/ 17 April 2023

Will the dollar hit a Brics wall?

ANALYSIS

A new discussion about de-dollarisation crops up every couple of years. Recently, it has come up in relation to the Brics alliance — Brazil, Russia, India, China and South Africa — which is reportedly clamouring to create a new reserve currency.

By challenging the greenback’s dominance, which is slowly fading in any case, a new currency holds the hope of reducing the sensitivities of emerging markets to policy decisions made in the US. 

As the world flirts with another financial crisis, and amid financial sanctions against Russia, the push for de-dollarisation appears to have more momentum behind it than ever. 

According to reports, earlier this month Russia’s state duma deputy chairperson Alexander Babakov foreshadowed the creation of new currency, which he said would be under discussion at the Brics summit in Durban later this year. 

If this comes to bear, it would go towards the bloc’s stated ideal to reform the global financial system, through which critics have argued the US enjoys exorbitant privilege.

The question remains whether Brics, which has yet to emerge as the alternative it promised to be, is the right alliance to topple the dollar.

Challengers

In a recent paper, Jim O’Neill, the former Goldman Sachs chief economist who coined the acronym Bric in 2001, argued that the bloc in its current form should expand and challenge the dollar’s dominance. 

Brics (which now includes South Africa, a development O’Neill did not anticipate) is reportedly mulling the inclusion of Saudi Arabia and Iran.

O’Neill said the US dollar plays a far too dominant role in global finance. “Even as the relative size of the US economy has decreased compared to others that are rising, especially China and India, the dollar has kept its dominant role in so many aspects of finance,” he added.

“Almost like clockwork through economic cycles, this has meant that whenever the Federal Reserve Board has embarked on periods of monetary tightening or the opposite, loosening, the consequences on the value of the dollar and the knock-on effects have been dramatic for each dollar of dollar-denominated debt of other countries, and destabilising for their monetary policy, and much bigger than the effects of their own domestic decisions.”

When O’Neill imagined the alliance, combining the economic power of Brazil, Russia, India and China, these emerging market economies were poised for greatness. He forecast, in the decade after 2001, all except for Brazil would expand faster than the average growth rate of the G7 nations.

For O’Neill, growth in the Bric bloc, and China especially, would have an important bearing on global monetary and fiscal policy. 

Published two years after the creation of the euro, O’Neill’s paper also suggested there was a strong case for a policy-induced strengthening of that currency, as well as the Japanese yen, the dollar’s most widely-traded peers. This was as the ongoing remarkable strength of the US dollar was expected to pose a big challenge to emerging market countries.

Bretton Woods

The dollar’s dominance goes back almost 80 years to the Bretton Woods agreement, through which 44 countries created a foreign exchange system. 

Under the Bretton Woods system, which became fully functional in 1958 and effectively came to an end in the early 1970s, gold was the basis for the dollar and other currencies were pegged on the greenback’s value. The decision to put the dollar at the centre of the system came as the UK’s battering during World War II effectively disqualified the sterling from contention.

After the collapse of the Bretton Woods system, the global monetary system evolved into what has been described as a fiduciary dollar standard in which the greenback remained the dominant international currency by default. Because the dollar is no longer anchored by gold, its support is largely based on confidence in America’s economic power.

Some have argued that the dollar’s continued dominance has made the international monetary system inherently unstable and inequitable, resulting in volatile exchange rates, macroeconomic imbalances and frequent financial crises. 

The dollar’s primacy — which has been increasingly questioned since the 2008 global financial crisis — means that policy in emerging markets is constrained, leaving their economies vulnerable to the whims of the US Federal Reserve

In the late 1990s, Mexico, Thailand, Indonesia, South Korea, Russia, Brazil and Argentina were rocked by currency runs and financial collapses as the ratcheting up of interest rates in the US caused the greenback to appreciate, their currencies to tumble and the burden of dollar-denominated debt to rise.

Graphic-Biz-Dollar-Website-1000px
(John McCann/M&G)

Diversification

Setting up a new financial system and challenging the Bretton Woods regime was at the heart of the Brics project. Leaders at the bloc’s first summit in Yekaterinburg, Russia, in 2009, expressed their commitment to reform international financial institutions so they better reflect changes in the global economy. 

“We also believe that there is a strong need for a stable, predictable and more diversified international monetary system,” they said in a statement. South Africa joined the alliance a year later.

Also in 2009, then Russian president Dmitry Medvedev expressed his ambition to create a new global reserve currency.

Meanwhile, although the dollar has held on to its dominance — which some contend is outsized considering the smaller role of the US in global trade — recent research has pointed to the greenback’s declining share of international reserves. 

An International Monetary Fund (IMF) paper released last year found that, in the past 20 years, the international reserve system has been characterised by the gradual movement away from the dollar. 

The dollar, the paper noted, “has not become more dominant. It has not even maintained the dominance of prior years.”

The shift out of dollars has been in two directions — “a quarter into the Chinese renminbi and three-quarters into the currencies of smaller countries that have played a more limited role as reserve currencies”, the paper added.

Currency internationalisation efforts in China have helped prompt this shift. Late last month, China and Brazil reportedly struck a deal to do away with the dollar and to favour their own currencies in trade transactions. In the wake of sanctions against Moscow, the Chinese yuan has replaced the US dollar as the most traded currency in Russia.

“The globe is shifting,” Momentum Investments economist Sanisha Packirisamy said. The contribution of the US to global GDP is falling and emerging markets, especially China, have increased their share in the global economy, she said. 

But, she added, it will probably take some time before another currency displaces the dollar, given its continued dominance in the foreign exchange market. 

Back in 2000, the euro’s introduction prompted a similar discussion about whether the dollar could be toppled, she noted. 

The euro example demonstrates that forming a monetary union is difficult, considering different countries have different labour, inflation and fiscal dynamics.

“If you think about the countries that belong to Brics, they all have very different backgrounds, very different growth outlooks, very different inflation, very different labour market dynamics and reforms that are taking place at a very different pace,” Packirisamy said.

Talk left, walk right

In his recent assessment of the Brics bloc, O’Neill noted China’s primacy in the alliance, in terms of the size of that economy. South Africa, on the other hand, stood out as the laggard of the group. Brics countries have also failed to foster multilateral co-operation, he said.

Political economist Patrick Bond said he firmly supports an alternative to the dollar. But whether Brics — and a possible Brics-plus alliance, which could include Saudi Arabia — is the proper vehicle for this is in dispute.

In 2014, Brics leaders signed a memorandum establishing a Contingent Reserve Arrangement, a fund for member states to draw on in financial emergencies. The fund, which would be an alternative to the IMF, is still not operational.

Brics has also failed to create an alternative to the three main ratings agencies, Bond noted. He has previously contended that the bloc has failed to offer an alternative to the Bretton Woods twins, the IMF and the World Bank, and has instead championed a strategy of “sub-imperialist financial assimilation” through its New Development Bank.

“They talk left and walk right,” Bond said this week.