Why in news? Countries  have tried to dethrone the dollar as the global reserve currency for many decades now for various reasons, of late such attempts have picked up pace in the aftermath of Russia’s invasion of Ukraine last year

What is De-dollarization?

• De-dollarization refers to the replacement of the U.S. dollar by other currencies as the global reserve currency.

Alternate to dollar

• Currently, the Chinese yuan is seen as the primary alternative to the U.S. dollar owing to China’s rising economic power.

What is reserve currency?

• A reserve currency refers to any currency that is widely used in cross-border transactions and is commonly held as reserves by central banks.
• The currencies of economic superpowers have usually ended up being used as the global reserve currency. As the economic clout of these countries waned, their currencies faced a similar downfall.

Role of Reserve Currencies

• They facilitate international transactions, stabilize exchange rates, and bolster financial confidence
• These currencies are typically characterized by their stability, liquidity, and wide acceptance in global markets, which make them attractive for holding and conducting international transactions.

Popularity of US dollar

• The US dollar has since long been the prominent reserve currency, a status cemented in the aftermath of World War II with the establishment of the Bretton Woods system.
• The dollar’s ubiquity in global trade, finance, and investment has endowed it with significant advantages, such as lower transaction costs, reduced exchange rate risk, and the ability to finance deficits at relatively lower costs.

Reasons for de-dollarization?

• Critics of the U.S. dollar believe that the global reserve currency status gives it unfair privileges over other countries
• The overreliance on the US dollar as a reserve currency has to some extent led to vulnerabilities and imbalances in the global economy.
• Additionally, the dollar’s dominance renders other economies susceptible to fluctuations in US monetary policy, often leading to spill over effects that may not align with their domestic economic conditions.
• Furthermore, countries with substantial dollar-denominated debt may face heightened vulnerability to currency fluctuations and capital flow reversals, exacerbating the risk of financial crises,

Global Efforts Towards Dedollarisation:

• In recent years, several countries and regions have embarked on the path towards dedollarisation, driven by a combination of geopolitical, economic, and strategic considerations.
• Notable examples include China, Russia, Brazil and the European Union, each of which has taken steps to reduce their reliance on the US dollar in international transactions and financial markets.
• Some countries, like China and Russia, have sought to diminish the influence of the US dollar as a means of countering perceived American hegemony and mitigating the impact of US sanctions.
• Other countries, particularly those in the Eurozone, have pursued dedollarisation to promote the international use of their currency, the euro, in a bid to enhance their global economic standing and secure greater financial autonomy.

Challenges Towards Dedollarisation

• As countries reduce their reliance on the US dollar, adjustments in the composition of global reserve assets may lead to shifts in capital flows and changes in asset prices.
• In the absence of adequate policy coordination and risk management, these fluctuations could create financial instability, particularly in emerging markets and countries with substantial dollar-denominated debt.
• Creating a viable alternative to the US dollar presents a formidable challenge. To achieve the requisite degree of stability, liquidity, and acceptability, an alternative reserve currency must be underpinned by a robust economy, deep and liquid financial markets, and sound monetary and fiscal policy frameworks.
• Currently, no single currency fully meets these criteria, although the euro and the Chinese yuan have made strides in this regard.
• Dedollarisation could result in increased volatility in currency exchange rates, particularly during the initial phases of transition.

Should India Focus on Dedollarisation?

Developing  countries such as India must carefully weigh the potential benefits and risks associated with this transition.

Benefits:

• Moving away from the US dollar could reduce their vulnerability to fluctuations in US monetary policy and enhance their monetary autonomy, enabling them to better tailor policy actions to their domestic economic conditions.
• Moreover, the diversification of reserve currencies could provide a buffer against currency fluctuations and capital flow reversals, reducing the likelihood of financial crises and improving overall financial stability

Challenges  and potential costs for developing countries.

• As developing countries transition away from the US dollar, they may face heightened exchange rate volatility, which could impact trade, investment, and capital flows.
• Additionally, the development of deep and liquid domestic financial markets – a prerequisite for currency internationalisation – could prove to be a formidable challenge for countries with less developed financial systems.
• Furthermore, the potential costs associated with the transition, such as adjustments to existing trade and financial arrangements, may be significant and could strain limited resources.