Will the Russia-Ukraine conflict spell the end of the dominance of the US Dollar?

The position of the Dollar as the world reserve currency actually began before the second world war. Its position was further strengthened following the Bretton Woods agreement in 1944 when it was pegged to gold at the rate of USD35 for one ounce of gold. Although the peg ended in 1971 when the American government announced it would no longer be obligated to exchange dollars for gold, the dominant position of the US dollar remained unchanged.

There are several factors that contribute to this. First and foremost is the size of the US economy as well as its role in international trade. The US economy is the largest in the world. It is also a major importer of goods from all over the world. Imported goods are paid in Dollars and parties exporting to America, including from other major powers such as China and Russia, are forced to accept dollars as payment.

But the main factor why many still accept the American Dollar as the currency to use in international trade transactions as well as to be a reserve currency is the economic and political stability of the United States. Despite the existence of social, political, and economic problems in the US, the American political and social situation is relatively more stable compared to other countries. Thus the perception of international financial institutions is that economic activities in the US will continue to run and therefore many are still confident that the American government, as well as their business organisations, will be able to pay off their debts or other liabilities in the future.

The fact is that if a country does not experience severe social unrest or does not experience severe inflation, usually its currency will remain of value and that is the situation that America is experiencing now. But if the opposite happens, then the country's currency will be worthless in the international financial market. Examples include Zimbabwe, Venezuela, and Lebanon.

Nevertheless, the economic developments of other countries in previous decades, particularly in Europe, Japan, and even China have caused the position of their currencies in the international financial system to increase against the Dollar. As a result, the percentage of the Dollar as a proportion of total reserve currencies in the world has fallen from 69% in 2007 to only 55% today and this reflects the increase in the position of other currencies, especially the Euro, Japanese Yen, Pound Sterling and Yuan. It should also be noted that although China's economy is growing rapidly, the percentage of the Yuan as an international currency reserve is only 2.5%, which is far behind the US Dollar. Another point to note is that the Ruble is not at all listed in the ten most important reserve currencies in the world.

The party that gains the most from the US Dollar dominance position is the US banking industry because they are the only ones allowed to create the US dollar. New dollars are created when the industry lends out money to parties willing to borrow from US banks. The total global debt owed to the industry is now in the hundreds of trillions of dollars. Imagine the amount of interest earned by the owners of the American banking industry each year.

One side effect of the position of the American currency as a reserve currency is the ability of the American government to continue to spend beyond its means. In addition, the United States does not need to worry about the problem of trade deficit. This means that America always imports in larger quantities than it exports. As a result, the total debt of the American government as well as that of American business organisations is constantly increasing every year. Right now the debt of the American federal government is nearly USD30 trillion. In other words, the dominant position of the American dollar in the international financial system has resulted in the country being encircled in debts that are creating many other problems. As an example, normal Americans are facing a high cost of living, which is exacerbated by the taxes that are imposed on them to help the government to pay its debts. In other words, the dominant position of the Dollar actually only benefits wealthy Americans while hundreds of millions of their ordinary citizens live in misery.

The question now is the American Dollar going to lose its eminent position as a result of the Russian-Ukrainian war and the decision of European countries and the United States to impose trade and financial sanctions on Russia? Will Russia's decision to force those who buy its oil and gas to pay in Rubles and not in US Dollars undermine the position of the US dollar? Will Russia’s decision to peg the value of the Ruble to gold at a price of RUB5,000 per gram of gold strengthen the Ruble and threaten the US dollar as predicted by some parties?

In reality, Russia’s decision to force the buyers of its oil and gas is an act of desperation following various forms of economic and financial sanctions imposed by America and its allies against it. Russia’s economy is deteriorating day by day. Many international business companies have ceased their Russian operations and have withdrawn their investments from Russia. Thus the demand for the Ruble has fallen sharply. Its value is temporarily propped up as a result of the need of some western countries, especially Germany, for oil and gas supplies from Russia.

But now America and European countries and their allies are drawing up plans to reduce their dependence on Russian oil and gas. If their plan succeeds, the value of the Ruble will likely decline again. If more parties perceive that Russia will be facing more problems, there will be increased demand to sell the Ruble for gold. But it is very likely that Russia will not be able to meet all the demands because its gold stock in its reserves totaling 2,200 tonnes is actually relatively limited and is far lower than the total US gold reserves of more than 8,000 tonnes. Russia's failure to meet the demands will inevitably result in the Ruble plummeting further.

We also need to be aware that Russia also owes money to external financial institutions that have to be repaid on certain set dates. Most of the debts are in US Dollars. Even though Russia has previously announced it will pay off its debts in Rubles, most likely this will not be accepted by international financial institutions, especially from America and Europe. Any default will mean Russia will face trouble getting funding from outside and this will make the economic situation worse. It is, therefore, not surprising that many analysts predict Russia will face a financial crisis as severe as the one it faced in 1918. These challenges may not have been foreseen by President Putin when he invaded Ukraine.

Back to the issue of the US Dollar, its position as the most important reserve currency will only be affected when there are other currencies that are eligible to replace its position. So far no other currency seems eligible. The main factor is that many parties, both governments and business organisations are not averse to borrowing from external sources, and when they do that, they are still inclined to borrow in Dollars. As long as this trend remains strong, the position of the US Dollar will remain superior.

The fall of the American Dollar will only surely happen if the social, economic, and political system in America is in severe turmoil. When that happens, its internal economic activities will also be severely affected and this will also affect the perception of international financial markets on the ability of the American government to pay its debts. Now there are already signs that social unrest is on the rise in America, including the January 2021 riot that took place at the Capitol building in Washington, following President Trump’s refusal to accept his election defeat.

Nonetheless, other countries including China, Japan, and major European countries, are also showing signs of growing social, economic, and political problems. Therefore, it is still unclear which country's currency will be able to replace the US Dollar as the most dominant international reserve currency.

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* Mohd Nazari Ismail is Honorary Professor at the Faculty of Business and Economics, University of Malaya