Reserve Currencies in the Post-Crisis International Monetary System

By Reza Moghadam

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. 

Global currency

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.

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5 Responses

  1. When I was a kid in the1970′s, fresh on the heels of Nixon putting the final nail in the coffin of a value-backed currency, I kept asking why the gov’t was borrowing money when there was nothing to borrow. The dollar is a (faith valued) non-convertible fiat currency. In fact that is why the U.S. gov’t designed it, so they wouldn’t have to borrow from anyone!

    Please step outside of the box for a moment and view it like I did as a child. With an asset-backed currency, there must be physical gold in place to back currency. With a non-convertible currency (which simply means the currency has nothing of physical value supporting it) the value consists of people (here and abroad) believing it has value. So if you compare the difference between the two, it is easy to understand that the U.S. gov’t is not borrowing money from anyone because there’s nothing to borrow. It is ink and paper, that is it!

    The U.S. government has a monopoly on its currency. If they don’t print it there is no money. They tax us to control population, spending power, and who gets the money. The gov’t must run a deficit in order to allow economy to run smoothly. When they don’t inject enough money into economy we end up with a lot of unemployment. Excessive government spending contributes to the hyperinflation we have here now where Americans pay from 100-5,000% more for products, services, and health care. The gov’t will never go broke, and they do not rely on tax revenues nor do they borrow money from china or any other country to finance this country! In short, they offer bonds to anyone to drain excess reserves and to control the overnight loan interest rates. Technically, the only reason this is done is because it is a law that has absolutely no merit and if China was to stop purchasing the securities the government would simply abolish the law

    The value of U.S. currency is determined by what the gov’t demands private sector must do or sell to obtain it. The more unemployed (welfare, forced involuntary unemployment, etc.), the less value the dollar has. Unemployment equals less output. The true debt, we and future generations will have to pay, is the lost output and depreciated human capital!

    The reason America imports more than they export is because exports are real cost (output and labor) and imports are pure benefit for the system. Basically for the cost of the ink and paper to make dollars, America’s elite can purchase the rest of the worlds products (their output and labor). And they keep printing and printing all they want! The down side to this is the taxpayer’s here obviously don’t get to enjoy receiving products from all over the world for the price of ink and paper, and the loss of millions of good paying manufacturing jobs. When the U.S. government started forcing outsourcing in the 1960s they knew this and they lied and said other equally compensating jobs would definitely replace lost jobs! That has never happened!

    Since my childhood I have spoken to several economists who are 100% aware of how our U.S. monetary system works. I have asked them why they believe the gov’t continues to lie to us. They seem to believe that the majority of gov’t really believes the whole borrowing system to be fact. As for the thousands of economists who also believe the borrowing theory, I suppose they have so much schooling, money, and time invested in the borrowing scam that they have put on blinders and refuse to look at it as a child did!

    I don’t see how one can’t see the truth when you simply understand that there is absolutely nothing to borrow!

    • There are other factors that I think must be taken into account when considering the issues surrounding a reserve currency.

      When you were a child, did you consider it a financial burden that the U.S. had taken over the role of world policeman from Britain because the role of world policeman is a financially onerous one? Political historians speak about WWII forcing/facilitating the evolution of Pax Britannica into Pax Americana. (I don’t think anyone or any group wanted that so much as global level factors beyond anyone’s ability to control at the time led to the Pax Anglo-Sassona that now exists through NATO in the West and something a little similar in the East).

      Living in England as a child I never considered the financial burden of any country or alliance of countries who take on, or have forced on them, the role of world policeman. But I had enough conversations with my father, who was a Lieutenant-Colonel in the British Army and a physical member of that world police force all his working life, to recognize that the gold standard idea is a very neat simplicity that entirely overlooks the hard and bloody peace-making police work my father and his colleagues felt obliged to do in, for example, Korea, Malaya, and Northern Ireland.

      So I think Mr. Moghadam is right to present us with the need to consider, now that the financial and military resources surplus to just keeping bread on the table are differently aligned from how they were when the IMF was founded, a global monetary system adjustment.

      Notwithstanding that viewpoint, I think it also necessary, when considering global monetary system options, to recognize that the existing system came under heavy strain only in the aftermath of the credit crunches that erupted in 2007-8. If one recognizes that, one cannot ignore the reality that those crunches were the proximate antecedent to the issues Mr. Moghadam is posing, nor ignore the reality that the financial reform that emerges as obviously necessary when one looks at the financial regulation aspects of those credit crunches remains dangerously incomplete.

      The IMF’s Mr. Vinals is in Toronto on March 16 to talk about financial stability, and it is my intent to add to the significance of the content of his presentation by pointing out that the part of financial reform remaining most dangerously incomplete is the part concerning financial derivative markets.

      For those interested, I have a paper on this subject that you can review at:

      http://www.authentixcoaches.com/ACdsFCF-1.html

  2. Dear Mr. Moghadam:

    May I add a comment to an observation included in your initiating post above? The one I refer reads as follows:

    “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.”

    The increased scope for arbitrage among more equal major reserve currencies, a situation I sense we are moving to steadily, would not make the system more unstable IF a “smart” financial transaction tax (FTT) were introduced through the G20 process. A smart FTT recognizes that the systemic risks in HFT can be managed by an FTT that is differentiated by contract length. A smart FTT also recognizes that systemic risks in derivatives generally can be managed by an FTT that is differentiated not only by contract length but also by an additional factor that reflects the number of ordinary (traditional) financial instruments synthesized into them.

  3. Dear Reza Moghadam,

    I cannot find the Supplements mentioned in document http://www.imf.org/external/np/pp/eng/2010/041310.pdf

    Could you please provide me with a link or e-mail me these Supplements?

    Thanks a lot,

    Georg Zoche

  4. Pakistan, within the MENAP region, is facing tougher security and governance issues; each time the hope of correcting things emerges, some harder issues pop up again and again.
    Oil exporting countries’ remittances helped Pakistan a lot during the crisis, when Pakistan suffered less from the global downturn, but faced a lybrinth of problems from terrorism in colloborating successive US governments. Easing oil and commodity prices could not imporve the domestic scenario as the over 20% depreciation of rupee counterbalanced most of the advantages.
    The IMF’s timely support was well received and kept Pakistan away from a deeper crisis, but hopes and potential of large scale recovery are still dim. Poverty grows quickly in Pakistan, as most of the population is living just around poverty line. A few shocks will bring many below poverty line.
    Ahmed Mukhtar
    Aaj TV/Business Recorder Islamabad

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