Category Archives: Dollar

Threats to Financial Hegemony

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The U.S. came out of World War II with the largest economy and a predominant place in the post-WW II international financial order. It was the only nation that could provide the international leadership that Charles Kindleberger wrote was necessary to avoid catastrophic events such as the Great Depression of the 1930s. But in return for stability the U.S. also received a degree of control, and that legacy is under attack today.

American financial hegemony evolved in the years following the end of WW II.  Capital flows were severely regulated under the Bretton Woods regime so that national governments could maintain autonomy over national monetary policy and also to avoid destabilizing speculation. But as international trade picked up the dollar served as a vehicle currency, which led to the U.S. serving in the role of what Emile Despres, Charles Kindleberger and Walter Salant called the “world’s banker.”

In 1971 President Richard Nixon revoked the U.S. pledge to accept dollars from foreign central banks in exchange for gold. But the end of this linkage did not diminish the use of dollars as an international reserve currency. Private capital flows continued to expand as governments deregulated their capital accounts and the dollar had a central role in the growing international financial markets.

Andrew Sobel identified the attributes of a financial hegemon in Birth of Hegemony. These include large and liquid capital markets and openness to foreign capital flows. In addition, Kindleberger in his account of the role of an international financial leader in The World In Depression specifically referred to the need for international liquidity. U.S. government actions, including those of the Federal Reserve, have been consistent with these principles (see here). Capital flows are largely unregulated, while the Federal Reserve has used swap agreements to provide dollars to foreign central banks which in turn could use them to maintain dollar funding in foreign financial markets.

Consequently, while other currencies such as the euro and the Japanese yen have been considered as possible rivals for the dollar, no single viable alternative has emerged. But Serkan Arslanap of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have shown in their IMF working paper, “The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies,”  that the composition of international reserves has shifted away from the dollar over time. This decline has been offset by a rise in what they call nontraditional currencies, including the Chinese renminbi but also the Australian dollar, the Canadian dollar, and the Swiss franc.

Two recent developments have reopened the question of the continued central role of the dollar. The first is the seizure of more than $300 billion of foreign currency assets of the Russian central bank in the wake of Russia’s invasion of Ukraine. This seizure, while not unprecedented, raises legal and political questions. To date the U.S. and its European allies have resisted confiscating these funds to assist the Ukrainian government, but the pressure to do so will mount as the war continues. The confiscation of the Russian central bank’s assets certainly causes other foreign central banks to reassess the composition of their foreign exchange holdings. Moreover, the People’s Bank of China has established its own swap lines to foreign central banks.

The second event is the debate that took place within the U.S. over the debt ceiling. This political theater was resolved, but the opposition of some Republican legislators to any increase in the U.S. Treasury’s borrowing authority triggered a reassessment of whether U.S. Treasury bonds are truly “safe assets.” When governments default on their debt, it usually is because economic conditions have curbed their ability to raise funds through domestic taxes or to roll over their debt. The U.S. situation is different: the government faced a self-inflicted attempt to force the Treasury into a position where it might not have made payments on its debt. Several bank failures had already, according to the IMF, shown the extent of U.S. financial fragility, and a debt default would have severely escalated the volatility.

Either of these events—the confiscation of Russian assets or the threat of a failure to raise the U.S. debt ceiling—is probably sufficient to increase the pace of currency diversification in central bank reserves.  But replacing  the U.S. dollar in the international financial system will be a more complicated task. First, as Michael Pettis has observed, the global role of the dollar allows the U.S. to offset the savings imbalances that exist in countries such as China, Saudi Arabia and South Korea. If the U.S. did not offset the current account surpluses of those and other countries, then either they would have to find a substitute or increase their domestic demand.

Second, international capital markets still deal in dollars. Bafundi Maronoti of the Bank for International Settlements points out in his examination of the international role of the dollar in the December 2022 issue of the BIS Quarterly Review that “About half of all international debt securities and cross-border loans issued in these offshore funding markets are denominated in USD.” It is difficult to imagine how any other currency could take the place of the dollar in these markets.

There are legitimate questions, therefore, about the dominance of the U.S. dollar in international finance. Central banks will continue to diversify the currency denominations of their foreign exchange holdings. But the dollar’s central role in global financial flows will not be easily replaced.

The Rising Dollar

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The foreign currency value of the dollar has been rising. The nominal broad dollar index of the Federal Reserve shows the dollar has incresed by by about 9% since its low point a year ago while other indexes register larger gains. What does this mean for the U.S. and other economies?

The appreciation reflects several factors. First, higher interest rates make investing in dollar-denominated assets more appealing, particularly since many other major central banks lag the Federal Reserve’s in its monetary tightening. The European Central Bank will not begin to raise its rates until July, while the Bank of Japan has no plans to change its accomodative policy stance. Second, the dollar’s “safe asset” status draws investors who fear the economic and political uncertainty due to the Russian invasion of Ukraine. Third, the COVID19 lockdowns in China have disrupted its economy, while the U.S. has not (yet) exhibited any significant slowdown.

A rising dollar will contribute to the increasing U.S. trade deficit. American consumers may be losing confidence because of inflation, but they are still purchasing foreign goods. Lower import prices will assist the Fed in combatting inflation, which could slow future hikes in interest rates..

 The dollar’s appreciation will also have an impact on the foreign-based revenues and profits of U.S. based multinationals. A 2018 S&P 500 research paper by Philip Brzenk showed that changes in the value of the dollar had an impact on S&P 500 companies with significant foreign activities. An appreciation (depreciation) of the dollar lowers (raises) the value of the foreign earnings of those companies with major foreign currency exposure, which is accompanied by decreases (increases) in the values of their share prices relative to those firms in the S&P 500 with little foreign exposure. A decline in foreign-sourced income will also affect the net income balance of the U.S. balance of payments, contributing to a further weakening of the current account.

The impact on foreign economies of the rising dollar is also mixed. On the one hand, those countries that export to the U.S. should benefit from lower prices for their goods. However, this effect is mitigated when their export prices are denominated in dollars.  Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl and Tra Nguyen of the IMF drew attention to the growing use of the dollar as a vehicle currency and the implications for trade balances in a 2020 IMF working paper, “Patterns in Invoicing Currency in Global Trade.”

Moreover, any expansionary effect due to increased trade can be offset by what has been called the “finance channel.” The financial channel reflects the impact of the exchange rate on the value of foreign currency liabilities, such as loans taken in a foreign currency. An appreciating dollar will raise the domestic value of those liabilities. Jonathan Kearns and Nikhil Patel of the Bank for International Settlements examined these channels in their article, “Does the Financial Channel of Exchange Rates Offset the Trade Channel?”, which appeared in the December 2016 issue of the BIS Quarterly Review. They found evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for the advanced economies.

Similarly, Boris Hoffman and Taejon Park of the BIS reported that a dollar apperciation contributes to a deterioration of growth prospects of emerging market economies in their 2020 BIS Quarterly Review paper, “The Broad Dollar Exchange Rate as an EME Risk Factor.” They found that a dollar appreciation dampens investment growth, and even export growth. These effects were larger in countries with high dollar debt and high foreign investor presence in local currency bond markets, which conttibute to the financial channel.

Another examination of the impact of changes in the value of the dollar on emerging market economies was undertaken by Pablo Druck, Nicolas E. Magud and Rodrigo Mariscal of the IMF in “Collateral Damage: Dollar Strength and Emerging Markets’ Growth,” which appeared in the North American Journal of Economics and Finance in 2018 (IMF working paper version here). They found evidence of a negative relationship between the strength of the dollar and emerging markets’ growth. They attributed this empirical relationship to two channels of transmission: first, a negative linkage with commodity prices that depresses demand for the exports of commodity producers; second, an increase in the cost of imported capital imports that are necessary for growth. While supply shocks will keep commodity prices elevated, the price of capital imports has already risen due to widespread inflation.

The impact of the appreciation of the dollar will spread far outside U.S. borders. These effects will occcur in countries already grappling with higher food and energy costs, and the consequences of a slowing Chinese economy. A global recession is not inevitable, but the IMF’s Managing Director Kristalina Georgieva is not exagerating when she says that the world economy faces “its biggest test since the second world war.”

The 2021 Globie: “Three Days at Camp David” and “The Global Currency Power of the US Dollar”

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Fall is the time of the year to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The prize is strictly honorific and does not come with a check. But the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column.

This year there are two winners, Jeff Garten for Three Days at Camp David and Anthony Elson for The Global Currency Power of the US Dollar. Each book deals with the financial hegemony of the U.S. dollar in the global financial system. Together they provide a fascinating account of how the dollar came to hold—and hold onto—this role.

Garten looks at the decision by President Richard Nixon in the summer of 1971 to end the link between the dollar and gold, a central foundation of the Bretton Woods system. Foreign central pegged their exchange rates to the dollar, which was convertible to gold by the U.S. government for $35 an ounce. This arrangement reflected the U.S. position at the end of World War II as the predominant economic power, able to use its influence at Bretton Woods to ensure a dollar-dominated system.

But the imbalance between the U.S. and the rest of the world shifted during the 1950s, particularly as Germany and Japan emerged as economic powers with growing trade surpluses. U.S. government spending resulted in growing foreign holdings of dollars. Yale Professor Robert Triffin pointed out that the ability of the U.S. to exchange its gold for dollars was deteriorating, and this incipient crisis became known as the “Triffin dilemma.” By 1971 this situation was no longer sustainable. Foreign central banks held about $40 billion in dollars while U.S. gold holdings had fallen to $10 billion. Speculators were taking positions on the response of the U.S. and other central banks in a global chicken game.

Garten describes the main players in the decision to end the link with the dollar. Nixon had appointed John Connolly as Treasury Secretary mainly because of Connolly’s political skills.  Connolly in turn depended on the expertise in international finance of Paul Volcker, then under secretary of the Treasury for international monetary affairs. George Schulz was known for his organizational expertise and served as the director of the Office of Management and Budget. Arthur Burns, Chair of the Federal Reserve, sought to serve Nixon while maintaining some semblance of institutional autonomy. Other participants in the decision included Paul McCracken of the Council of Economic Advisors and Peter Peterson of the White House Council on International Economic Policy.

These men (yes, all men) had different perspectives on the best way to handle the crisis. Volcker and Burns shared an appreciation of the existing framework, and wanted to consult with their counterparts in other countries on reforming the system. Schulz, influenced by his background at the University of Chicago, looked forward to a day when flexible exchange rates would replace pegged rates. Connolly, on the other hand, had no ideological agenda. He sought to promote American interests and Nixon’s re-election, and saw the two as entirely compatible.

Nixon, Garten makes clear, was concerned about the impact of the situation on his 1972 election campaign, and his response must be understood in that context. Nixon consulted with these advisors at Camp David on the weekend of August 13 – 15 on how best to meet the dollar crisis. After a broad discussion, the decision to end the link of the dollar with gold sales was made. The rest of the weekend was spent on deciding on how to present the issue to the American public and U.S. allies.

Nixon spoke that Sunday night, making the case on the need to achieve economic prosperity in the aftermath of the Vietnam war. Other measures he presented included a tax credit for investment, a freeze on wages and prices and the establishment of a Cost of Living Council to enact measures to control inflation, and a 10% temporary tariff on imports. He justified the latter on the “unfair edge” that competitors had gained while the U.S. promoted their post-World War II recovery.

The U.S. subsequently negotiated with the other leading advanced economies on establishing new fixed rates, but the effort was unsuccessful. By March 1973, almost all of the Western European economies and Japan had embraced flexible exchange rates. The Jamaica Accords of 1978 marked the official of the Bretton Woods exchange rate system. Central banks could continue to peg their currencies against the dollar, but there was no obligation on the U.S. to support the “non-system.”

Anthony Elson brings the story forward in time to explain the continuing dominant position of the dollar. It is doubtful that anyone in 1971 or 1978 would have predicted a key role for the dollar in the post-Bretton Woods era, and Elson shows that the dollar’s continued dominance reflects several factors. First, the dollar continues to be used for invoicing international trade, even for non-U.S. trade flows. The dollar is used for this purpose in order to minimize transaction costs, as well as its record of macro stability. Second, the continued dominance of financial markets in the U.S. draws foreign investors looking for safe and liquid markets. This in turn has encouraged the growth of dollar-based financing outside the U.S. Third, the dollar continues to the most commonly-used currency for the foreign exchange reserves of central banks. U.S. Treasury bonds are seen as a global “safe asset.”

All this, Elson points out, bring benefits for U.S. traders and investors, who can use the dollar to purchase foreign goods and assets. In addition, the government can finance a continuing current account deficit through its provision of U.S. Treasury bonds. The foreign demand  for these securities also lowers the cost of financing the fiscal deficits. On the political side, the government has learned how to use access to the dollar-based international clearing system as a tool of foreign policy, effectively “weaponzing the dollar.”

Can this system continue? The “new Triffin dilemma” has arisen as a result of the relative decline of the U.S. economy in terms of its share of world GDP at the same time as the demand for safe assets continues to grow. An increase in the issuance of U.S. securities to finance fiscal deficits coupled to the political posturing over the debt ceiling may threaten the confidence of foreign investors in the ability of the U.S. government to meet its obligations, much as the declining gold stock led to the 1971 crisis.

But what alternatives are there? The Eurozone and China have grown in size and importance and their currencies may serve as regional rivals for the dollar. But a multipolar reserve currency system may itself be unstable. The IMF’s Special Drawing Rights were designed to supplement the dollar, but their use has been limited, and it would take concerted intergovernmental action to encourage its use. Digital currencies may change how we view money, and central banks are actively investigating their use.

There is little history to provide a guide on the circumstances that lead to a change in the hegemonic currency. The dollar began to rival the British pound in usage in the 1920s as the U.S. economy rapidly grew. But the transition was finalized by the costs to Great Britain of fighting World War II. If a peaceful transition to a new reserve currency system is to take place, it will require more international cooperation than has been shown on other issues.

 

2020    Tim Lee, Jamie Lee and Kevin Coldiron, The Rise of Carry: the Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis

2019    Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World

2018    Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World

2017   Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic,  Global Inequality

2015   Benjamin J. Cohen,  Currency Power: Understanding Monetary Rivalry

The Challenges to the Dollar

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The dollar’s position as the premier global currency has long seemed secure. The dollar accounts for about 60% of the foreign exchange reserves of central banks and similar proportions of international debt and loans. But recent developments raise the possibility of a transition to a stratified world economy in which the use of other currencies for regional trade and finance becomes more common.

Such a statement may seem to be inconsistent with the Federal Reserve’s activities to stabilize global financial markets. As it did during the global financial crisis of 2008-09, the Fed has activated currency swap lines with other central banks, including those of the Eurozone, Great Britain, Japan, Canada and Switzerland, as well as the monetary authorities of South Korea, Mexico and Singapore. Those central banks that do not have swap agreements can borrow dollars from the Fed via its new foreign and international monetary authorities (FIMA) facility. Under this program, central banks that need dollars for their domestic financial institutions exchange U.S. Treasury securities for dollars through a repurchase agreement. These moves accompany the Fed’s extensive range of activities to support the U.S. economy, which include cutting the federal funds rate to zero, purchasing large amounts of Treasury, mortgage backed and corporate securities, and lending to corporations and state and municipal governments.

But other governments are uneasy with the U.S. government’s use of the dollar’s position in international finance to enforce compliance with its foreign policy goals. International transactions in dollars are cleared through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking network and the Clearing House Interbank Payments System (CHIPS). The U.S. has denied foreign banks access to these systems when they wanted to penalize the banks for dealing with governments or companies that the U.S. seeks to punish. This practice has become more common under the Trump administration, which has used the sanctions to strike at Iran, North Korea, Russia, Venezuela and others.

European leaders have made clear that they find this use of the dollar’s international role no longer acceptable. When the U.S. abandoned the agreements on nuclear weapons with Iran, European banks were forced to choose between defying the U.S. or their own governments, which encouraged them to continue their ties with Iran. In response, Britain, France and Germany have founded a clearing house, Instex, to serve as an alternative system, and several other European Union members will join it. Moreover, if the Europeans proceed with the issuance of a common EU bond, there will be an alternative safe asset to U.S. Treasury bonds that will foster the use of the euro in foreign exchange reserves.

China is also moving to encourage the international acceptance of its currency as an alternative to the dollar. The Chinese bond market is the world’s second largest, and the foreign appetite for Chinese bonds has increased. Foreigners bought $60 billion of Chinese government bonds last year, and now hold 8.8% of these bonds. Some of these bonds will be held by central banks diversifying the composition of their foreign currency reserves.

China’s Belt and Road Initiatives have expanded its economic presence in emerging markets, which also leads to a wider usage of its currency. Chinese investments in infrastructure and other projects in these countries increase the usage of the renminbi, as will the trade that follows.  The number of banks processing payments in renminbi has grown greatly in recent years, and most of these banks are based in Asia, Africa and the Middle East.

There are obstacles to the wider use of both the euro and the renminbi. While Germany’s Chancellor Angela Merkel has voiced support of a common European bond, the heads of other European governments have expressed their concerns.  China continues to maintain capital controls, although it has allowed foreigners to invest in the bond market through Hong Kong. But the imposition of a new security law for Hong Kong raises concerns about China’s willingness to allow financial concerns to affect its political goals.

The euro was once more widely seen as a viable alternative to the dollar. Hiro Ito and Cesar Rodriguez of Portland State University in their recent research paper, “Clamoring for Greenbacks: Explaining the Resurgence of the U.S. Dollar in International Debt”, examine the determinants of the currency composition of international debt securities. In their analysis they undertake a counterfactual analysis to examine what would have happened to the shares of the dollar and the euro in the composition of these securities if the global financial crisis had not occurred. They report that the predicted share of the euro in international debt would have been higher than it actually has been, while the share of the dollar would be lower.

When Ito and Rodriguez wrote their paper, they forecast that the dollar would continue to be the dominant international currency. But the Trump administration has damaged the international standing of the U.S., and this will have long-term consequences. Benjamin J. Cohen of UC-Santa Barbara has pointed out that “…there is palpable resentment over Trump’s indiscriminate use of financial sanctions to punish countries…” More generally, the U.S. government has sought to limit the county’s international interactions.

Harold James of Princeton wrote about the dominance of the dollar after the global financial crisis in his book, The Creation and Destruction of Value: the Globalization Cycle, which was published in 2009. At that time he foresaw the central role of the dollar as continuing because of the “political and military might of the U.S.”, as well as its economic potential. But he also stated that:

 “Such concentrations of power can be self-sustaining when they attract not only the capital resources, but also the human resources (primarily through skilled immigration) that allow exceptional productivity growth to continue.”

James warned that if a country closes itself off from exchanges with other nations, its relative decline can be hastened. He pointed out that:

“Since the isolationist impulse is a major strand in the American political tradition, it is impossible to close off this possibility; in fact, its likelihood increases as the economic and political situation deteriorates.”

The pandemic has the potential of serving as an inflection point, which follows a period of confrontations with other countries over trade. The fumbled response of the U.S. to the pandemic will encourage the governments of Europe and China to extend their influence in the financial sphere.  A world with several dominant currencies need not be inferior to one with a single hegemonic currency. But it will come about in large part as a result of the self-inflected damage that the Trump administration has perpetrated on the international standing of the U.S.

The Exorbitant Privilege in a World of Low Interest Rates

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The U.S. dollar has long enjoyed what French finance minister Valéry Giscard d’Estaing called an “exorbitant privilege.”  The U.S. can finance its current account deficits and acquisition of foreign assets by issuing Treasury securities that are held by foreign central banks as reserves. The dollar’s share of foreign reserves, while falling, remains over 60%.  But in a world of low interest rates, how exorbitant is this privilege, and is it solely a U.S. phenomenon?

John Plender of the Financial Times has pointed out that U.S. Treasury bonds offer a rate of return that matches or is higher than that of other government bonds with similar risk ratings.  This is true whether we look at nominal returns or real rates of return. The nominal returns reported below are those available on the ten-year government bonds of Germany, Japan, the U.K. and the U.S., while the changes in prices are those reported for their Consumer Price Indexes :

 

Nominal Return Change in Prices Real Return
Germany -0.05% 2.0% -2.05%
Japan -0.06% 0.5% -0.56%
U.K. 1.13% 1.9% -0.77%
U.S. 2.47% 1.9% 0.57%

 

The bonds of other advanced economies offer higher yields but more risk. The rate of return on ten-year Italian government bonds is 2.68% and on Greek bonds 3.49%. An investor in government bonds can do better in Brazil (8.76%) or Mexico (8.09%), but these securities also come with the risk of depreciation.

Private foreign investors also hold U.S. Treasury debt as well as U.S. corporate securities. John Ammer of the Federal Reserve Board (FRB) , Stijn Claessens of the Bank for International Settlements (BIS), Alexandra Tabova (FRB) and Caleb Wroblewski (FDB) analyzed the foreign private holdings of U.S. bonds in “Home Country Interest Rates and International Investment in U.S. Bonds,” published in the  Journal of International Money and Finance in 2018 (working paper here). They collected data for 31 countries where private residents held both U.S. Treasury securities and corporate bonds during the period of 2003-2016.  They found that low domestic interest rates led to increased holdings of U.S. bonds, and in particular, corporate securities. The corporate share of foreign-held U.S. securities in these countries had risen to about 60% by the end of their sample period.

The “long equity, short debt” structure of the U.S. external balance sheet is not unique to the U.S. Robert McCauley of the BIS in “Does the US Dollar Confer an Exorbitant Privilege?”, also published in the JIMF in 2015, shows that foreign holdings of Australian government bonds have allowed that country to accumulate foreign currency assets. Some of these holdings were attributed to the desire of foreign central banks to hold safe and liquid assets.

U.S. Treasury securities possess an appeal besides their relatively attractive rates of return in a world of low interest rates. They are seen as safe assets, and given the size of the U.S. economy and the liquidity of its capital markets, it is not surprising that they hold a predominant role in the global financial system. But Pierre-Olivier Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Maxime Sauzet of UC-Berkeley have pointed out in “The International Monetary and Financial System” (NBER Working paper #25782) that the mounting size of the eternal debt of the U.S. may lead to a loss of confidence in the U.S. government’s ability to service it without engaging in inflationary finance or triggering a depreciation of the dollar. At the same time, the relative size of the U.S. economy in global output is shrinking while the demand for dollar liquidity is growing. They conclude that this may be the basis of a “New Triffin Dilemma.”

There is, however, another, more immediate danger. The U.S. reached its debt ceiling of $22 trillion on March 2. The Department of the Treasury can engage in various measures to continue paying the government’s bills until next fall. The White House wants to obtain a rise in the debt ceiling this spring before it has to engage in budget negotiations with Congress. But given the toxic relations between the Trump administration and the House of Representatives, the danger of a lack of agreement cannot be dismissed. The Trump administration promised to disrupt the global order, and the full extent of that disruption may have only begun.

Mars Descending? U.S. Security Alliances and the International Status of the Dollar

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A decade after the global financial crisis, the dollar continues to maintain its status as the chief international currency. Possible alternatives such as the euro or renminbi lack the broad financial markets that the U.S. possesses, and in the case of China the financial openness that allows foreign investors to enter and exit at will. Any change in the dollar’s predominance, therefore, will likely occur in response to geopolitical factors.

Linda S. Goldberg and Robert Lerman of the Federal Reserve Bank of New York provide an update on the dollar’s various roles. The dollar remains the dominant reserve currency, with a 63% share of global foreign exchange reserves, and serves as the anchor currency for about 65% of those countries with fixed exchange rates. The dollar is also widely utilized for private international transactions. It is used for the invoicing of 40% of the imports of countries other than the U.S., and about half of all cross-border bank claims are denominated in dollars.

This wide use of the dollar gives the U.S. government the ability to fund an increasing debt burden at relatively low interest rates. Moreover, as pointed out by the New York Times, the Trump administration can enforce its sanctions on countries such as Iran and Venezuela because global banks cannot function without access to dollars. While European leaders resent this dependence, they have yet to evolve a financial system that could serve as a viable alternative.

The dollar’s continued predominance may also reflect other factors. Barry Eichengreen of UC-Berkeley and Arnaud J. Mehl and Livia Chitu of the European Central Bank have examined the effect of geopolitical factors—the “Mars hypothesis”—versus pecuniary factors—the “Mercury hypothesis”—in determining the currency composition of the international reserves of 19 countries during the period of 1890-1913. Official reserves during this time could be held in the form of British sterling, French francs, German marks, U.S. dollars and Dutch guilders.

The authors find evidence that both sets of factors played roles. For example, a military alliance between a reserve issuing country and one that held reserves would boost the share of the currency of the reserve issuer by almost 30% if there was a military alliance between these nations. They conjecture that the reserve issuer may have used security guarantees to obtain financing from the security-dependent nation, or to serve the role of financial center when the allied country needed to borrow internationally.

Eichengreen, Mehl and Chitu then use their parameter estimates to measure by how much the dollar share of the international reserves of nations that currently have security arrangements with the U.S. would fall if such arrangements no longer existed. South Korea, for example, currently holds 84% of its foreign reserves in dollars; this share would fall to 54% in the absence of its security alliance with the U.S. Similarly, the dollar component of German foreign exchange reserves would decline from 98% to 68%.

In previous eras, such calculations might be seen as interesting only for providing counterfactuals. But the Trump administration seems intent on cutting back on America’s foreign military commitments. The U.S. and Korea, for example, have not negotiated a renewal of the Special Measures Agreement to finance the placement of U.S. troops in Korea.  German Chancellor Angela Merkel has defended her country’s role in NATO in the face of criticism from President Trump that Germany must spend more on defense expenditures. The possibility of a pan-European army to serve as an alternative security guarantee is no longer seen as totally far-fetched.

The dollar may be safe from replacement on economic grounds. But the imminent shrinkage of the British financial sector due to the United Kingdom’s withdrawal from the European Union  shows that political decisions follow their own logic, sometimes without regard for the economic consequences. If the dollar lose some of its dominance, it may be because of self-inflicted wounds.

The Continuing Dominance of the Dollar

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Ten years after the global financial crisis, we are still coming to an understanding of how profound a shock it was. The changes in political alignments within and across nations and the diminished public support for globalization continue. But one aspect of the financial system has not changed: the dominance of the U.S. dollar in the monetary system.

An article by Fernando Eguren Martin, Mayukh Mukhopadhyay and Carlos van Hombeeck of the Bank of England in the BOE’s Quarterly Bulletin documents the different international roles of the dollar. First, it continues to be the main currency in central bank reserves, with a share of about 70% of total holdings. Second, the dollar is used as an invoicing currency for many international transactions, such as commodity sales. Third, firms outside the U.S. obtain funding through dollar-denominated bank loans and debts.

The use of the dollar for finance has also been examined by Iñaki Aldasoro and Torsten Ehlers of the Bank for International Settlements in an article in the BIS Quarterly Review. They report a rise in the use of international debt securities, driven primarily by dollar denominated debt issued by non-U.S. residents. The increase in such funding is particularly noticeable in emerging markets economies in Asia and Latin America. This debt includes sovereign bonds issued by governments that sought to lock in low interest rates.

What about the alternatives? A report on the international role of the euro issued by the European Central Bank acknowledges the primacy of the dollar. An index of the global status of the euro developed at the ECB shows a decline in the last fifteen years, which may have stabilized in the most recent year. This includes a fall in the euro’s share of international debt securities. The report also notes that the deleveraging of Eurozone banks as they built up their capital ratios led these banks to reduce their cross-border lending.

Why does the dollar continue to possess a hegemonic status a decade after the crisis that seemed to signal an end to U.S.-U.K. dominated finance? Gillian Tett of the Financial Times offers several reasons. The first is the global reach of U.S. based banks. U.S. banks are seen as stable, particularly when compared to European banks. Any listing of the largest international banks will be dominated by Chinese banks, and these institutions have expanded their international business.  But the Chinese banks will conduct business in dollars when necessary. Tett’s second reason is the relative strength of the U.S. economy, which grew at a 4.1% pace in the second quarter. The third reason is the liquidity and credibility of U.S. financial markets, which are superior to those of any rivals.

The U.S. benefits from its financial dominance in several ways. Jeff Sachs of Columbia University points out that the cost of financing government deficits is lower due to the acceptance of U.S. Treasury securities as “riskless assets.” U.S. banks and other institutions earn profits on their foreign operations. In addition, the use of our banking network for international transactions provides the U.S. government with a powerful foreign policy tool in the form of sanctions that exclude foreign individuals, firms or governments from this network.

There are risks to the system with this dependence. As U.S. interest rates continue to rise, loans that seemed reasonable before now become harder to finance. The burden of dollar-denominated debt also increases as the dollar appreciates. These developments exacerbate the repercussions of policy mistakes in Argentina and Turkey, but also affect other countries as well.

The IMF in its latest Global Financial Stability (see also here) identifies another potential destabilizing feature of the current system. The IMF reports that the U.S. dollar balance sheets of non-U.S. banks show a reliance on short-term or wholesale funding. This reliance leaves the banks vulnerable to a liquidity freeze. The IMF is particularly concerned about the use of foreign exchange swaps, as swap markets can be quite volatile. While central banks have stablished their own network of swap lines, these have been criticized.

The status of the dollar as the primary international currency is not welcomed by foreign governments. The Russian government, for example, is seeking to use other currencies for its international commerce. China and Turkey have offered some support, but China is invested in promoting the use of its own currency. In addition, Russia’s dependence on its oil exports will keep it tied to the dollar.

But interest in formulating a new international payments system has now spread outside of Russia and China. Germany’s Foreign Minister Heiko Maas has called for the establishment of “U.S. independent payment channels” that would allow European firms to continue to deal with Iran despite the U.S. sanctions on that country. Chinese electronic payments systems are being used in Europe and the U.S. The dollar may not be replaced, but it may have to share its role as an international currency with other forms of payment if foreign nations calculate that the benefits of a new system outweigh its cost. Until now that calculation has always favored the dollar, but the reassessment of globalization initiated by the Trump administration may have lead to unexpected consequences.

The Spillover Effects of Rising U.S. Interest Rates

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U.S. interest rates have been rising, and most likely will continue to do so. The target level of the Federal Funds rate, currently at 1.75%, is expected to be raised at the June meeting of the Federal Open Market Committee. The yield on 10-year U.S. Treasury bonds rose above 3%, then fell as fears of Italy breaking out the Eurozone flared. That decline is likely to be reversed while the new government enjoys a (very brief) honeymoon period. What are the effects on foreign economies of the higher rates in the U.S.?

One channel of transmission will be through higher interest rates abroad. Several papers from economists at the Bank for International Settlements have documented this phenomenon. For example, Előd Takáts and Abraham Vela of the Bank for International Settlements in a 2014 BIS Paper investigated the effect of a rise in the Federal Funds rate on foreign policy rates in 20 emerging market countries, and found evidence of a significant impact on the foreign rates. They did a similar analysis for 5-year rates and found comparable results. Boris Hofmann and Takáts also undertook an analysis of interest rate linkages with U.S. rates in 30 emerging market and small advanced economies, and again found that the U.S. rates affected the corresponding rates in the foreign economies. Finally, Peter Hördahl, Jhuvesh Sobrun and Philip Turner attribute the declines in long-term rates after the global financial crisis to the fall in the term premium in the ten-year U.S. Treasury rate.

The spillover effects of higher interest rates in the U.S., however, extend beyond higher foreign rates. In a new paper, Matteo Iacoviello and Gaston Navarro of the Federal Reserve Board investigate the impact of higher U.S. interest rates on the economies of 50 advanced and emerging market economies. They report that monetary tightening in the U.S. leads to a decline in foreign GDP, with a larger decline found in the emerging market economies in the sample. When they investigate the channels of transmission, they differentiate among an exchange rate channel, where the impact depends on whether or not a country pegs to the dollar; a trade channel, based on the U.S. demand for foreign goods; and a financial channel that reflects the linkage of U.S. rates with the prices of foreign assets and liabilities. They find that the exchange rate and trade channels are very important for the advanced economies, whereas the financial channel is significant for the emerging market countries.

Robin Koepke, formerly of the Institute of International Finance and now at the IMF, has examined the role of U.S. monetary policy tightening in precipitating financial crises in the emerging market countries. His results indicated that there are three factors that raise the probability of a crisis: first, the Federal Funds rate is above its natural level; second, the rate increase takes place during a policy tightening cycle; and third, the tightening is faster than expected by market participants. The strongest effects were found for currency crises, followed by banking crises.

According to the trilemma, policymakers should have options that allow them to regain monetary control. Flexible exchange rates can act as a buffer against external shocks. But foreign policymakers may resist the depreciation of the domestic currency that follows a rise in U.S. interest rates. The resulting increase in import prices can trigger higher inflation, particularly if wages are indexed. This is not a concern in the current environment. But the depreciation also raises the domestic value of debt denominated in foreign currencies, and many firms in emerging markets took advantage of the previous low interest rate regime to issue such debt. Now the combination of higher refinancing costs and exchange rate depreciation is making that debt much less attractive, and some central banks are raising their own rates to slow the deprecation (see, for example, here and here and here).

Dani Rodrik of the Kennedy School and Arvin Subramanian, currently Chief Economic Advisor to the Government of India, however, have little sympathy for policymakers who complain about the actions of the Federal Reserve. As they point out, “Many large emerging-market countries have consciously and enthusiastically embraced financial globalization…there were no domestic compulsions forcing these countries to so ardently woo foreign capital.” They go on to cite the example of China, which “…has chosen to insulate itself from foreign capital and has correspondingly been less affected by the vagaries of Fed actions…”

It may be difficult for a small economy to wall itself off from capital flows. Growing businesses will seek new sources of finance, and domestic residents will want to diversify their portfolios with foreign assets. The dollar has a predominant role in the global financial system, and it would be difficult to escape the spillover effects of its policies. But those who lend or borrow in foreign markets should realize, as one famed former student of the London School of Economics warned, that they play with fire.

Not All Global Currencies Are The Same

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The dollar may be the world’s main global currency, but it does not serve in that capacity alone. The euro has served as an alternative since its introduction in 1999, when it took the place of the Deutschemark and the other European currencies that had also been used for that purpose. Will the renminbi become the next viable alternative?

A new volume, How Global Currencies Work: Past, Present and Future by Barry Eichengreen of the University of California-Berkeley and Arnaud Mehl and Livia Chiţu of the European Central Bank examines the record of the use of national currencies outside their borders. The authors point out that regimes of multiple global currencies have been the norm rather than an exception. Central banks held reserves in German marks and French francs as well as British sterling during the period of British hegemony, while the dollar became an alternative to sterling in the 1920s. The authors foresee an increased use of China’s renminbi and “..a future in which several national currencies will serve as units of account, means of payments, and stores of value for transactions across borders.”

Camilo E. Tovar and Tania Mohd Nor of the IMF examine the use of the reminbi as a global currency in a IMF working paper, “Reserve Currency Blocs: A Changing International Monetary System.” They claim that the international monetary system has transitioned for a bi-polar one based on the dollar and the euro to a tri-polar system that also includes the renminbi. They provide estimates of a dollar bloc equal in value to 40% of global GDP that is complemented by a renminbi bloc valued at 30% of global GDP and a euro bloc worth 20% of world output. The renminbi bloc, however, is not primarily Asian, but rather dominated by the BRICS countries (Brazil, Russia, India, China, South Africa). This suggests that its increased use may be due to geopolitical reasons rather than widespread regional use.

If relative size is a driving factor in the adoption of a currency for international transactions, then an increasing role for the renminbi is inevitable. But the dollar will continue to be the principal currency for many years to come. Ethan Ilzetzki of the London School of Economics, Carmen Reinhart of Harvard’s Kennedy School and Kenneth Rogoff of Harvard examine the predominance of the dollar in a NBER working paper, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” They show that the dollar is far ahead of other currencies in terms of trade invoicing , foreign exchange trading, and most other measures.

The U.S. also holds a dominant role in international financial flows. Sarah Bauerle Danzman and W. Kindred Winecoff of Indiana University Bloomington have written about the reasons for what they call U.S. “financial hegemony” (see also their paper with Thomas Oatley of the University of North Carolina-Chapel Hill and Andrew Penncok of the University of Virginia). They point to the central role of the U.S. financial system in the network of international financial relationships. They claim that the financial crisis of 2008-09 actually reinforced the pivotal position of the U.S., in part due to the policies undertaken by U.S. policymakers at that time to stabilize financial markets and institutions. This included the provision by the Federal Reserve of swap lines to foreign central banks in countries where domestic banks had borrowed dollars to invest in U.S. mortgage-backed securities. (Andrew Tooze provides an account of the Federal Reserve’s activities during the crisis.)

The central position of the U.S., moreover, evolved over time, and reflects a number of attributes of the U.S. economy and its governance. Andrew Sobel of Washington University examined the features that support economic hegemony in Birth of Hegemony. He cites Charles Kindleberger’s claim of the need for national leadership in order to forestall or at least offset international downturns, such as occurred during the depression (see The World in Depression 1929-1939). Kindleberger specifically referred to the need for international liquidity and the coordination of macroeconomic policies by a nation exercising economic leadership.

Sobel, drawing upon the history of the Netherlands, Great Britain and the U.S., maintains that the countries that have provided these collective goods have possessed public and private arrangements that allowed them to provide such leadership. The former include adherence to the rule of law, a fair tax system and effective public debt markets. Among the private attributes are large and liquid capital markets and openness to foreign capital flows. Sobel shows that these features evolved in the historical cases he examines in response to national developments that did not occur in other countries that might have been alternative financial hegemons (such as France).

Will a new dominant financial hegemon appear to take the place of the U.S.? It is difficult to see the European Union or China assuming that role in the short- or medium-term. European leaders are dealing with disagreements over the nature of their union and the discontent of their voters, while China is establishing its own path. (See Milanovic on this topic.) U.S. financial institutions are dedicated to preserving their interests, and not likely to surrender their predominance. It would take a major shock, therefore, to current arrangements to upend the existing network of financial relationships. But we now live in a world where such things could happen.

The Changing Fortunes of the Renminbi and the Dollar

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Last fall the International Monetary Fund announced that China’s currency, the renminbi, would be included in the basket of currencies that determine the value of the IMF’s reserve asset, the Special Drawing Right (SDR). The IMF’s statement appeared to confirm the rise in the status of the currency that could at some point serve as an alternative to the U.S. dollar as a global reserve currency. But in retrospect the renminbi is a long way from achieving widespread use outside its regional trading partners, and recent policies will only limit the international use of the currency.

It has been widely speculated that the drive to include the renminbi in the IMF’s currency basket was a tool by reformers such as People’s Bank of China governor Zhou Xiaochuan to move their country towards a more liberal economic regime. The SDR currencies are supposed to be “freely usable” by foreign and domestic investors, so capital controls were eased in the run-up to the SDR announcement. But Chinese authorities are loath to give up their ability to control foreign transactions.

This has become particularly true as a result of China’s recent capital outflows. These have in part reflected outward foreign direct investment by Chinese firms seeking to expand. But the outflows are also due to Chinese firms and individuals moving money outside their country. These movements both reflect and contribute to a continuing depreciation of the renminbi, particularly against the dollar. Chinese authorities have burned through almost $1 trillion of their $4 trillion in foreign exchange reserves as they sought to slow the slide in the value of their currency.

To reduce pressure on the renminbi, the authorities are imposing controls on the overseas use of its currency. But these regulations to protect the value of the currency reduce the appeal of holding the renminbi. As Christopher Balding of the HSBC Business School in Shenzhen points out, monetary authorities can not control the exchange rate and the money supply while allowing unregulated capital flows.

Even if the authorities manage to weather the effects of capital outflows, the long-term prospects of the renminbi becoming a major reserve currency are limited. Eswar Prasad of Cornell University has written about the role of the renminbi in the international monetary system in Gaining Currency: The Rise of the Renminbi. After reviewing the extraordinary growth of the Chinese economy and the increased use of the renmimbi, Prasad evaluates China on the criteria he believes determine whether it will graduate to the status of a global currency. China had until recently been removing capital controls and allowing the exchange rate to become more flexible, benchmarks followed by foreign investors. Its public debt is relatively low, so there are no fears of sovereign debt becoming unmanageable or inflation getting out of hand.

On the other hand, the rise in total debt to GDP to 250% has drawn concerns about the stability of the financial sector. This is troubling, because as Prasad points out, this is the area of China’s greatest weakness. This vulnerability reflects not only on the increasing amount of private debt but also precarious business loans on the books of the banks, the growth of the shadow banking system and stock market volatility. Prasad writes: “China’s financial markets have become large, but they are highly volatile, poorly regulated, and lack a supporting institutional framework.” This is crucial, since ”… financial market development is likely, ultimately, to determine winners and losers in the global reserve currency sweepstakes.”

The growth in the use of renminbi has not eroded the primacy of the dollar in the international monetary system.. An investigation by Benjamin J. Cohen of UC-Santa Barbara and Tabitha M. Benney of the University of Utah of the degree of concentration in the system indicates that there is little evidence of increased competition among currencies. The dollar is widely used as a vehicle currency for private foreign exchange trading and cross-border investments, as well as for official holdings of reserves. Expectations for the euro have been scaled back as the Eurozone area struggles with its own long-term stability.

Carla Norrlof of the University of Toronto examines the sources of the dominance of the dollar. She investigates the factors that contribute to “monetary capability,” the resources base necessary for exercising currency influence. These include GDP, trade flows, the size and openness of capital markets, and defense expenditures. Norrlof’s empirical analysis leads her to confirm the status of the U.S. as the monetary hegemon: “The United States is peerless in terms of monetary capability, military power and currency influence.”

Cohen and Benney stress that their analysis holds for the current system, which could change. What could undermine the status of the dollar? Benjamin Cohen worries that President-elect Trump’s policies may increase the government’s debt and restrict trade, and possibly capital flows as well. These measures need not immediately demolish the role of the dollar. But Cohen writes, “…the dollar could succumb to a long, slow bleeding out, as America’s financial rivals try to make their own currencies more attractive and accessible.”

The renminbi, therefore, does not represent any short-term threat to the dollar’s place in the international monetary system. But the U.S. itself could undermine that status, and a potential opening may spur Chinese efforts to establish a firmer basis for the use of its currency, just as it has done in international trade in the wake of the demise of the Trans-Pacific pact. The transition could take decades, and during that period the global system could disintegrate into regional alliances that encourage unstable trade and financial flows. Those in the U.S. who voted for change may rue the consequences of President-elect Trump’s efforts to deliver on that electoral promise.