Currency and International Trade: A Shift from Dollar Dominance?

Some few weeks ago, I had a stimulating conversation with Martina Zukina on currencies in international trade and how they reflected recognition, economic strength and liquidity. While I noted the wide acceptance and use of the United States Dollar (Dollar) in international trade, she stressed that the status quo need not be maintained for long, and that countries could choose to trade solely in their local currencies. I acknowledged this but questioned the realities that would make this seamless without economic blowback to countries. Recent activities in international trade have brought this to the top of my notepad again and since I enjoyed the conversation, I decided to consider this subject in this issue of On Trade.

Where we are

There's a high chance that if you ask someone to name three currencies, they will name the Dollar and probably the Great British Pound (Pound). If they are asked to name two, they probably would still mention the dollar. If asked to name one, the high chance still remains that they mention the Dollar. Why is this so?

The reason is perhaps more rooted in psychology, specifically 'reinforcement', than any other thing. In reaching the stage of reinforcement in our minds, though, several factors have had contributory roles. These factors range from Stability and trust, to liquidity, reserve currency status as well as the political and economic power of the United States (US).

The US Dollar was first introduced sometime between 1785 and 1792 and from that time till present day, there has been a significant level of trust in the Dollar. This may in part be due to the status of the US as one of the largest economies in the world, and also due to the commitment of the US government to pay its obligations which inspires investors and central bankers to hold the dollar in terms of uncertainty. This yin and yang of economic stability and trust reposed have thus seen the Dollar maintain its heightened status for many years, and relate to another factor - Liquidity.

Historically, humans have always favoured convenience over stress, and this has influenced the shift from gold as legal tender to paper-based currency and recently to digital currencies. While gold and digital currency have their uses and worth, in the words of the singer Akon, "cash rules everything around me". The Dollar is widely used in international trade because it has high liquidity. Liquidity in this sense means that it is easy to quickly change it for another. It is easier to exchange paper-based currency than gold (and perhaps for now, digital currencies). Flowing from the preceding paragraph, since most investors and central bankers trust in the Dollar, it is ever present in most financial markets and thus, easy to trade in or exchange due to its wide acceptance.

In the same vein, the fact that the dollar is widely accepted means that most central banks hold significant amounts of dollars as a reserve currency. Reserve currencies are used by central banks to stabilise national currencies and are used in international transactions and international investments. While the dollar is not the only widely used reserve currency, and indeed the Pound was the primary reserve currency in the 19th and 20th centuries, the dollar has steadily been the primary reserve currency for most countries. The logic is simple - since central bankers always have dollar amounts with them, and it is widely accepted, why not use keep some in national coffers as foreign exchange reserves?

Closely linked to the above is the fact that oil is priced in Dollars - a system that dates back to the 1970s, where the US dollar replaced gold as the preferred commodity to trade in oil. This means that all crude oil purchases around the world are carried out in Dollars, partly due to its popularity and also because the US is one of the world's largest economy and goods importer.

Also significant is the fact that the US, alongside the UK exert strong political and economic influence globally, trading with several countries in their currency and establishing numerous reciprocal economic relationships that use the dollar, improving its popularity.

Reinforcement then comes into play for the trust in and stability of the Dollar makes it popular to trade in. Because it is popular, it is a safe bet for liquidity as it can easily be changed into other currencies. Further, since oil is priced in Dollars and has a high need in financial markets, many central banks hold portions of it, increasing the US' economic power and increasing the everyday preference of the Dollar over most other currencies, especially in international trade. These above reasons then influence individuals and countries to continue using the dollar in international transactions.

 The Problem

The problem with trade in US' dollars is that it makes other countries question the relevance of their currencies if they can't easily use these currencies in international trade. Further it raises questions on the overdependence of another country's currency, especially in bilateral agreements between two countries where none of the countries is the US.

Another key problem with the status quo lies in fluctuations of the strength of the dollar. Since oil prices are quoted in dollars and the dollar is the most traded currency with some central bank reserves in dollars, should dollar prices fall, the value and price of goods around the world wavers. This is especially troubling for countries that rely heavily on imports. Why? Because the price to be converted in local currency for imported goods like oil and fertilizer priced in dollars gets significantly higher if the dollar is worth more at the time. Since most countries borrow in dollars, also, an increase in the value of dollars between the time of lending and the time of repayment may mean a significantly higher sum to be repaid. This may be more troubling for developing countries who are often beneficiaries of foreign loans.

Thus, US importers and consumers will pay more for goods when the dollar is weak but their trade partners and by extension, anyone who exports to the US will pay more for goods when the dollar is high. Essentially, when the dollar is strong, the US pays less and the rest of the world pays more. This then may be interpreted as a depreciation in another currency or economy. Whereas when the dollar is weak, US companies selling goods overseas may become more competitive as prices of goods priced in the dollar will reduce, possibly increasing sales.

The Way forward

Recently, countries like Brazil, Russia, China and Kenya amongst others are pushing for a shift from the Dollar dominance in international trade. Already, there have been talks among the BRICS countries (Brazil, Russia, India, China and South Africa) of establishing a new global reserve currency based on the currencies of their respective countries. This may make for an attractive alternative to central banks looking to diversify their holdings into other currencies than the dollar, and is a reaction to the perceived overarching influence of the US.

Since the term BRICS was coined to highlight the above 5 countries with fast-growing economies, it is only natural to consider a currency stabilisation system that helps developing economies progress despite the dominance of the dollar in international trade.

To this end, the call for a shift from dollar dominance in international trade may present a fighting chance for developing countries to strengthen their local currencies by trading in their currencies and not in the dollar. Where trade isn't directly in national currencies, then the call for a new reserve currency such as the proposed central currency mutually agreed by a bloc of trading partners like the BRICS may help trade groups and regions maintain some form of stability while maximizing trade internally and with international counterparts.

Similarly, an increase in reserve currency diversification where countries diversify reserve currencies may help reduce vulnerability to fluctuations in the dollar and its adverse effects on internal markets. Currencies such as the Euro or the Chinese Yen may be viable alternate reserve currencies alongside the dollar reserved in central banks. This diversification may provide greater stability and security especially for countries heavily reliant on exports.

Just as well, the effective administration of regional trade arrangements such as the African Continental Free Trade Area (AfCFTA) can provide countries with alternative trading partners. It can reduce their reliance on the US dollar since exports and imports within such arrangements can use local or mutually agreed currencies. It can also improve wider international trade since regional acceptance of a currency may make an argument for its wider acceptance, and ultimately propel its reinforcement in the human mind as the dollar has.

Admittedly, the existence of differing reserve currencies by region or affiliation may make international trade more difficult and may strain relationships among states, especially where there is little to no recognition of the 'new' reserve currency outside its sponsors.

In the absence of introducing a new currency, currency swaps which operate in a similar way to trade by barter may be utilised. This may mean that trade partners agree on equivalents of and exchange currency to currency or of currency to goods without any external currency like the dollar. This can help hedge against dollar fluctuations and bypass overreliance in international trade. It may however mean lengthier negotiations and deep knowledge of respective currencies to accurately measure currency value.

For international loans and debts ordinarily valued in the dollar, local currency financing may be a good way forward. This would mean that financers like the World Bank or the International Monetary Fund (IMF) disburse loan amounts in the local currency of borrowing countries and such loans amount, since they are in the country's local currency, would not be subject to changes in the strength of the dollar. Any interest rates in local currencies will generally also be fixed and will provide stability and predictability in repayment.

Conclusion

As humans, we are used to operating in line with traditions and reinforce generally accepted ways of doing things. International trade through widely recognised currencies is no different. However, as humans, we are also naturally predisposed to change, so the call for a shift from US dollar dominance in international trade may also signal positive tidings for national and regional corners. While some of the suggestions in this article may help smoothen this shift and propel economic growth for developing countries, proper dialogue and negotiations among countries may ultimately be the key to collective growth and improved trade.