The dollar has been the cornerstone of the international monetary system since the Second World War. It is the most important reserve currency, accounting for at least two-thirds of reserve assets, according to the IMF’s Composition of Foreign Exchange Reserves database. Among central banks that do not report this information to the IMF, it is estimated (e.g. by Brad Setser) that 70 percent is held in dollar assets.
The bulk of foreign exchange transactions involve dollars, and significantly more trade gets settled in dollars than involves the United States. Goldberg and Tille examined 23 advanced and emerging economies in Asia and Europe and found that all settled a greater proportion of their trade in dollars than their trade with the United States. The divergence was particularly stark for emerging Asia, where trade with the United States only accounted for about 20 percent of total trade but the bulk of total trade was settled in dollars. ( “Vehicle Currency Use in International Trade,” Journal of International Economics, Issue 76, Vol. 2, pp. 177-192, December 2008).
The recent crisis has prompted an abundance of commentary on the future of the international monetary system and potential alternative reserve currencies. Those calling for a re-examination of the dollar’s role include Italian economy minister Giulio Tremonti, People’s Bank of China Governor Zhou Xiaochuan, Ousmène Jacques Mandeng of Ashmore Investment Management Limited, and Nobel Laureate Joseph Stiglitz. What does all this mean for the future of the international monetary system and the role of the dollar?
First, let’s recall that while under the Bretton Woods system, the dollar’s primacy was rooted in law, this has not been the case for the past 30 years: dollar usage has continued as a matter of choice. Its widespread acceptance is partly the consequence of the dominant position of the U.S. economy, but has also been sustained by the following factors:
- The depth and liquidity of the United States’ financial and forex markets, which remained resilient even during the financial crisis.
- The U.S. economy’s track record of macroeconomic stability, which bolsters confidence in the dollar’s long term purchasing power.
- The willingness of the U.S. fiscal and monetary authorities to allow the dollar to be used in international transactions, and to generate sufficient high quality liabilities to meet international demand for assets denominated in dollars.
- Network effects—the more a currency is used and held, the more useful it becomes, which in turn increases demand for it even more.
Is a natural alternative to the dollar waiting in the wings? Any contender will need to exhibit these characteristics to a similar or superior degree. This post considers three alternatives: (1) new or multiple core reserve currencies; (2) a system based on the SDR; and (3) a sui generis global reserve currency that circulates along with other currencies.
Competitors to the dollar
Based on economic size, there are potential competitors to the dollar on the horizon, most notably the euro. The share of the euro in total international reserves has grown in the last decade, from 18 percent when the single currency was created to more than 25 percent today. By one estimate, it could overtake the dollar by 2022. Looking further ahead, China’s dynamic growth may lead to the renminbi becoming more widely accepted internationally. However, both are some way from rivaling the dollar across the criteria outlined above.
Of course, merely replacing one dominant currency with another would do little, if anything, to alleviate the concerns that have been expressed about the current system. Potentially better would be a system where multiple currencies operate on a par. It is unclear, however, whether such a system could emerge on its own—given network effects—and, how stable it would be. In fact, the increased scope for arbitrage among the major reserve currencies could potentially make such a system unstable, unless tight policy coordination among reserve issuers could be achieved.
To combine the advantages of multiple and single currency systems, a basket-based reserve system, perhaps built on the IMF’s Special Drawing Rights (SDRs), could be envisaged. The SDR is not a currency; it takes its value from its constituent currencies (currently, the US dollar, euro, pound sterling, and yen, but the basket is periodically reviewed), and this makes it more stable: if one of its constituent currencies depreciates, the share of the others in the basket rises proportionately, dampening the volatility of the basket. However, for the SDR to take on such a significant role, its liquidity would need to increase massively. While an increase in demand (from BRIC central banks) and supply of SDR assets (from the Fund) have recently materialized, the scale remains limited–about 4 percent of global reserves. Generating a liquid SDR market of the size needed to create a new reserve currency would be a major undertaking.
An even more ambitious solution would be to move to a truly global currency, along the lines of Keynes’s “bancor”, that would circulate alongside countries’ own currencies and would offer a store of value truly disconnected from economic conditions and policies in any country. To achieve this, one would need to set up a global monetary institution that would issue the global currency depending on global economic conditions, and that could act as a global lender of last resort. It would need to have an impeccable (“AAAA”) balance sheet, and governance arrangements that engender widespread credibility and acceptability. Given the practical and political challenges it raises, this option is probably one for the very long time horizon. But perhaps the experience with another international monetary authority, the European Central Bank, suggests that it is not altogether impossible.
While it is interesting to speculate about the future of the international monetary system, and the dollar’s role in it, the reality is that the current system has proved its resilience while the alternatives have not; and though change is likely over time, it will not happen overnight, or by decree. The key challenge for policy makers is to continuously nudge the system toward stability along the way.