Yellen: USD decline as reserve currency

Yesterday, during a hearing at the US House Committee on Financial Services, Janet Yellen stated that USD may soon lose its dominance as a reserve currency. 

Janet Yellen is the current Treasury secretary of the US government, which is the equivalent of the finance minister. 

She also previously served as governor of the US central bank, the Fed. 

She is therefore very familiar with financial and monetary matters, especially with regard to their national currency, USD (the US dollar). 

Yellen’s hearing: the role of USD as a reserve currency

A hearing was held yesterday at the US House Committee on Financial Services in which Janet Yellen participated. 

It was the Treasury Secretary’s annual testimony before the committee, and concerning the state of the international financial system. 

Thus the topic was really not only the international financial system, but specifically the role of the United States of America in the global financial environment. 

The press release regarding this hearing states that Yellen told the committee that institutions that have been battling pandemic and war in Ukraine since 2020 are leveraging dollars to mobilize funding from US partners and the private sector. 

For example, she cited the International Monetary Fund (IMF) and the World Bank. 

Yellen also admitted that the US currently has leadership in these institutions such that they would reflect American values. 

In addition, she said that going forward, Gov. Biden, of which Yellen is a member, would like to further strengthen US leadership in these institutions. 

But then she went further. 

The decline of USD as a reserve currency

Even though she expressed confidence that USD will remain the global reserve currency for a long time to come, she also admitted that China and Russia could potentially want to develop an alternative.

In such a context, the Treasury Secretary believes that there should be an expectation of a slow decline of USD as a reserve currency. 

So on the one hand she argues that USD will not be replaced as the world’s reserve currency anytime soon, while on the other hand she imagines that nonetheless a phase of USD decline is underway.

She imagines that this phase will be very slow, so for now it is not likely to cause USD to lose its role as a global reference currency. 

On the other hand, if we analyze the trend of the Dollar Index (DXY), that is, the value of USD against a basket of major other currencies and global level, we see that despite the immense amount of dollars created and injected into the markets between 2020 and 2021 its strength has increased. 

At the beginning of 2020 the Fed’s balance sheet was $4.1 trillion, but with the onset of the pandemic and the start of the last major QE in just over two years it has come close to $9 trillion. In other words, it has more than doubled in about 25 months. 

This QE generated inflation, so much so that from 2% in early 2020 it rose to over 9% a few months after the end of QE itself. 

All this should also have resulted in a devaluation of USD, but instead this did not happen. 

At the beginning of 2020, the value of the DXY index was about 99 points, while now it is above 103. 

Truth be told, during the first part of QE, DXY fell all the way to below 90 points in December 2020, but already in 2021 it rose again, ending the year at 96 points. 

As soon as QE ended it soared, reaching 114 points in just over seven months. 

It has since fallen, but remaining at levels not seen since 2003. 

Present and future

Hence, at this time the USD decline has not occurred yet, although perhaps that hypothetical long phase suggested by Yellen may have begun. 

Even though in the seven eight months DXY has fallen, it has now been hovering more or less around 103 points since January. Moreover, the current rate is still much higher than it was two, three or four years ago. 

In other words, to date there is really no concrete sign of this decline, although there are indications that suggest that it may indeed begin. 

Therefore Yellen’s reasoning refers to the future, to the next few years or decades, partly because to date there is no real alternative to the dollar as the global reference currency. 

Instead, there is an attempt to create this alternative, the success of which is by no means a foregone conclusion. 

However, if Yellen is right, such an attempt should have real effects, although not necessarily major ones and especially not in the short term. 

Regarding the breadth and depth of the consequences that the introduction of an alternative currency to the dollar could concretely have on the global financial system at this time, there are no certainties, there are only many very different hypotheses. 

Not least because, just to give a concrete example, in recent years the value of the Chinese yuan against the US dollar has remained relatively constant, because after rising in 2020 (as the DXY fell) it subsequently fell, returning to even slightly lower levels than in 2019.