De-dollarization: Shifting Sands in Global Finance

The article discusses the growing trend of de-dollarization, where countries aim to reduce their reliance on the US dollar in international trade and currency reserves. Despite this trend, the US dollar's dominance remains strong due to high US interest rates and significant foreign investment driven by economic incentives.

However, shifts in global capital flows, particularly reduced investments in China and potential changes in US policies, could alter this dynamic. This situation presents new opportunities for other emerging markets like India, Mexico, and Vietnam.

Due to the dollar's extensive use, the United States enjoys disproportionate sway over other economies.

The goal of de-dollarization is to some extent an effort to protect national central banks from geopolitical dangers associated with the United States Dollar's position as the world's reserve currency. The term "de-dollarization" has gained popularity in recent years as countries work to lessen their reliance on the US dollar and assert greater control over their economies. The economic and geopolitical difficulties experienced by many nations because of US sanctions or influence have been a driving force behind this pattern.

 There is often talk that the US dollar's dominance is being challenged on several fronts. However, as we witness in the IMF report below, the story is not one that necessarily revolves only around reserves and may exhibit various nuanced contradictions even if the underlying theme plays out.

  An International Monetary Fund analysis published the 11^th of June 2024 shows that the US share of global flows has climbed — not fallen — since a shortage of dollars in 2020 spooked global investors and the 2022 freezing of Russian assets stoked questions about respect for free movement of capital. The pre-pandemic US average share was just 18%, according to the IMF it now stands at almost one-third of global capital flows.

And in fact the rise of the US Dollar dominance may also be to some extent reflected by the strength of the Dollar Index, as illustrated below.

For all the angst over the dollar’s dominance, a run-up in US interest rates to the highest levels in decades proved a major draw for overseas investors. The US has also pulled in a fresh wave of foreign direct investment (FDI) thanks to billions of dollars’ worth of incentives under President Joe Biden’s initiatives to spur renewable energy and semiconductor production not to mention the “Exceptionalism” of US tech that is driving the stock market to almost weekly all-time highs.

The trend marks a major shift from the pre-pandemic days when capital poured into emerging markets, including a rapidly growing China. The big US geopolitical rival has seen its share of gross global inflows more than halve since the pandemic hit. But with Donald Trump pledging to reverse the key elements of Bidenomics if he wins the November election, and the Federal Reserve signalling it will start lowering interest rates later this year, the US advantages may not last.

More stark is that FDI flows into China and portfolio flows into the US have changed dramatically from the years prior to the start of the pandemic. China’s share of gross cross-border capital flows amounted to 3% over the 2021-23 period, down from around 7% during the decade through 2019, according to IMF data. FDI flows into China and portfolio flows into the US have changed dramatically. Those figures showcase why President Xi Jinping and his lieutenants have for some time now been fighting to revive foreign investor interest in the country.  Xi is also preparing for a Chinese Communist leadership confab where new reform steps are expected — potentially shifting the investor narrative over China.

April data showed overseas investment into China slowed for a fourth straight month. And, with interest rates around the lowest levels in modern times, domestic Chinese capital is pouring out, with local firms buying the most foreign exchange since 2016 in April.

Why it matters to investors?

Higher interest rates in the US mean overseas investors can make decent returns from low-risk assets like government bonds or benefit from capital gains associated with the burgeoning tech sector. In addition, the country’s trillion-dollar incentives for its renewable energy and semiconductor industries are attracting opportunistic investors. But that could change on a dime.

For one, the looming presidential election could overturn those policies. And for another, the Federal Reserve is hinting at lowering interest rates later this year, which could make certain US assets look less appealing to global investors.

China is trying to woo back foreign investors. Yet even though the country’s stock market has picked itself up from its January lows, Chinese stocks have still been snubbed by several new funds. Fifteen emerging market-focused funds have launched this year – and none of them included China, which underscores ongoing worries about the country’s policies and geopolitical risks. In turn that could be a jackpot for countries like India, Mexico, and Vietnam: they’ll be prime targets for foreign investment, especially if interest in the US wanes.

This post is inspired from extracts of the daily newsletter of the forex, precious metals, and derivatives Advisory team.

Contributors: Robert Lane - Head of Forex, Precious Metals & Derivatives Advisory.