The "dollarization" of the global economy has sparked concerns that the developing world is becoming overly vulnerable to US monetary policy. Foreign holdings of dollar-denominated assets have quadrupled since 2000, surpassing $24 trillion this year alone. Over 55 percent of the world’s financial assets are managed by US banks, giving American firms an outsized role in the global financial system.
At first glance, the dollar’s growing importance in foreign financial systems seems troubling. The US economy only accounts for 24 percent of global output, and the American population makes up only 4 percent of the world’s people. Both of these shares are shrinking: The developed world is steadily adding workers, and the US is entering an era of slower demographic growth. Yet a full 60 percent of the world’s commerce is now conducted in dollars or in currencies pegged to the dollar. Clearly, this growing imbalance cannot be sustained forever. But just because the dollar’s dominance will someday fade does not mean that its current role is harmful to the world’s economy.
Overseas investors and foreign central banks have acquired dollar-based assets because doing so promotes growth. Rapidly developing economies naturally run trade surpluses—their factories export a steady stream of products to affluent nations, but their citizens are not yet rich enough to import an equal value of goods.
Export-driven economies benefit from maintaining an inexpensive currency, which makes their goods more attractive in overseas markets. International firms are also more willing to make long-term investments in nations with relatively stable currencies, and keeping large reserves of US dollars on hand allows central bankers greater control over exchange rates. For this reason, it is common for developing nations to retain a large share of their trade surpluses in dollar-denominated assets. So it should be no surprise that rapid economic growth in the developing world has resulted in similar growth in the amount of US dollars held by foreign governments.
The current situation has similarities with the Bretton Woods monetary policy that enabled the rapid reconstruction of postwar Europe. In the decades following World War II, the US Dollar anchored a system of fixed exchange rates among European economies. The Bretton Woods system kept European currencies cheap, promoting rapid growth across the continent and ensuring a steady market for exports. By the 1970s, the rebuilt economies no longer benefited from running trade surpluses, and the Bretton Woods system was replaced by free-floating currency markets.
Hopefully, developing nations will follow a similar path—as growing prosperity makes trade surpluses less desirable, they will taper the purchasing of dollar-denominated assets and allow their currencies to float freely on the open market.
While there are certainly drawbacks to holding excess dollars, the benefits of accelerated growth for developing nations far outweigh potential problems. Dollarization comes with political and monetary risks—it constrains the ability of nations to set their own monetary policies, and it ties their financial systems to US politics. Persistent trade imbalances also carry costs for American citizens: The $24 trillion tied up in dollars held abroad represents an enormous amount of displaced trade and foregone American exports.
For the moment, however, dollarization serves the interests of the developing world. It is a fundamental principle of economics that individuals and organizations will make appropriate decisions for themselves—nations that are voluntarily accumulating dollars have decided that the added growth is worth the risks.
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