This is the second installment of a series on global currencies. The first part details the forces eroding the U.S. dollar’s reserve status.
Half a century ago today, on August 15, 1971, U.S. President Richard Nixon took a momentous step.
After World War II, the U.S. had used its leverage as the last advanced economy standing to make the dollar the foundation of a global system of exchange rates. The postwar dollar was backed by huge gold reserves built up in part through American sales of munitions to Europe during the war. The system, known as Bretton Woods for the New Hampshire site of its enactment, played a key role in the reconstruction of devastated economies in Europe and Japan.
But by 1971, those recovering economies had become a threat to the gold-backed dollar. Rising exports from Europe and Japan eroded the U.S. share of global trade, reducing demand for American currency. Combined with excess U.S. spending, this convinced financial markets that the dollar was overvalued against its $35 per ounce gold peg. Starting in the 1960s, dollars were redeemed for gold at a faster and faster clip, a “gold run” motivated by the belief that the dollar’s peg might break, leaving dollar holders short.
Finally, 50 years ago, Richard Nixon suspended dollar redemptions for gold. Though the process took a few more years to play out, this effectively ended the gold standard and the fixed Bretton Woods exchange system that relied on it.
The significance of this moment is arguably exaggerated in the sweep of financial history – the “gold standard” that Nixon ended had lasted less than three decades, under extremely unusual circumstances. In its place eventually came the relatively free-floating exchange rates we know today, in which the relative value of currencies changes based broadly on the economic clout and political stability of the issuing nation.
As it happened, despite the rise of Europe and Japan, this new currency regime still favored the (now unbacked) U.S. dollar. For the half-century since, it has remained the dominant currency for global trade, and the overwhelming choice of foreign central banks looking for a stable store of value. As we discussed in the first installment of this series, this has given the U.S. a variety of economic and political advantages, often referred to as the dollar’s “exorbitant privilege.”
But now, the status quo of dollar dominance is eroding. Post-pandemic inflation has reignited worries about the dollar’s declining reserve status, but it’s a much longer-term trend: In May, the dollar’s share of central bank reserves fell to a 25-year low of 59%.
The dollar’s lost share has been taken up in large part by growth in reserves held as euros, Japanese yen, and Chinese yuan. There’s also another competitor, though it’s still just a glimmer on the horizon: Crypto advocates have long argued that bitcoin or another digital asset could serve as a global reserve currency, and recently much more mainstream figures, including the former head of the Bank of England, have supported the idea of a supranational digital reserve instrument.
Reserve status is not a winner-take-all competition. The circumstances that led to nearly a century of dollar dominance were an anomaly, and experts generally don’t expect any single currency or instrument to become similarly dominant in the 21st century.
But which of the candidates have the best chance of stealing significant reserve market share from the dollar – along with a share of the power and privilege that come with it?
The euro has many huge advantages as a potential global reserve currency. Despite a legacy of economic mismanagement by a few member states like Greece and Spain, the Eurozone is by and large made up of healthy, well-regulated economies, with a total GDP slightly higher than China’s. And while the European Central Bank is certainly not without its flaws, it is generally governed in a steady and fairly predictable manner. It has also weathered one truly terrifying crisis in 2010, managing to pull together a bailout package and ward off the euro’s dissolution, considered a real possibility at the time.
So it’s no surprise the euro is already the world’s second-biggest reserve currency, with roughly €2.5 trillion ($2.94 trillion) in central banks globally.
But there are barriers to further growth in euro reserves.The biggest of these is not economic, but political. Power over interest rates and other aspects of euro monetary policy is in the hands of the Governing Council of the European Central Bank, which is made up of a six-member Executive Board and the governors of all 19 Eurozone central banks. That means major conflicts between member states on monetary policy could lead to governance gridlock or breakdown, which creates risk relative to the more unitary U.S. Fed.
Another problem for the euro’s reserve currency potential, according to Stanford economist Darrell Duffie, is that the European Central Bank for many years did not issue Europe-wide bonds. The central banks of member states issue euro-denominated bonds, but they don’t mirror the strengths and weaknesses of the Eurozone as a whole. Each country’s bonds have their own independent yields, for instance. That adds to the complexity and risk of using them as reserves. Bonds, rather than currency, make up the bulk of international central bank reserves, so the lack of true “euro bonds” has constrained the euro’s reserve role.
This situation changed during the pandemic, however. The European Union announced last October that it would begin the first large-scale issuance of Europe-wide debt to fund pandemic relief. The bonds have been generally well-received by markets, and the European Commission plans to borrow 900 billion euros ($1.06 trillion) over the next five years. Though the bonds will go to a variety of buyers, that’s enough to significantly displace dollar-denominated bonds in central banks, which currently total close to $7 trillion.
More importantly, the issuance sets a precedent. “Whether there will be a lot more of them or not is hard to foresee,” says Duffie. “But because this kind of breaks the ice, it may mean there’s more in the future.” That wouldn’t simply add assets to the market for reserves – Duffie argues that shared debt issuance would increase European political cohesion, reinforcing the utility of the bonds as stores of value.
(A note: Despite its past glories, the British pound is not generally part of the discussion of reserve shifts, in part because of the U.K.’s relatively small economy – one fifth the size of China’s and half the size of Japan’s.)
The situation of the yen is maybe the most counterintuitive when it comes to reserve status, and it casts crucial light on the challenges facing China’s yuan. Broadly, despite its economic strength, Japan’s financial system still has certain isolationist tendencies rooted in its export-driven postwar rebuilding strategy. Above all, most Japanese debt is held domestically, limiting the available supply of yen-denominated reserves.
“It’s never been Japan’s ambition” to have a global reserve currency, says Alicia Garcia-Herrero, Chief Economist for Asia-Pacific at investment bank Natixis. “If you have a current accounts surplus, like Germany and Japan, you don’t need an international reserve currency, because you don’t have anything to finance. You buy assets.”
In other words, if a nation is a net exporter, it may simply not have enough international debts for its bonds to serve as global reserves. Japan’s high domestic savings rate, which has averaged a stunning 30% over the last 40 years, also means there’s huge demand for government bonds at home.
It’s a strange insight when turned back on the dollar: one reason USD is a dominant reserve currency is because Americans can’t seem to live within their means.
The yuan is something of a boogeyman of the dollar these days – a threat looming just offstage, more rumor than light.
China has been trying to make its currency appealing as a global reserve and trading instrument for at least a decade, and as the world’s second-largest economy, it’s got the muscle. The push for reserve status has included creating offshore bond markets in Hong Kong, a troubled attempt to balance global yuan flows with the CCP’s desire for domestic capital controls. More recently, some observers argue China’s “digital yuan” project is an attempt to gain a technological edge that would increase the yuan’s share of trade transactions and, in turn, its viability as a reserve.
But these efforts face an array of challenges so great that most experts don’t foresee the yuan succeeding as a reserve currency any time soon.
One major obstacle is a global lack of faith in Chinese political stability and rule of law, which was highlighted recently by a sudden, broad crackdown on financial technology by the ruling Chinese Communist Party. Bitcoin miners were caught in that net, but the crackdown also crashed big portions of the Chinese stock market, as well as Chinese stocks listed abroad. That included some companies, such as Luckin Coffee, that were found to be engaging in large-scale accounting fraud.
This led Joseph Sullivan, an economist on Donald Trump’s White House Council of Economic Advisers, to call the CCP an unwitting ally to the dollar’s reserve status. Such interventions and collapses cast doubt on China’s commitment to free markets, its regulatory rigor and, in turn, the fundamental strength of the Chinese economy. The potential consequences are fresh in the memory of the finance industry: a similar stock market crash in June of 2015 was quickly followed by China’s central bank devaluing the yuan to boost export competitiveness.
This all stems from a likely irresolvable conundrum at the heart of China’s…