What powers the dollar hegemony

Global demand for dollar assets validates world’s faith in stability of the US financial system

President Donald Trump’s electoral victory last November was decisive and sweeping. He now has majority control over both legislative houses, i.e. the lower house called the Congress or House of Representatives, and the upper house called the Senate. Sometimes, both houses together are also misleadingly called the “Congress”. He has, of course, the control of the White House, and this is called a “governing trifecta” which is a sweet spot. He has already exercised his increased influence in the passage of 64 executive orders in barely three weeks of assuming office. Unlike his first term which began in 2017, he also has a two-thirds majority of the conservative judiciary. This might prove crucial if he tries to deliver on his promise of no birthright citizenship. This cannot be merely done by an executive order, and might require a constitutional amendment, which might in turn be challenged in the Supreme Court. The apex court could come to Trump’s aid, although this is not guaranteed in this case of citizenship debate.

Trump’s popularity is also supposed to be 10% higher than what he got from his voters, which means that even some of those who did not vote for him now support his policies. These policies cover tariff action against trading partners, stricter action against illegal aliens, withdrawing from expensive wars in distant theatres and making NATO allies pay more, and finally reducing the size of the government.

The President has threatened that America will charge reciprocal import tariffs, as a tit-for-tat strategy. In response India has immediately reduced import duty on American Bourbon whiskey from 150 to 100%. The duty on Harley Davidson motorcycles was reduced earlier. India enjoys a trade surplus of about $30 billion with the US, and it is this that Donald Trump wants to reduce. The defence purchases of F35 fighters and other combat vehicles are on the cards, partly to assuage US sentiment.

Some of President Trump’s wishes seem contradictory. On one hand, his desire to reduce the trade deficit and make the dollar cheaper is to increase American exports and jobs. On the other hand, he wants the dollar to remain the world’s dominant currency. He threatened nations in BRICS – of which India is a member – that if they contemplate trading among themselves in non-dollar currencies, he will impose 100% import tariffs on them. You can’t simultaneously ask for a weak and a strong dollar. The fact is that the dollar index, measured as DXY, is close
to being the highest it has been in the past 25 years.

Drawing on inherent stability

What is the real source of the dollar’s strength and hegemony? It can’t be President Trump’s political support and popularity or his enjoying the governance trifecta. Incidentally, the trifecta is still not good enough because in the upper house, the Senate, the bills need a 60% majority to be passed as law – which Trump doesn’t have. Murmurs from within the Republican Party indicate less than enthusiastic support for some of Trump policies, especially on downsizing government and cutting benefits.

So what, really, drives this strength? The first source is the absence of another candidate currency. Neither the pound sterling in terminal decline since the second world war, nor the euro born in 1999, nor the Chinese yuan are anywhere close to the dollar’s unmatched supremacy. In terms of global trade, the US share is barely 11%. But the US economy makes up one-fourth of the global GDP and, of course, is the largest. President Trump is upset about the trade deficit which is close to $1 trillion. Mirroring that, the Chinese have a trade surplus of $1 trillion, one-third of which is with the US. Many countries including India have a trade surplus with America. So what happens to all the surplus dollars held by export-surplus countries? It is in the form of exchange reserves. A whopping 60% of all reserves worldwide are held in dollar assets, i.e. US government-issued bonds.

This, really, is the reason for dollar hegemony – the strong desire of the rest of the world to hold dollars, or dollar assets. The strong demand for US bonds reduces the cost of borrowing for the US government. To add to the privileges is the factor that 90% of worldwide foreign exchange transactions are in dollars. It is the most preferred invoicing currency due to its inherent stability and the belief that America will never default on its debt. This is tested from time to time, since the law and constitution do not allow the US government to pile on unlimited debt. It is currently about $33 trillion. But the debt ceiling cannot be breached unless approved by the Congress which sometimes leads to brinkmanship between the ruling party and the opposition. But invariably, the debt ceiling is relaxed, until the new limit has to be relaxed again in a few years.

Whenever there is global turmoil and uncertainty, investors rush to dollar assets, causing outflows from developing countries, and leading to a fall of their currencies. This has happened to India as well. But the real reason is that implicitly, the world has faith in the stability of America’s financial system, its judiciary in resolving disputes speedily and fairly, its capability of resilience, and the US government’s way of not passing too many irrational and isolationist laws and policies. Of course, none of this can be taken for granted. The rise of India and China in the 21st century will surely challenge the hegemony of the dollar. India’s rise is benign, while China’s rise threatens the west. Their evolving bilateral relationship will surely shape world trajectory as well as affect the dollar’s dominance. But for now, the dollar is king.

(The writer is an economist; Syndicate: The Billion Press)