Geopolitical ructions and the role of the dollar

Central banks now face profound challenges. The foundations of the current international monetary order are in jeopardy if the policies of the new US administration undermine the US dollar as the ultimate means of settlement for international financial transactions and as the primary international reserve asset. To understand these challenges, it is useful to consider three questions:

1. How real are the risks of decline of the US dollar hegemony, and how quickly could it happen?
2. What are the key risks arising during any transition to an uncertain alternative system?
3. What priorities does this suggest for central banks?

Disintermediation and decline of the dollar?

The radical change in the approach of the new US administration towards policy-making constitutes a fundamental reset in international economic relations. There is no discernible intellectual underpinning for the change, and it could easily have a range of unintended consequences. The capricious approach to tariffs, taxes and trade, as well as the avowed aim of weakening or removing US defence support, could erode confidence in the US as an ally, and trust in the dollar as the anchor for the international monetary system.

Pressures for change have been building for a long time (see box), but what is happening now is dramatic and forbodes a secular shift. The emergence of risk premia on US government debt and a new tendency to sell dollar assets in the face of economic and financial uncertainty not only raise the cost of the growing US government deficit, but they also make the international financial system more brittle.

Failing to appreciate that it is excess demand, unleashed by a combination of excess private credit and growing public deficits that has generated current account deficits, the US administration is targeting multiple economic, political and defence objectives by engaging in tactics of deliberate disruption. It is unclear to others, and perhaps to the administration itself, just how those objectives fit together and whether the actions taken will help to achieve them. Whatever the intent, the approach of moving forward and then backing off when imposing differentiated import duties will fragment markets and disrupt supply chains. It may also imperil the existing international monetary order based on the US dollar. The situation can be summed up in the proposition that ‘Tax Americana’ is replacing ‘Pax Americana’.

The ultimate consequences of this are unclear, but the following developments are evident:

• Extreme events become more likely so that even the idea of a risk-free interest rate ceases to be meaningful; this complicates monetary policy, both in the US and elsewhere.
• A declining dollar, combined with tariffs and corresponding supply disruptions, is likely to fuel renewed US inflation and lower growth, with spillovers to many countries, not least the 38 countries that the IMF classifies as having a US dollar peg of some sort. Disruptions to trade and supply chains will harm growth.
• There are already moves afoot to settle international obligations in some jurisdictions without recourse to the dollar. These are likely to gain momentum.
• Demand for gold and other physical assets is rising; central banks are estimated to have added 1,000 tones to gold holdings in the past three years.
• The arbitrary imposition of highly punitive tariffs followed by their partial removal creates enormous uncertainty that could easily lead to the fragmentation of the trading system, with the prospect that the international financial system will, in turn, be fractured.

What are the key risks?

A disorderly flight from the dollar would be catastrophic for the global economy and perhaps just for this reason it may well not happen, but it is an eventuality that is no longer fanciful. Rates on 10-year Treasury bonds jumped 50 basis points in the wake of the US tariff announcement. At the same time, the dollar exchange rate continued the fall that had started in anticipation (losing nearly 10% versus the euro between January 1, 2025 and its mid-April low). Global funds are overweight in the US dollar, and increased uncertainty of US policy could lead to a longer-term secular decline in the use of the dollar.

Reduced demand for dollar-denominated assets could be self-reinforcing once values start to decline. The US trade deficit was more than 3% of US GDP in 2024, and the fiscal deficit over 6%, making the dollar – and US bond prices – vulnerable to an abrupt change in sentiment regarding capital flows. The government debt ratio stands at around 125% of GDP and is set to rise. Government interest expenditure (both gross and net) exceeds total US military expenditure and could increase significantly if investors begin to demand a higher risk premium. Increased issuance of government debt to fund the growing deficit presumes both domestic and foreign investors will be prepared to maintain or even boost the share of dollar assets in their portfolios.

Classic crisis prevention and management rely on liquidity being made freely available when needed. In the post-WWII order, such liquidity has been reliably provided by the IMF, by countries acting together (General Arrangement to Borrow (GAB), Chiang Mai Initiative, etc) and, most importantly, through swap lines from the Federal Reserve. Given the present attitude displayed towards the international community by the US administration, the question arises as to whether such lender-of-last-resort liquidity can be relied on, looking ahead.

A further risk is that increased weaponisation of the dollar will ultimately deprive it of its role as the primary reserve asset. The US obtains enormous amounts of information about transactions, and it has used it to combat crime and terrorism. Unlike any other country, it has an alternative to military action in the form of payments sanctions. Because of the centrality of the dollar, the US can sequester assets held within its jurisdiction more easily than other countries. By imposing secondary sanctions on vassal states, it can leverage this power. However, overuse of this part of the arsenal will ultimately lead to the development of substitutes, reducing its relevance.

The proposal emanating from the chairman of the Council of Economic Advisers to compel foreign holders of US Treasury paper to swap their claims into ultra-long, low-interest instruments illustrates this type of thinking. It would amount to the first default by the US since it became the world’s principal reserve currency (see annex). The budgetary legislation before the US Congress (Section 899) could reduce the attractiveness of dollar claims as it would empower the administration to impose withholding taxes ranging from 5–20% on residents of ‘discriminatory foreign countries’.

A disorderly flight from the dollar would be catastrophic for the global economy and perhaps just for this reason it may well not happen, but it is an eventuality that is no longer fanciful

Priorities for central banks: handling the transition

Near-term issues

Central banks need to attend to:

• direct challenges to central bank independence from populist governments who may wish to use monetary policy for political ends;
• the risks of larger fiscal deficits eg, from greater military expenditure, lower tax receipts and greater interest expenditure. Fiscal dominance could effectively compromise independence and central bank policy objectives, even if the latter are not explicitly constrained;
• greater uncertainty and frequent shocks to both the real economy and the financial sector arising from erratic political decisions that could complicate both monetary and financial stability even if independence and the commitment to low inflation are not formally revoked or otherwise compromised; and
• the promotion of meme coins, cryptocurrency and other substitutes for bank and central bank money, which could undermine the ability of central banks to respond effectively to shocks, whatever else happens.

In the short term, it behoves central banks to engage in contingency planning, thinking of the worst case where the Fed could not – or would not – provide US dollar swap lines during an international liquidity crisis. Altogether, central banks have almost $2 trillion in US dollar assets. If they could mobilise them quickly, this should suffice for managing liquidity needs in most conceivable liquidity crises. But having US dollar-denominated bonds is not the same, and not as useful, as having cash. Only the Federal Reserve can supply US dollar cash in unlimited quantities.

Many reserve assets are held in custodial arrangements with US banks in the US and subject to US jurisdiction. By shifting the custody agreements to non-US banks, central banks would reduce the risk of actions by the US administration to hinder efforts to draw on such assets in a crisis.

Beyond that there is nothing to stop central banks and sovereign wealth funds from diversifying away from the dollar and amassing reserves in a multitude of currencies issued by smaller countries, though the scope for this is limited by the size and depth of markets in these currencies. Furthermore, the loss of trust in the dollar is likely to strengthen demand for holdings of real physical assets, such as gold held in central banks’ own vaults.

In addition, central banks could establish mutual credit lines among themselves along the lines of either the GAB (which in fact was a specific obligation to lend more than a general agreement to borrow) or the European Monetary Cooperation Fund, set up in 1973 to pool European Monetary System central bank reserve holdings. The EMCF received administrative, legal and technical support from the Bank for International Settlements.

Central banks have a long and productive track record of co-operation that could be at risk as other co-operative arrangements are weakened or disappear entirely. The Basel Accord may be especially at risk. US commitment to the IMF might become increasingly uncertain. There could also be a more general lowering of standards as previous agreements, or even international treaties, are ignored or repudiated. Because the stability and resilience of the international financial system depends on the well-established ability of central banks and financial regulatory authorities to co-operate in normal times in order to be able to react swiftly in a crisis, it is more important than ever for them to continue to do so if the US scales back its engagement in this area as it has in others.

Long-term issues

Currently, there is no real alternative to the US dollar as the main international reserve asset and numeraire, and other nations will need to minimise disruption by engaging constructively with the US. The ‘exorbitant privilege’ is for the US to lose. There are at present none that seek to appropriate it. Still, in the longer term it is advisable to plan strategically, to find alternative ways to ensure the effective operation of a global payments system and to provide a reliable store of value for the assets underlying monetary liabilities issued by central banks.

Means of payments: ensuring robust international payment and settlement systems

The replacement of the dollar as a means of payment and settlement in commercial transactions between third countries is easier than its replacement as the principal reserve asset. The US accounts for about 10% of global trade, less than either China or the eurozone, which each account for about 15%. China is developing both CIPS and digital RMB clearing. Ten Association of Southeast Asian Nations countries and six middle eastern countries are participants in the latter, which notionally could replace 38% of settlements going through Swift. In principle, fintech can streamline payments in any currency or set of currencies, potentially reducing the need for a fiat currency such as the US dollar. For payments, if not for finality of settlement, cryptocurrencies or central bank digital arrangements could prove to be effective substitutes for the dollar as a currency in international payments.

Store of value: holding suitable reserve assets

Incumbency provides significant advantages, particularly in the absence of credible alternatives. It permitted the dollar to retain its position after the US unilaterally renounced the link with gold in 1971 (viz John Connally: “The dollar is our currency, but your problem”) in large part because of the unquestioned creditworthiness of the US government. Government debt was then only 35% of GDP and falling, compared with 125% now and rising – US Treasuries were risk free, and the Fed’s swap lines were eventually developed to become the ultimate source of emergency international liquidity assistance in a crisis.

Contenders to replace the dollar

The absence of a means to provide ample amounts of liquidity at short notice in the face of a crisis – the capacity to serve as a lender of last resort – means cryptocurrencies are not currently a suitable substitute for the dollar or other fiat currencies. The only two credible potential candidates are the euro and the renminbi. In neither case is it likely they could replace the US dollar as the primary reserve asset quickly.

For the time being, the euro is not a viable substitute. Europe is still too fragmented; there is not enough common euro government debt outstanding, and the secondary market in such debt is not large or deep enough. To be sure individual member states issue euro-denominated debt (circa €14 trillion ($16.2 trillion in total), but their creditworthiness varies. Only European Commission borrowing is guaranteed by the EU budget and constitutes an unconditional legal obligation of all member states under the EU treaties. The total stock of such debt is less than €0.5 trillion, which is too meagre to absorb significant transfers from US dollar holdings. Total foreign exchange reserves of the world amounted to $12.36 trillion at the end of 2024.

Recent US actions have been a rude awakening for Europe. The change in the global security landscape now under way could, over time, enhance the role of the euro. European countries are likely to increase their military expenditure, and this will need to be funded. EU-issued debt could increase substantially if there were a shift from reliance on the North Atlantic Treaty Organization towards a more autonomous European defence strategy less reliant on US security guarantees. 

The renminbi could also become a credible rival to the dollar as a reserve asset but only if the Chinese were to liberalise capital controls and promote deep and liquid secondary markets in risk-free RMB assets. This would not happen overnight, even if China was to decide that it sought the exorbitant privilege now being forsaken by the US. However, it could happen. And if it did, China would then gain significant information on payments and transactions that would supplement its vast amount of personal data (facial recognition; geolocational info, etc) and enable it to expropriate the power to impose sanctions now enjoyed by the US. 

Update: This article was amended to recognise Paul Fisher as one of its authors.