The World Needs More Reserve Currencies

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About the author: Christopher Smart is chief global strategist and head of the Barings Investment Institute, and is a former senior economic policy official at the U.S. Treasury and the White House.

The mighty dollar shows some signs of flagging amid hope the Fed’s hikes will end soon, but resentment still abounds. With the world’s reserve currency still nearly 12% stronger than a basket of its major counterparts since last spring, the questions are hard to avoid. Why should America force its monetary policy on everyone else? Wouldn’t the world be better with more than just 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 had somehow managed to flourish across the global economy. But in light of current political trends that seem to bolster autocrats, that day is not coming soon and we are likely stuck with dollar dominance for a very long time.

The current configuration of global currency markets does, in fact, carry key advantages. For the United States, these include lower borrowing costs, powerful enforcement tools through financial sanctions, and a small amount of “seigniorage” revenue on what amounts to an interest-free loan from foreigners holding dollar cash.

But there are advantages for other countries, too. Above all, the dollar offers a reliable store of value, whether as U.S. Treasuries in a multinational’s corporate account or a roll of cash in a family’s coffee can. A dominant currency facilitates trade across many jurisdictions with a common unit of account. And when crisis strikes, the U.S. Federal Reserve stands ready as the lender of last resort to ease liquidity in key jurisdictions. 

Of course, there are plenty of disadvantages. U.S. financial instability is almost instantaneously transmitted to the rest of the world, as the collapse of Lehman Brothers illustrated. In times of dollar strength, dollar debt is suddenly more expensive to repay from local currency earnings. Commodities prices denominated in dollars make food and energy imports even more inflationary. Emerging market central banks are also being forced to hike rates and deepen their own downturn just to stem financial outflows. And, adding insult to injury, no one wants to be caught on the wrong side of U.S. sanctions, which seem to multiply by the year.

So as a thought experiment, imagine a world with several reserve currencies. Assume the world’s central banks diversify their reserves across 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 parts 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 greater diversity of holdings, reserve values would be much less sensitive to bilateral foreign exchange movements. 

This scenario has a ring of Europe in the 1930s, when England, France, and America each used their dominant currencies to gain a narrow advantage over the other, ultimately leading to depression and war. But those currencies relied on a peg to gold. Today’s dominant currency no longer does. Importantly, it depends on the political and institutional credibility of the issuer. The dollar has been desirable long after it ceased being even theoretically convertible to a precious metal because the U.S. economy is considered resilient, its democratic institutions are viewed as durable, and its legal and regulatory framework are deemed fair.

The euro is clearly well on its way to serving a similar function after just 20 years in circulation. The main obstacle to the euro is capital markets that are not integrated enough and the absence of enough jointly guaranteed debt to create a reliable safe asset. But that will come. A more open Japanese economy would create similar opportunities for the yen. China, India, and Brazil all have much longer journeys on the road to political and regulatory development.

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

That is the good news. The even better news is that the reforms required 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 they will not come quickly. Indeed, the immediate future looks more like economies falling into competing political and trading blocs, which will only make their currencies less appealing as reserve assets. We will be living with a dominant dollar for many years to come.

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