Explained: What Is Dedollarisation & Why Are Countries Dumping The US Dollar?

Earlier this month, while facing criminal charges, former US President Donald Trump had warned "Our currency (US Dollar) is crashing and will soon no longer be the world standard, which will be our greatest defeat in 200 years".

His warning came amid rising interest in countries to go towards dedollarisation. In recent years, China, Russia and Brazil have been among the expanding list of nations that have embarked upon the path of dedollarisation. Earlier this year in January, it was reported that Iran and Russia will jointly issue a new cryptocurrency backed by gold, to serve as a payment method in foreign trade.

Amidst all this, it's becoming clearer that a growing list of countries is going towards dedollarisation. But what exactly is dedollarisation, and why are countries taking that path? Let's help you understand.

What Is Dedollarisation?

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As the name suggests, dedollarisation is a term that refers to the process wherein countries tend to reduce their reliance on the US dollar as a reserve currency, medium of exchange, and also a unit of account.

While it's a no-brainer that the US dollar has long held a dominant position in the global financial system, this recent shift towards dedollarisation represents a critical transformation with significant implications for the future of international trade, investment, and monetary policy.

As the world becomes more and more interconnected, the need for a stable and equitable financial system is paramount. And with that, the overreliance on the US dollar as a reserve currency has to some extent led to vulnerabilities and imbalances in the global economy. These factors, combined with the growing economic power of emerging markets and their desire for a more diversified and resilient financial architecture, have spurred many countries' interest in going ahead with dedollarisation.

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Role of Reserve Currencies

Simply put, reserve currencies are foreign currencies held by central banks and other monetary authorities to facilitate international transactions, stabilize exchange rates, and bolster financial confidence, as per Kumar Vivek, Deputy Commissioner at the Ministry of Finance, Government of India.

These currencies are typically characterized by their stability, liquidity, and wide acceptance in global markets, which make them attractive for holding and conducting international transactions.

The US dollar has since long been the prominent reserve currency, a status cemented in the aftermath of World War II with the establishment of the Bretton Woods system. The dollar's ubiquity in global trade, finance, and investment has endowed it with significant advantages, such as lower transaction costs, reduced exchange rate risk, and the ability to finance deficits at relatively lower costs.

And that's not all. The US dollar's prominence has been underpinned by the size and strength of the US economy, the deep and liquid US financial markets, and the perception of the US as a bastion of stability.

However, a single reserve currency system, particularly one centred around the US dollar, has its own set of drawbacks. The "exorbitant privilege" afforded to the US allows it to maintain large current account deficits and accumulate significant amounts of debt, which can contribute to global imbalances and economic instability. Additionally, the dollar's dominance renders other economies susceptible to fluctuations in US monetary policy, often leading to spillover effects that may not align with their domestic economic conditions. Furthermore, countries with substantial dollar-denominated debt may face heightened vulnerability to currency fluctuations and capital flow reversals, exacerbating the risk of financial crises, Mr Vivek mentioned in his Linkedin post last week.

Global Efforts Towards Dedollarisation

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In recent years, several countries and regions have embarked on the path towards dedollarisation, driven by a combination of geopolitical, economic, and strategic considerations. Notable examples include China, Russia, Brazil and the European Union, each of which has taken steps to reduce their reliance on the US dollar in international transactions and financial markets.

Some countries, like China and Russia, have sought to diminish the influence of the US dollar as a means of countering perceived American hegemony and mitigating the impact of US sanctions. Other countries, particularly those in the Eurozone, have pursued dedollarisation to promote the international use of their currency, the euro, in a bid to enhance their global economic standing and secure greater financial autonomy, as per the govt official's post.

Yet another reason stems from a desire to foster a more diversified and resilient global financial system, one that is less susceptible to the idiosyncrasies of a single dominant reserve currency. In this context, dedollarisation is viewed as a means to reduce the risks associated with an overreliance on the US dollar, while simultaneously promoting stability and mitigating the potential for economic contagion.

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Challenges Towards Dedollarisation

As per Kumar Vivek, Deputy Commissioner at the Ministry of Finance, Government of India, several key challenges must be addressed to ensure a smooth and stable transition away from the US dollar-centric system.

Firstly, the potential impact on global financial stability warrants careful consideration. As countries reduce their reliance on the US dollar, adjustments in the composition of global reserve assets may lead to shifts in capital flows and changes in asset prices. In the absence of adequate policy coordination and risk management, these fluctuations could create financial instability, particularly in emerging markets and countries with substantial dollar-denominated debt. Consequently, policymakers must be vigilant in monitoring these dynamics and taking appropriate measures to safeguard financial stability.

Secondly, creating a viable alternative to the US dollar presents a formidable challenge. To achieve the requisite degree of stability, liquidity, and acceptability, an alternative reserve currency must be underpinned by a robust economy, deep and liquid financial markets, and sound monetary and fiscal policy frameworks. Currently, no single currency fully meets these criteria, although the euro and the Chinese yuan have made strides in this regard. However, fostering a multicurrency reserve system may alleviate some of the risks associated with reliance on a single dominant currency while providing the benefits of diversification.

Lastly, dedollarisation could result in increased volatility in currency exchange rates, particularly during the initial phases of transition. As market participants adjust to the changing landscape and reassess their currency preferences, exchange rate fluctuations could become more pronounced. This, in turn, could impact trade, investment, and capital flows, particularly for countries with less developed financial markets or limited policy tools to manage exchange rate volatility. Thus, it is essential for policymakers and market participants to closely monitor these developments and deploy appropriate policy measures to mitigate potential disruptions.

In summary, while dedollarisation presents opportunities for a more diversified and resilient global financial system, it also poses significant challenges that must be carefully managed to ensure the preservation of global financial stability and sustained economic growth.

Internationalisation Of Other Currencies

The process of dedollarisation is inextricably linked to the internationalisation of other currencies, as the reduction in the global reliance on the US dollar necessitates the emergence of viable alternatives. In this context, the Euro and the Chinese Yuan have emerged as the leading contenders to assume a more significant role in the global financial system, the govt official's post mentioned.

The internationalisation of these currencies entails their increased usage in cross-border transactions, investment, and as reserve assets, which can offer several potential benefits. Firstly, a more diverse reserve currency system can contribute to enhanced global financial stability by reducing the vulnerability to shocks emanating from a single dominant currency. Secondly, the internationalisation of currencies can bolster the financial autonomy of the issuing countries, providing them with greater policy flexibility and insulation from external economic influences.

Should India Focus on Dedollarisation?

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Now comes the question of whether India too should ride on this path of dedollarisation. Last year, RBI had allowed international trade settlements in Rupee amid the Ukraine-Russia war.

Mr Vivek mentioned that as the global financial landscape undergoes a transformative shift towards dedollarisation, developing countries such as India must carefully weigh the potential benefits and risks associated with this transition.

On the one hand, dedollarisation offers several potential benefits for developing countries. Moving away from the US dollar could reduce their vulnerability to fluctuations in US monetary policy and enhance their monetary autonomy, enabling them to better tailor policy actions to their domestic economic conditions. Moreover, the diversification of reserve currencies could provide a buffer against currency fluctuations and capital flow reversals, reducing the likelihood of financial crises and improving overall financial stability.

However, dedollarisation also presents challenges and potential costs for developing countries. As developing countries transition away from the US dollar, they may face heightened exchange rate volatility, which could impact trade, investment, and capital flows. Additionally, the development of deep and liquid domestic financial markets ¨C a prerequisite for currency internationalisation ¨C could prove to be a formidable challenge for countries with less developed financial systems. Furthermore, the potential costs associated with the transition, such as adjustments to existing trade and financial arrangements, may be significant and could strain limited resources.

In light of these considerations, developing countries like India should adopt a prudent and measured approach towards dedollarisation. Policymakers must strike a delicate balance between the potential benefits of reducing reliance on the US dollar and the risks and costs associated with such a transition.

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