As we approach the end of the decade, the status of the world’s reserve currencies have undergone shifts, but has the structure really changed, or are they so incremental that 2019 more resembles 2009 than a new world order? In 2009, Barry Eichengreen’s article about the future of the USD in global reserve banks predicted that because of weaknesses in the alternatives, the US would remain the primary reserve currency, and this has largely been true up to this point. The RMB increased its role, cryptocurrencies appeared to be making an attempt to upend the system, but the overall shift has truly been negligible and it seems that for the foreseeable future, this will remain the case, barring some international crisis.
This review goes to show the truly minimal changes that have taken place in the last decade, where stability of reserve market share has prevailed over this period, whilst the lack of significant competitors keeps the status quo in place, verifying the predictions made by Eichengreen.
The author begins by stating that to buy foreign reserves, countries must run a current account surplus with the United States, and this carries its own set of political implications and demands between both buyer countries and the United States, as they both work to support this system. The consequent high demand for USD causes artificially low interest rates in the US as reserve banks and institutional investors flock to treasury notes, as well as increasing the liquidity of the currency and raising the relative exchange rate of the USD. The sheer quantity of demand for USD is further helped by the number of countries in the world that have some sort of peg mechanism ties to the USD which causes even more purchases in order to hedge against shifts. The author suggests that this process funds US debt spending, both on the consumer and government side and unfairly promotes inflationary growth in the US, a kind of cash party with freely flowing funds. Accepting this narrative implies that this system is unsustainable, and that the current state is not preferred while most of the world countries, also implying that if and when the world shifts away from the USD as a reserve currency, the shock will hurt the US as the retraction impacts economic growth and debt financing availability contracts. He also neglects to mention that the trade deficits produced by this have domestic political cost in terms of flexibility of monetary policy, the implications of the trade deficit, and the entrenchment of inequality brought about by the net effect tend to favor large firms over consumers who often pay more for imports.
The author presents that this is a problem for the world, and that many states view this phenomenon as a kind of subsidization of the US economy – the reality is that it has risks and costs for the US as well, so is the current USD based system optimal, and if so for whom? It would seem that the current system is stable and there is not enough momentum to drive away the status quo, and this momentum is more important than the preferences of any single state actor especially as they would need to bear significant costs to move the equilibrium away from where it currently sits.
The article was written in 2009, just after the worst of the US financial crisis, and presents the irony of the importance of the US dollar, even after the deep instability in US markets post-2008. This continued reliance on the USD was largely due to central banks, and rather than flocking to precious metals, the world still saw treasury bonds as amongst the most stable of financial instruments. As of 2008, 45% of global debt security were dollar issues, and 32% for the Euro. The number of foreign reserved denominated in USD was even higher, and has barely budged since that point.
What about other currencies? The Pound and the Swiss Franc are still regarded as too small to be major players. The volume of their currency on the open market and relative size of their transactions relative to the rest of the world may be too small to adequately compete, having no other effect than shaving a couple of points off of the US. The Japanese Yen offers interest rates that are far too low, and the Japanese economy faces stagnation issues, partly as a result of economic industrial and productivity problems and partly as a result of demographic issues that keep growth rates extremely low.
The US’ dominance has been more threatened in recent years by the global introduction of the Euro. The Euro has increased in importance, but even with a relatively immense GDP share and important role in trade, it suffers issues, too, that make it difficult to predict and rely on. One large problem with the EUR as a reserve tool is that while all the governments in the currency area issue debt in EUR, the governments each issue their own separate instruments including various levels of risk, terms, and possibility of default, as seen in recent years. This makes it difficult to set policy to increase the stability of the region, or make system wide economic shifts to promote it as a reserve currency, as nearly every country in the European Union has its own incentives to preserve their respective sovereignty on domestic monetary policy and not to work together on increasing its reserve status. Compounding these issues, the EU has severe demographic issues, political complications, and economic stagnation that keep the US dollar more attractive. Many of these have arisen in the years since the article was published and make the weakness of the EUR all the more apparent after the contagion from Greece and Italy threatened the very viability of the Euro project.
When Eichengreen wrote in 2009, the IMF’s Special Drawing Rights basket, included just four currencies, USD, EUR, JPY, GBP (2008). As of 2019, the RMB is now a part of this basket and thus China’s role in the world currency system and importance in the IMF has improved since 2009. This may have been in part due to a modicum of cooperative behavior from Obama, who was relatively politically friendly to China, allowing them increased voting rights in the voting share and quota reforms of 2010 in both the World Bank and the IMF, appeasing their demands for increased recognition of their importance. He suggests that the IMF could conceivably issue bonds issued in the SDRS basket to increase the diversity of foreign reserve holdings. The author at the time suggests using SDRS as a kind of exchange currency to settle accounts, but also for issuing instruments to form a kind of international currency – the problem is it is not international, nor immune – it’s simply a basket of other currencies, most of which are so tightly interlinked that the diversification to avoid risk is essentially useless. He suggests that serious countries create a liquid market for SDRS instruments, or an SDRS forex market, and there has been little movement on this front. Further, the IMF issuance of SDRS bonds requires 85% majority, a prospect unlikely to go anywhere really, especially in light of the US-China trade war and its consequent reduction in economic cooperation between China and the primary IMF vote holders, the US and Japan.
The author suggests that the main problem with uptake of SDR bonds is the novelty of such products, that it will mean additional costs for liquid markets, and that the illiquidity is a huge problem. Likely the bigger issue is the uselessness of such a device. If reserve banks have the ability to self select a basket and choose its own ratios, directly buying currency and debt instruments, the IMF instruments would have to provide benefits to keep them from simply buying their own baskets on the open market. The sheer un-usability and inconvertibility make it unlikely to be important in the future, absent increasing open marketization.
This is the same culprit that killed cryptocurrencies, another false miracle promised to bring openness and decentralization to currency that appeared in the last decade. Both could have affected reserve holdings had it not been for their fatal flaws. In reality, the technical failures of a currency whose “decentralized” servers often took hours or days to clear a single transaction, experienced such extreme swings of volatility gaining and losing hundreds of fold in value in only a handful of months, and couldn’t be used to purchase goods at more than an extremely small handful of online retailers because of these two problems, made it unfeasible as anything more than a form of online gambling. In the end cryptocurrencies failed to serve either as a good store of value, or a convertible instrument for purchasing goods and services, and thus could never serve as a form of currency for real consumers.
China, for its part a major economy, although its true scale could be debated considering major questions about the legitimacy of its output numbers, would prefer to move away from US reserves. The author mentions that because their holdings are so high, beginning a selloff would depreciate the value of their residual holdings. What is fascinating is how persistent this problem remains even today. Selloff of US treasury notes was discussed as a potential retaliation for the trade war and summarily dismissed because of this problem. The question, therefore, is what is keeping the RMB from being uptaken as a major reserve currency.
Although China purports that it wants the RMB as a serious reserve currency, it seems more like China wants the prestige with none of the costs, appreciating and lobbying for such token gestures as being placed in the SDRS while ignoring the reform measures that should accompany a country taking seriously its responsibility as a reserve currency. Of these, the RMB’s biggest problems are transparency and liquidity, the latter of which was mentioned by the author, although not in the depth that it deserved. The Chinese government has essentially only shown concern about maintaining stability and low forex rates, and seems willing to do so at all costs, mostly expressing fear over capital flight. The capital controls system has undergone minor loosening since 2009, but nothing on the scale of making the RMB a truly liquid currency, a necessary prerequisite for the liquidity needed to make it a serious contender. The lack of clear signals or transparency of monetary statistics, policy, and government decision making make it a dangerous bet for cautious central bankers.
The article made the prescient claim that by 2020, the RMB would be a reserve currency, and as of 2019, it in fact is, albeit a very minor one. With limited convertibility, it will continue to face problems. Even if their GDP numbers are trusted and their economy’s size continues to grow – liquidity is too important to allow its uptake.
The fact that the SDRS now include the RMB also means that there is increased scrutiny of China’s role as a reserve currency holder and buyer and its demands for increased representation in the IMF. It sometimes seems, though, that China’s actions regarding the set of international financial institutions, IFIs, a group originally formed and funded, as well as still largely following the demands of Western-aligned countries, aim more to increase China’s prestige than actually affect policies or increase China’s role as a responsible governor of the global financial system. Their much hyped AIIB, which originally aimed to be China controlled, was diluted from 50% to just over 25%, giving them only a majority over supermajority votes, and this serves as evidence that they perhaps seek prestige over real political power over these institutions and the responsibility that that entails.
Meanwhile, the BRI, the Belt and Road Initiative, initially touted as an industrialization and development program, has shown its true colors in the group of countries it lends to, pariah states and political allies in loans that are often impossible to repay. These countries have been forced to cede land and resources to China when they inevitably fail to repay. Thus, China is perhaps not truly interested in either forming a China dominated institution, or in reforming global development practices. The CCP seems far more concerned with domestic stability and how the soft power politics of these institutions affect the way China is treated on the world state. For its own part, China’s deeply flawed economy is teetering on the edge of a debt explosion even while hundreds of millions of people living outside of coastal areas remain in abject poverty. The economic figures they have been releasing, if true, show a deeply unstable and unequal development in between urban and rural China, raising questions about the sustainability of their ability of the CCP government to fund international lending on the scale it is, or tinker with their currency to preserve their share in reserve holdings at the expense of domestic stability.
The fact that the politicized and China-dominated BRI and the funds outlaid for its lending outstrip the funding of the multilaterally controlled and funded AIIB by a scale of nearly 70:1 demonstrates the priorities of the CCP. Chinese internal politics will always outstrip international prestige, and therefore it seems unlikely that the CCP will allow the renminbi to further liberalize if it disturbs their domestic political order, regardless of the benefits that using the USD as a reserve currency affords their political enemies..
The author raises the question of whether the future could hold a regional Asian currency. The answer is never. Asia is not Europe. The scale of asymmetry between the countries, e.g. China versus Brunei, and more importantly, the complete lack of political cooperation in Asia both make this inconceivable. The European political union preceded the success of the Euro, and was a necessary first step. The notion of an Asian currency also neglects the natural animosity and suspicion between many Asian states that characterizes their interactions, making their cooperation on land and maritime borders so contentious that to speak of a unified monetary policy, even amongst a smaller group like ASEAN is almost unthinkable. Asian geopolitics is still largely focused on questions of sovereignty. The desire to reduce the supremacy of the USD as a reserve currency falls far under the problems of political asymmetry and the complete lack of political cooperation in Asia.
This leaves the US Dollar, still reigning as the primary reserve currency, but how long will this last, and should America aim to preserve its place? The paper ignores the costs related to having the currency in reserves. The inflexibility might mean less ability to use monetary policy because of political implications of not preserving this status in terms of currency and exports. There are few alternatives, but the bigger question is, should the US, and should the world accept multipolarity or leave the status quo as is?
Claims that increasing multipolarity will make central bank leaders more accountable, and force them to pick good policy in order to compete for foreign reserve market share are not necessarily true. If adequately decentralized, there will be a new equilibrium between states, likely leading to reserve holding of a large basket of currencies in low quantities, and with adequate diversification, perhaps investors will be less choosy. Therefore, the pressure to govern responsibly could be close to nil. Further, it remains to be seen whether countries all seek this cycle of high debt and low exports, for many countries, stability is preferable to an inflationary economy that is more prone to shocks.
The paper left more questions than answers. Its perspective initially appears to be critical of US hegemony, offering a raft of alternatives, but in the end appears conservative, striking away these options one by one, and proclaiming that the USD will remain the primary reserve currency for the foreseeable future.
If using a countries currency does give advantages in terms of lowering interest rates, should we be more choosy/political about foreign reserve choices? This carries deep implications for states inimical to eachothers’ political interests. Whether China should buy the USD whilst it disparages their political system and votes against them in the UN at every opportunity, or should the Western world support Chinese totalitarianism by buying RMB bonds, these questions seem were never raised but are politically pertinent.
Further, there are already precious metals markets, derivatives and commodities markets, non-nation specific currency markets that don’t have these problems, why does the author seem intent on diversifying the basket or increasing the number of available reserve currencies instead of focusing on non-fiat currency reserves? Often they are significantly more liquid than the RMB and other “reserve” currencies, so it is not clear why the world needs alternatives to the USD, or simply a more diverse basket of the existing group.
In summation, the status quo is likely to persist, largely due to the natural conservatism of central bankers and the need for stability in monetary policy. Absent a crisis, it is not unlikely that in 2029 the system will still largely resemble 2019. Alternatives exist, as the original paper presented quite well, but they all have significant drawbacks, some of which have been exacerbated in the last decade. Even the SDRS basket doesn’t provide a significant second choice to a natural basket of the top stable currencies.
The largest question at this point relates to the trajectory for China. Whether the decoupling of the American and Chinese markets that occurs as a result of the growing political rift result in a break between the systems remains to be seen. This could lead to Chinese exclusion from IFI decision making and a reduction in the uptake of the RMB into the international currency reserve system. or the tensions could temper down, and the RMB share in the SRDS could possibly even be increased. It is possible, too, that the US could draw down its own role in the IFIs and the politicization of these institutions and reserve holdings choices could be reduced. The unpredictability of the Trump administration make this nearly impossible to predict, and the outcome of the next three presidential elections in the United States, as well as Xi Jinping’s possible transition in 2022 will decide the results of the next 10 years.
Staff writer: Ari B
Source: Eichengreen, Barry. 2009. “The Dollar Dilemma: The World’s Top Currency Faces
Competition.” Foreign Affairs 88(5):53-68.