central Asia: 75.3%  South Asia: 76.1%

Latin America/Caribbean: 78.2%  Middle East/North Africa: 62.6%  Sub-Saharan Africa: 64.8%

 

As you can see many countries, regions, and income groups have a large portion of their loans denominated in Dollars. This likely means that many of these groups will be servicing these loans with Dollars, which will only further increase demand. 

 

4.   The United States Dollar and Investment

 

In this section I will be talking mostly about Foreign Direct Investment (FDI). Investopedia defines FDI as

"an investment made by a firm or individual in one country into business interests located in another country. FDI takes place when an investor establishes foreign business operations or acquires foreign business assets in a foreign company."

According to the OECD, FDI inflows to the US are about 19% of the world's total FDI inflows and about 36% of the total for the OECD countries. In the definition provided by Investopedia you can see that FDI is typically a result of foreign investment in creating domestic operations for their foreign business within the United States or vis-a-vis the acquisition of a US based firm. Both of these activities will require dollars in order to pay the taxes in the local currency, set up operations, pay employees, or to complete the acquisition transaction.

 

4.   The United States Dollar FX Markets and Reserves 

 

All the demand create from the previously discussed have given the Dollar a serious advantage on the international monetary stage. That being said it should come as no surprise that the dollar makes up 88% of all forex trading volume. Much of that volume is likely due to the facts we've previously discussed and one last but very important point. The Dollar is the world's most widely used currency for foreign exchange reserves. In the IMF's most recent report on currency composition of official foreign exchange assets (COFER), the US Dollar makes up about 61% of total global reserves.

 

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The IMF's official guidelines state, that the intended goal of holding and maintaining a foreign exchange currency reserve are to:

 

  • Support/maintain confidence in domestic monetary policy. Provide the ability to act/intervene in support of domestic currency.
  • Limit external vulnerability and absorb shocks in times of crisis.
  • Provide confidence to external markets that the country is able to meet its obligations (debt and otherwise)
  • Demonstrate that the domestic currency's value is backed by external assets.
  • Assist governments in meeting foreign exchange needs/external debt obligations)
  • Maintain reserve for national disasters and emergencies. 

The Dollar's role as the "World's Reserve Currency" gives it a huge demand push and thus a major advantage. In fact, as of 2007 the St. Louis Fed reported that 60% of all US banknotes in circulation (or about $500 billion) are held outside of the United States. The vast majority of those Dollars are probably sitting in central banks all around the world.

I'd also like to mention the fact that there are countries outside of the US and its territories where Dollars are accepted between citizens for day-to-day transactions. According to Business Insider more than two dozen countries and territories use the Dollar as currency. These countries include many Caribbean, Central/South American nations, and a couple of African and Asian nations as well.

 

A Parting Note

I've discussed in this article the many ways maintains itself as the king of the fiat world but as Bloomberg reports, the dollar (in the form of stablecoins, namely Tether) is creeping up to take the top spot in the cryptosphere as well.

Moving forward this series is going to discuss other currencies and their roles both in the fiat and crypto space.

Thanks for reading and I hope you have enjoyed this article. Stay tuned and be sure to follow for more in this series. 

 

 

 

 


Jtodd
Jtodd

Crypto and Finance Enthusiast.


The Zone
The Zone

I am a stablecoin connoisseur and overall crypto junkie. Jump into the zone with me as I analyze economic news, connect lessons learned from traditional finance to crypto, provide trading strategies, and suggest alternative investments for these trying times.

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