The dollar's exposure to Asia could erode its dominance

The dollar’s secure status as the dominant global currency is under potential threat for various reasons, particularly because of the increasing use of financial sanctions against Iran, Russia, North Korea, and actors in other countries such as China. While some maintain that the dollar’s preeminence remains secure because of its incumbent advantage and the absence of compelling alternatives, others argue that these sanctions could drive reserve banks and financial institutions away from transactions and reserves in dollars. A frequently overlooked dimension of this debate, however, is the disproportionate demand for dollar reserves originating from Asia. This means that even a limited shift toward de-dollarization in Asia would have a significant impact on the overall global demand for dollars.

The demand for dollars that comes from central banks—i.e., dollar denominated foreign exchange reserves, the focus of this blog post—is an important measure of the global dominance of the dollar, although not the only one. The figure below reports a regional breakdown of global dollar reserves at the end of 2022. Such a breakdown must rely on estimates, as most countries do not disclose the currency composition of their reserves. The figure was constructed using a dataset assembled by Ito and McCauley (2020) and making informed guesses about the countries that are missing from their database. More details about the construction of my estimates of dollar reserves can be found in the appendix.

The key insight from the figure is that Asia dominates the global demand for dollar reserves. If we were to liken the US economy to a company exporting “dollar services” to the rest of the world, one might worry about its overexposure to the Asian market.

The relatively modest share of non-Asian regions in global dollar reserves is explained by various factors. Africa, Latin America, and the Middle East invest significant fractions of their GDP in reserves, and their reserves are mostly in dollars. However, their limited contribution to global GDP means that their reserves do not constitute a significant portion of the global total.

Europe is a different story. Euro area countries invest their reserves mostly in dollars, but their foreign exchange reserves are not large relative to their GDP, given the freely floating nature of the euro. Non-euro European countries, on the other hand, tend to hold a larger portion of their reserves in euros rather than dollars.

This leaves Asia with a commanding two-thirds share of the global demand for dollar reserves. With a large GDP, a large fraction of GDP invested in reserves, and a major portion of reserves invested in dollars, Asia is the main source of this demand.

How safe is the dollar’s dominance in Asia? While it is unlikely that the dollar will face massive displacement soon, some plausible developments could significantly erode the dollar’s role in the coming decade.

First, consider China's renminbi. Undoubtedly, key regional reserve holders like Japan and India will be reluctant to accumulate significant amounts of renminbi reserves because of geopolitical considerations. However, there is room for the renminbi to gain prominence regionally. Chinese authorities could adopt a more assertive stance in promoting the renminbi in Asia. Given China's status as the primary trade partner for many Asian nations, Chinese banks play a crucial role in regional trade financing. This gives Chinese authorities the leverage to increase the share of Chinese exports invoiced in renminbi, thereby boosting regional demand for renminbi liquidity.

There is evidence that this process is already underway. The ongoing internationalization of the renminbi could receive an additional push from the advancements in the Chinese central bank's digital currency. Moreover, the renminbi, alongside gold, provides a hedge against US financial sanctions. While the renminbi has its limitations, most notably China’s capital controls and relative financial underdevelopment, the factors mentioned above could significantly increase its share in Asian trade invoicing and reserves from its current very low base.

The reserves of China, Japan, India, Taiwan, and Korea, amounting to 80 percent of Asian reserves, are at little or no risk of shifting significantly to the renminbi.  However, there is potential for an increase in the share of the euro (currently standing at around 10 percent) and gold in Asian reserves. Assuming that euro area countries can increase their supply of safe debt, increasing the share of the euro in Asian reserves would make sense from the perspective of portfolio diversification. For China, gold offers some protection against potential financial sanctions from the United States and Europe.

While a widespread de-dollarization of Asian reserves is not imminent, the point of this blog post is that even a limited level of Asian de-dollarization could have a significant negative impact on the global demand for dollars. To illustrate, consider a scenario where China, Japan, India, Korea, and Taiwan collectively increase the share of the euro and gold in their reserves by 20 percent, while other Asian nations raise the share of the renminbi by 20 percent—both shifts occurring at the expense of the dollar. Such a scenario would suffice to reduce the dollar's share in global reserves from about 70 percent at the turn of the century to below the symbolic threshold of 50 percent. Not an abrupt demise, perhaps, but a clear capitis diminutio for the dollar.

APPENDIX

The data on foreign exchange reserves come from the latest version of the Lane and Milesi-Feretti (LMF) external wealth of nations database. I use the data for each country’s foreign exchange reserves at the end of 2022. The Ito-McCauley (IM) data on the currency composition of reserves can be found here. I use the most recent year for which the dollar share is available (2020 for most countries). I explain below the assumptions that were made for the countries that are missing from the IM online database.

Latin America. Ito and McCauley obtained data on the currency composition of Latin American reserves from the Latin American Reserve Fund (FLAR). However, the Latin American country data are not reported in the online database. Thus, for Latin American countries I used the share of dollar reserves in the Western hemisphere reported in figure 3 of Ito and McCauley (2020), which is approximately 80 percent.

Asia. IM data do not report the currency composition of Japanese reserves because Japan is a currency issuer. I assume that the dollar share for Japan is 70 percent. It is slightly higher than the Asian average because Japan is a US ally and cannot invest its foreign exchange reserves in its own currency. I applied a rate of 65 percent (close to the Asian average rate) to the countries for which the data were not available in the IM dataset.

Middle East and North Africa. The IM dataset does not report data for the reserves of Middle Eastern countries. I assumed an average dollar share of 70 percent, higher than the global average to reflect the fact that oil and gas exports are invoiced in dollars. It should be observed that oil producers hold a significant fraction of their dollar assets in sovereign wealth funds that are not included here.

Country list. The countries included in the IM online database are indicated with a star.

Africa: Ghana*, Kenya*, Mozambique*, Namibia*, Nigeria*, South Africa*, Tanzania*, Uganda*, Zambia*.

Latin America: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, Venezuela.

Europe: Euro Area*, Denmark*, Iceland*, Norway*, Sweden*, Switzerland*, United Kingdom*, Bulgaria*, Czech Republic*, Moldova*, Poland*, Romania*, Serbia*, Ukraine*, North Macedonia*, Bosnia and Herzegovina*.

Middle East and North Africa: Bahrain, Egypt, Iraq, Israel*, Jordan, Kuwait, Lebanon, Libya, Oman, Qatar, Tunisia*, Turkey*, Saudi Arabia, United Arab Emirates.

Asia: Australia*, Bangladesh*, Bhutan, Brunei Darussalam*, Cambodia, China*, Hong Kong*, India*, Indonesia, Japan, Korea*, Macao, Malaysia, Myanmar, New Zealand*, Pakistan, Philippines*, Russia*,Singapore, Sri Lanka*, Taiwan*, Thailand, Kazakhstan*, Kyrgyz Republic*, Tajikistan*, Vietnam.

The total estimated amount of dollar reserves is $7.5 trillion. This is broadly consistent with the International Monetary Fund Currency Composition of Official Foreign Exchange Reserves (COFER) database. In Q4 2022 COFER lists $6.5 trillion of dollar reserves plus $878 billion of unallocated reserves.

References

Chinn, M., Hiro Ito, and Robert McCauley. 2021. Do Central Banks Rebalance Their Currency Shares? National Bureau of Economic Research Working Paper No. W29190 (August).

Ito, Hiro, and Robert McCauley. 2020. Currency Composition of Foreign Exchange Reserves. Journal of International Money and Finance 102, 1-21.

Milesi-Ferretti, Gian Maria. 2022. The External Wealth of Nations Database. Washington: Brookings Institution (based on Philip R. Lane and Gian Maria Milesi-Ferretti, 2018, "The External Wealth of Nations Revisited: International Financial Integration in the Aftermath of the Global Financial Crisis," IMF Economic Review 66, 189-222).