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A formula to end the dollar’s reserve currency domination
Posted by Simon Hinrichsen on May 22 13:58. 11 comments | ShareOne reserve currency to rule them all.
But does it need to be this way? Or is it indeed possible to have two, or even several such currencies? Or to get straight to the heart of it: can the euro or Chinese yuan ever have the status of the US dollar?
FT Alphaville has previously traced the historical travels of the US dollar on its road to reserve currency stardom, and discussed some of the things we would expect to see before other currencies could share the podium.
This week saw the publication a study by Livia Chitu and Arnaud J. Mehl, based out of the ECB, and Barry Eichengreen of UC Berkeley in which they outline the historical precedent for multiple reserve currencies, and model what allowed such a situation to exist.
When we say “multiple” here, what we actually mean was “two”. From the paper (emphasis ours):
Getting to the empirical examination, the study uses four explanatory variables to analyse currencies, and their relative ranking in terms of reserve status:
1) Network externalities. Basically the “incumbent effect” in which a currency is more likely to being used in FX markets, trade, international debt markets, or as a reserve currency if it’s already heavily used in one or more of these.
2) Country size. The bigger the country, the bigger the market for its currency.
3) Currency stability and inflation. People will want assurances that the value of the currency will not be inflated away, or subject to extreme volatility.
4) Financial depth or liquidity.
The output of the model shows that liquidity in a given currency and its debt market is what matters most. To get a bit more specific about it, financial depth variable is measured by taking the ratio of banking assets-to-GDP. What the researchers then show is that the larger the banking sector relative to the economy, the more debt is issued in that currency, the higher the potential for the currency to be a reserve currency, as happened with the US dollar:
Given this result, what they suggest for the euro going forward is that more financial integration is needed if it is to further develop its international profile. If one looks at the yuan, then the opening of domestic markets and FX reform are clearly minimum requirements if they want to reach reserve status (surprise!).
So given that it is within the realm of possibility, how quickly could a shift to a system with more than one reserve currency happen?
Eurobonds, for one, could mean increased use of the euro in international debt markets, leading to an increase in the use of the euro. As Chitu et al. suggest, though, even that might not lead to the demise of the dollar. While China is certainly on the rise, in absolute terms they still have long to go in terms of financial depth.
Or, as the IMF wrote:
http://ftalphaville.ft.com/blog/2012...cy-domination/
Posted by Simon Hinrichsen on May 22 13:58. 11 comments | ShareOne reserve currency to rule them all.
But does it need to be this way? Or is it indeed possible to have two, or even several such currencies? Or to get straight to the heart of it: can the euro or Chinese yuan ever have the status of the US dollar?
FT Alphaville has previously traced the historical travels of the US dollar on its road to reserve currency stardom, and discussed some of the things we would expect to see before other currencies could share the podium.
This week saw the publication a study by Livia Chitu and Arnaud J. Mehl, based out of the ECB, and Barry Eichengreen of UC Berkeley in which they outline the historical precedent for multiple reserve currencies, and model what allowed such a situation to exist.
When we say “multiple” here, what we actually mean was “two”. From the paper (emphasis ours):
Much of the 1920s and the 1930s saw the use of both sterling and the dollar as currencies of denomination in international debt markets. This was a bipolar rather than a unipolar currency system.This finding is at odds with the presumption that there is room for only one dominant international currency in the market.
The researchers go on to point out that it is international debt markets that largely decide which currency dominates, i.e. it’s a battle fought by foreign debt issuance. That is, it was largely the rise of the dollar as the favorite currency for government debt issues that led to the dollar’s rise before World War II. They suggest this shift, from the pound to the dollar, happened as early as 1929.Getting to the empirical examination, the study uses four explanatory variables to analyse currencies, and their relative ranking in terms of reserve status:
1) Network externalities. Basically the “incumbent effect” in which a currency is more likely to being used in FX markets, trade, international debt markets, or as a reserve currency if it’s already heavily used in one or more of these.
2) Country size. The bigger the country, the bigger the market for its currency.
3) Currency stability and inflation. People will want assurances that the value of the currency will not be inflated away, or subject to extreme volatility.
4) Financial depth or liquidity.
The output of the model shows that liquidity in a given currency and its debt market is what matters most. To get a bit more specific about it, financial depth variable is measured by taking the ratio of banking assets-to-GDP. What the researchers then show is that the larger the banking sector relative to the economy, the more debt is issued in that currency, the higher the potential for the currency to be a reserve currency, as happened with the US dollar:
The full model estimate suggests that in the short run (over one year) an increase in the ratio of banking assets to GDP by 10 percentage points is associated with an increase in the share of the US dollar (sterling) of about three percentage points.
Grow, banks, grow!Given this result, what they suggest for the euro going forward is that more financial integration is needed if it is to further develop its international profile. If one looks at the yuan, then the opening of domestic markets and FX reform are clearly minimum requirements if they want to reach reserve status (surprise!).
So given that it is within the realm of possibility, how quickly could a shift to a system with more than one reserve currency happen?
The international status of a currency will rest on solid foundations, however, only if financial deepening in the issuing country is sustainable, and not if financial innovation and liberalization simply causes a boom that eventually goes bust.
There might still be some way to go, then.Eurobonds, for one, could mean increased use of the euro in international debt markets, leading to an increase in the use of the euro. As Chitu et al. suggest, though, even that might not lead to the demise of the dollar. While China is certainly on the rise, in absolute terms they still have long to go in terms of financial depth.
Or, as the IMF wrote:
Is the renminbi on a trajectory to usurp the U.S. dollar’s role as the dominant global reserve currency? Perhaps, but the day is a long way off. It is more likely that, over the next decade, the renminbi will evolve into a reserve currency that erodes but doesn’t end the dollar’s dominance.
http://ftalphaville.ft.com/blog/2012...cy-domination/
