The world needs more reserve currencies

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About the Author: Christopher Smart is Chief Global Strategist and Director of the Barings Investment Institute, and is a former senior economic policy official at the US Treasury and the White House.

The mighty dollar is showing signs of running out of steam on hopes the Fed hikes will end soon, but resentment still abounds. With the global reserve currency still nearly 12% stronger than a basket of its major counterparts since last spring, questions are hard to avoid. Why should America impose its monetary policy on everyone? Wouldn’t the world be better off with more than one dominant currency?

The short answers are “no, it shouldn’t” and “yes, it would”. A world in which reserve assets were more diversified would certainly be a better place, not least because it would mean that democratic institutions and open capital markets would have managed to thrive in the global economy. But in light of the current political trends that seem to be bolstering autocrats, that day isn’t coming soon and we’re likely stuck with dollar dominance for a very long time.

The current configuration of the world foreign exchange markets does indeed offer essential advantages. For the United States, these include lower borrowing costs, powerful enforcement tools through financial penalties, and a small amount of “seigniorage” revenue on what amounts to a loan. without interest granted by strangers holding dollars in cash.

But there are also advantages for other countries. Above all, the dollar offers a reliable store of value, whether it’s US Treasury bills in a multinational’s account or a roll of cash in a family’s coffee can. A dominant currency facilitates trade between many jurisdictions with a common unit of account. And when crisis hits, the US Federal Reserve stands ready as a lender of last resort to facilitate liquidity in key jurisdictions.

Of course, there are a lot of downsides. American financial instability is transmitted almost instantaneously to the rest of the world, as illustrated by the bankruptcy of Lehman Brothers. In times of dollar strength, dollar debt is suddenly more expensive to repay from local currency earnings. Dollar-denominated commodity prices make food and energy imports even more inflationary. Emerging market central banks are also being forced to hike rates and deepen their own slowdown just to stem the outflow of funds. And, adding insult to injury, no one wants to be caught on the wrong side of US sanctions, which seem to be on the rise year after year.

So, as a thought experiment, imagine a world with multiple reserve currencies. Suppose the world’s central banks diversify their reserves into the world’s largest economies, rather than keeping 60% in dollars as they do now. Think of financial flows and international trade denominated in roughly equal shares of dollars, euros, Japanese yen, Chinese renminbi, Indian rupees and Brazilian reais.

Presumably, money would move from one dominant currency to another based much more on fundamental trade flows and economic cycles rather than raw swings between greed and fear. With a greater diversity of holdings, reserve values ​​would be much less sensitive to bilateral exchange rate movements.

This scenario is reminiscent of 1930s Europe, when England, France, and America each used their dominant currency to gain a narrow advantage over the other, ultimately leading to depression and war. But these currencies were based on a peg to gold. Today’s mainstream currency no longer does this. Above all, it depends on the political and institutional credibility of the issuer. The dollar has been desirable long after it ceased to be even theoretically convertible into a precious metal, as the US economy is considered resilient, its democratic institutions are considered enduring, and its legal and regulatory framework is deemed fair.

The euro is clearly on track to fulfill a similar function after only 20 years of circulation. The main obstacle to the euro is capital markets that are not sufficiently integrated and the absence of sufficiently jointly guaranteed debt to create a safe and reliable asset. But it will come. A more open Japanese economy would create similar opportunities for the yen. China, India and Brazil all have much longer journeys down the path of policy and regulatory development.

A few key emerging markets have already made such institutional progress. Independent central banks rose early to limit depreciation. Better macroeconomic management, currency flexibility and more developed local markets helped to cushion dollar shocks. The Mexican peso, for example, is stronger against the dollar this year. As one astute observer notes, this crisis has confirmed that good policies do lead to better outcomes.

That’s the good news. The even better news is that the reforms needed to make currencies more attractive as alternative reserve assets will also improve a country’s growth prospects and contribute to greater stability in global markets.

The bad news is that such changes cannot be decreed from above and will not happen quickly. Indeed, the immediate future looks more like economies will fall into competing political and trade blocs, which will only make their currencies less attractive as reserve assets. We will live with a dominant dollar for many years.

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