There have been few “winners” from the coronavirus crisis, but one stands out: the U.S. dollar. As investors realized earlier this year the size of the economic shock that COVID-19 would cause, they sold riskier assets like stocks and bonds, taking safety in cash. But not just any cash. Investors all over the world wanted U.S. dollars. Demand for dollars was so high that the U.S. Federal Reserve set up new swap lines to lend dollars to other countries’ central banks. From Shanghai to Sao Paolo, investors scrambled for dollars.
In some ways, the demand for dollars was not surprising: whenever the world economy seems riskier, investors gravitate toward greenbacks. The increased demand for dollars came even as the U.S. government was taking unprecedent actions that, according to textbook economics, ought to weaken the dollar’s value. Massive deficit-funded government spending programs coupled with a huge expansion of the Federal Reserve’s balance sheet is the type of policy that often degrades the value of a currency. Rather than getting cheaper, the dollar appreciated against its peers. The benchmark DXY index, which measures the dollar against a basket of peer currencies from other advanced economies, appreciated several percentage points this year.
The dollar’s increase in value amid the COVID crisis comes after years of predictions by many analysts that the dollar was poised to lose its status as the world’s safest asset. Overuse of U.S. sanctions, some analysts argued, would reduce other countries’ willingness to hold dollars, fearing the long arm of the U.S. Treasury. Others predicted that massive U.S. government deficits would reduce investors’ trust in the dollar. Neither of these appear to matter: The Trump administration has used sanctions more aggressively and has increased the deficit to a scale unseen since the Second World War—and the value of the dollar has gone up.
How can this be explained? There are several theories of the durability of dollar demand even in the face of vast budget deficits and expansionary monetary policy. The first sees dollar dominance as a function of U.S. military dominance, and suggests that America’s “empire of bases exists to protect the dollar’s exorbitant privilege,” as one scholar has put it.
It is true, of course, that the dollar, like the military, can be used as a tool of power abroad. The fact that the U.S. uses financial and military pressure simultaneously against rivals does not mean that military power sustains the dollar. If so, we would expect a correlation between the dollar’s value and U.S. military power. Since the mid-2000s, demand for the dollar has changed little even as U.S. defense spending declined substantially under the Obama administration, and the military capabilities of U.S. rivals such as Russia and China grew enormously. America’s military advantage over its rivals is the lowest at any point since the end of the Cold War, but the dollar’s dominance is as great as ever.
A second explanation for the dollar’s preeminent position points to income inequality as a driver. In a recent essay, Yakov Feygin and Dominik Leusder argue that growing income inequality in other countries drives up demand for savings, some of which must be parked in foreign assets. The most obvious example of this is China, which has accumulated a vast stockpile of dollar assets, notably U.S. Treasury bonds. Beijing has accomplished this via a growth model that keeps household consumption extraordinarily low. As a share of GDP, China’s households buy less than any country in the world, except for a few small city states and oil producers. A disproportionate share of China’s income goes into savings, especially the savings of China’s firms and its government. Much of this savings, in turn, is parked in dollars.
If income inequality in China were lower—and if households were given more resources to spend, either via lower taxes, a stronger social safety net, or higher wages—there is little doubt that China’s corporate savings rate would decline, and so, too, would demand for foreign currency savings. And the Chinese government’s $3 trillion in foreign exchange reserves would decline.
Why do Chinese prefer dollars to the currencies of other advanced economies, say euros, yen, pounds, or Swiss francs? Eurozone governments create many debt securities, but unlike in the U.S., where all treasury bonds are equal, not all euro sovereign bonds are the same. Investors think heavily indebted Italy is far more likely to default than thrifty Germany. But there are relatively few sovereign bonds issued by Germany compared to those issued by riskier Southern European countries. So, in general, German bonds are more expensive—and thus generally less attractive than U.S. Treasuries. If the Eurozone were to issue bonds guaranteed by the entire bloc, then there would be far more genuinely safe assets denominated in euros. However, richer Germans don’t want to be held responsible for the debts of poorer Southern Europeans, a divide that is unlikely to disappear.
It is possible to explain the relatively limited demand for euros in part as a result of inequality between Northern and Southern Europeans, just as China’s demand for dollars stems from high savings among that country’s wealthy individuals and firms. Nevertheless, inequality cannot explain why the Japanese hold so many dollars, or why so few foreigners like to save in yen. In the 1980s, many observers saw the yen as a currency that could overtake the dollar. Since then, it has had a relatively stable value and low inflation—characteristics that investors value. Why hasn’t the yen overtaken the dollar? Rising inequality cannot explain this.
A better explanation is a type of path dependency and network effects. Everyone has gotten used to trading, borrowing, and lending in dollars, and much of the world’s financial plumbing is denominated in dollars. So, there are major transaction costs to shifting to a new currency, and few obvious benefits.
The failure of the yen to make a serious dent in the dollar’s dominance shows just how hard it will be for China’s renminbi to take market share. Several years ago, Beijing was trumpeting the “internationalization” of the renminbi. But its share in global trade and finance has barely budged. And China lacks many of the characteristics of the dollar, yen, or euro, notably strict capital controls that make it hard to withdraw money from China. Hence, Chinese prefer, when they can, to save not in renminbi, but in foreign currency. The currency they most frequently chose, naturally, is the dollar.
Eventually, the deficit spending and central bank asset purchases undertaken to fight COVID may well reverse the dollar’s gains this year. But the effect is unlikely to be drastic. Every other major economy has undertaken similarly vast fiscal and monetary efforts, so the fundamentals behind the dollar look no worse in comparison with the euro or the yen. China’s government will be even more unlikely to loosen its capital controls given the economic shock of COVID, which will further deter use of the renminbi. The dollar’s dominance is unlikely to be challenged any time soon.
The views expressed in this article are those of the author alone and do not necessarily reflect the position of the Foreign Policy Research Institute, a non-partisan organization that seeks to publish well-argued, policy-oriented articles on American foreign policy and national security priorities.