The World Is Seeing How the Dollar Really Works

Dollar Background

By Adam Tooze, Foreign Policy

2022 has been a year of dollar power—power that manifests itself in both overt and subtler forms.

In the spring, the financial sanctions slapped on Russia’s Central Bank following Russian President Vladimir Putin’s invasion of Ukraine demonstrated the extent of U.S. financial sway, especially when it is exerted in cooperation with America’s European partners. If you export far more than you import and thus hold really large foreign exchange reserves—like Russia’s $500 billion—there really is nowhere else to hold them other than dollars or euros. If it comes to a confrontation, that puts you at the mercy of the financial authorities of the United States and its alliance partners. NATO reveals itself to be a financial power.

Russia has, so far, ridden out the storm, but to do so it has had to close its financial system to the outside world. Its imports have been squeezed to barely more than half their pre-crisis level.

When the sanctions were applied, the shock to Russia provoked the question of whether a monetary system that conferred such one-sided power on the United States could possibly be sustainable. Surely Russia, China, and India would look to build an alternative currency system. This might perhaps be denominated in China’s renminbi and would be centered on the exchange of key commodities. One model might be the kind of deal recently brokered by a leading Indian cement producer, which paid for imports of Russian coal in Chinese currency. To secure funding, you could borrow in the so-called dim sum bond market in Hong Kong, where issuers from around the world issue offshore renminbi debts.

Such a system would secure independence from the United States. But it would take years, if not decades, to reach substantial scale. It also depends on the continuing shortage of key raw materials, which makes it interesting to lock in privileged customer-supplier relations, and the continuing growth of the Chinese economy, which makes it look like the economic champion of the future.

Those trends were never guaranteed to continue. From our current vantage, six months on from the start of the war, a future beyond the dollar seems more remote than ever. As the world economy slows down, commodity prices are far off their peaks. There is still excess demand for oil, gas, and coal, but other commodities such as iron ore are going cheap. China, rather than asserting its dominance as an alternative center of the world economy, is seeing a hemorrhage of foreign capital at a rate faster even than that during the crisis period of 2015-2016.

With talk of rivals to the dollar system on the wane, what dominates the global economic news cycle in mid-2022 is another face of U.S. financial power: the tightening of Federal Reserve policy in response to inflation and a surging U.S. dollar. This changes the conditions under which the entire world economy operates, not through legal or geopolitical interventions but through currency values, interest rates, and the demand and supply of credit. It is on this all-pervasive presence of the dollar that the more overt leverage of financial sanctions ultimately rests.

First and foremost, the dollar system is a commercial and financial network. Political and military power plays a part in anchoring the global dominance of the dollar. It is hard to imagine U.S. Treasury debt having the status that it does in the world economy if it were not ultimately backed by the world’s preeminent military power. But the more prosaic motive for the dollar’s adoption as the main currency of trade and finance is that dollar liquidity is abundant and cheap, and the currency is universally accepted. That is the reason that close to 90 percent of all currency trades—a daily turnover of $6 trillion before the COVID-19 pandemic—involve the dollar as one of the currencies in the pair. Whether there is a new cold war with China or Russia or not, an unanticipated, sudden increase in U.S. interest rates—which tightens credit conditions and strengthens the dollar—sends a shuddering shock through this entire network of commercial transactions.

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