As we head into a more multipolar monetary and financial system, central banks in both developed and emerging markets will have greater range of reserve assets to choose from.
For much of the last century, the US dollar has occupied a unique place in the global financial system. The immense size of the American economy, combined with the preeminent status that its currency enjoys in international trade and investment, means that the country can provide the rest of the world with a limitless amount of reserve assets. But monetary authorities may not be able to rely so much on US dollar-denominated assets in the future.
“The current dollar-centric system cannot continue forever,” said Barry Eichengreen, Professor of Economics and Political Science, University of California, Berkeley. “A multipolar international monetary and financial system is coming, as the United States accounts for a declining share of the global economy.”
Prof. Eichengreen was speaking at HSBC’s flagship Global Emerging Markets Forum, where he discussed the various assets that could challenge the US dollar’s position as reserve asset of first choice.
It is a topic that is highly relevant to emerging market investors, as these rapidly growing economies will require enough reserve assets to support economic and financial stability.
The first set of candidates are pre-existing currencies associated with two of the world’s largest economies.
The euro is an obvious contender. The EU is forecast to account for 18.7 per cent of the world’s economy by the end of 2021 1, putting it on a par with the US. It is also a well-established reserve asset in its own right, with 20.5 per cent of the allocated reserves in euros, compared with 59.2 per cent for the US dollar 2. There are however, obstacles that will likely impede the eurozone’s currency from taking the US dollar’s leading position.
Prof. Eichengreen highlighted that the eurozone does not have a deep enough market of high-grade euro-denominated securities that can be held as reserves by central banks outside of the eurozone. Furthermore, many of the AAA-rated securities are held within the EU by local banks or have been purchased by the ECB. This leaves little left over for central banks in other parts of the world.
Beyond the euro, the other currency that has attracted attention as a potential reserve asset is China’s renminbi. Over the last decade, the Chinese currency has rapidly internationalised to become the world’s fifth most active currency for global payments 3.
As a reserve currency, it is currently far behind the US dollar, with only 2.6 per cent of the total held by central banks 4. There are expectations however, that this share will rise as the world’s second largest economy grows even larger.
Prof. Eichengreen pointed to a number of limitations for the renminbi. For a start, the currency is still subject to capital controls that restrict its free movement in and out of China. Over time, he said, these rules will gradually be relaxed.
The second set of potential contenders to the US dollar, are not fiat currencies like the euro or renminbi. Instead, they are assets that derive their value from something else.
Special Drawing Rights (SDRs) are a reserve asset created by the International Monetary Fund in 1969. SDRs are a basket of currencies – including the US dollar, euro and the renminbi – that represent an IMF member state’s claim to the underlying assets.
This unit of account for the IMF received a huge boost in 2021, when a general allocation equivalent to USD600 billion was approved to boost global liquidity during the pandemic 5.
Prof. Eichengreen says that the main obstacle for SDRs becoming the dominant reserve asset is that they are not used in trade or finance. There is little incentive for a central bank to hold SDRs as reserves because they cannot be used to provide liquidity for the private agents they oversee. Furthermore, there is no lender of last resort for SDRs that can backstop the market like the US Federal Reserve does in times of stress.
The final asset that Prof. Eichengreen considered were stablecoins – a relatively new cryptocurrency that pegs its market value to another asset. The single largest is Tether, which claims to be backed by US dollars, and has USD67.2 billion in circulation 6. There is a future scenario where stablecoins become used so widely in the future that central banks decide to hold them as reserves.
But are stablecoins as stable as their name suggests? “If they are only partially backed by US dollars, then they will be subject to the same speculative attacks that pegged currencies face,” he said. He also questioned whether governments would be willing to surrender control of currency matters to a non-government organisation.
Making sense of the multipolar world
If none of the above international assets look set to take the place of the US dollar, then perhaps its biggest threat is at home. Some believe that a multipolar financial system will arise due to a shock in the US that causes a migration away from its currency.
Prof. Eichengreen highlighted the latest debate on the debt ceiling. Although the cap on public borrowing has always been lifted just in time to avert a default, the failure of the US to pay its debt would dent its attractiveness as a reserve asset.
But instead of thinking of outright winners and losers in the reserve currency race, it makes sense think of the multipolar financial world as a more diverse future, where central banks hold a greater range of assets. This is especially true for emerging markets, where much of the demand for reserve assets will come from.
More euros, renminbi, and maybe even stablecoins will be held alongside a still popular US dollar. And since diversification is a fundamental risk management strategy, reserve managers should be looking forward to the coming monetary system.
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