The U.S. dollar in the wake of unprecedented sanctions
In response to the Russia-Ukraine conflict, the United States, the European Union, and other countries imposed unprecedented economic sanctions on Russia, leveraging the role of the US dollar role as the key global reserve currency.
“The use of sanctions does not come without consequences. Investors are increasingly concerned that the aggressive use of dollar-based sanctions could accelerate the adoption of alternatives to the global dollar network, helping to dilute the dollar’s hegemony and fundamentally changing the strategic investment landscape,” says Merril.
What is the outlook for the U.S. dollar in the near term, and is the dollar’s reserve currency status at risk?
Market View
Taking Stock of the Rip-Roaring ‘20’s: The Rip-Roaring ‘20s have been event-driven and action-packed, bookended by a pandemic and a conflict in Europe, with soaring inflation sandwiched in the middle.
Markets will remain choppy and volatile in the near term, with our portfolio tilt toward inflation and geopolitical hedges/opportunities.
“We are shifting from an era of geopolitics based on conventional military might to geoeconomics—whereby foreign security goals and national interests are fought not only with tanks, missiles and submarines but also markets, currencies and commerce,” it says.
Q&A: U.S. Dollar Outlook
What is the near-and medium-term outlook for the dollar? The U.S. dollar is considered a “safe-haven” currency and benefits from risk-off sentiment related to elevated geopolitical risk. Year-to-date, the Bloomberg Dollar Spot index, a trade and liquidity weighted index, is up over 2%. Forward-looking economic growth differentials, which previously favored the dollar over the euro, were also amplified because Europe is more economically exposed to the Ukraine crisis.
Upside risk to domestic inflation is also pressuring the Federal Reserve (Fed) to raise rates faster, favoring the dollar on an absolute and relative basis. “We expect elevated geopolitical risk to remain supportive of the dollar in the near term, but valuations are a medium-term headwind for the dollar, and we continue to see dollar strength eventually giving way to valuations.”
Why is the U.S. dollar considered a “safe-haven” currency? The U.S. dollar’s hegemony is a product of geoeconomic power. Economic size, existing networks/alliances, deep and liquid capital markets, technological supremacy, military might, fiscal responsibility, and sound governance—all are tangible, measurable properties that are viewed favorably by the foreign exchange market participants, according to various empirical studies.
Transparency, predictability, trust, credibility and forward guidance are also key metrics for central banks, multinational corporations and individuals to gauge confidence in a sovereign currency.
The U.S. has been historically dominant across most of these factors, but certainly has a growing set of vulnerabilities and threats. Fiscal responsibility and the aggressive use of sanctions are two examples of emerging vulnerabilities.
Why is dollar hegemony important for investors? The U.S. dollar’s status as the primary global reserve currency has been called an “exorbitant privilege,” as has provided the U.S. with several competitive advantages and tools in the macroeconomic and international-relations arenas.
These benefits include the ability to finance twin (current and fiscal account) deficits at lower rates, to use dollar-based sanctions as a tool for economic statecraft, to leverage the international transactions infrastructure for financial intelligence, and to be the global liquidity provider of last resort.
Because of the depth and breadth of information that goes into foreign exchange market pricing, currency status can also broadly be viewed as a proxy for economic power, a real-time economic scoreboard.
Larger shares of central bank reserves and cross-border trade allocated to dollars, and foreign exchange trading using the dollar as a base currency, are all votes of confidence.
The power of the dollar
Reserve and transactional dominance form the backbone of the U.S. economic sanctions power that is clearly on display in Russia, with obvious investment implications. The rest of the world depends on the dollar-based system to purchase a number of critical resources.
The U.S. Treasury Department, through its Office of Foreign Assets Control (OFAC), can sanction banks and individuals to blacklist them from the dollar-based system.
Countries can also experience non-punitive effects of dollar dominance. For example, during the 2008 Great Financial Crisis (GFC), the interbank markets and dollar lending shut down, and China could not trade with neighbors.
How do sanctions put the U.S. dollar’s status at risk? From other countries’ perspectives, dependency on the dollar is a significant vulnerability, and the recent sanctions make that even more apparent.
The Chinese economy, for example, represents a growing share of global trade and more than a quarter of global nominal gross domestic product (GDP) over the last five years, yet most of its trade is transacted in dollars.
Globally, the dollar represents 55% of central bank reserves versus just 2.5% for China, while the large majority of international transactions that run through the Society for Worldwide Financial Telecommunication (SWIFT) system are in U.S. dollars or euros.4, 5 And the dollar also takes the lion’s share of foreign exchange trading.
Broadly speaking, the rest of the world has to access the U.S. banking system or use dollars to participate in the global economy. Bottom line: The dollar is an Achilles’ heel for China, Russia and other countries that are susceptible to loss of access to the dollar system to pay for critical resources. This provides enormous incentive for an alternative.