First appeared at Policy Center for the New South
The heavy financial sanctions against Russia after the invasion of Ukraine sparked speculation that militarizing access to dollar, euro, pound and yen reserves would trigger a split in the international monetary order. China would tend to strengthen its own international payments system and accelerate the establishment of its currency – the renminbi – as a rival reserve currency in order to reduce its vulnerability to similar movements against it. Countries facing geopolitical risks in their relations with the United States and Europe would seize the opportunity to exit the dollar system. However, there is a way to go between wanting and doing in this case…
Last Thursday, the International Monetary Fund (IMF) published a study (Arslanalp et al., 2022) on the evolution of international reserves since the beginning of the century. The “dominance of the dollar” appears in its weight on world markets. The U.S. dollar’s share of foreign trade invoicing, international debt issuance and non-banking transactions is much higher than the country’s shares in international trade, international bond issuance and cross-border borrowing suggest. .
The dominance of the dollar has been maintained despite the decline in the share of US GDP in the global economy. From the 1970s, it survived the end of gold convertibility and the fixed exchange rate regime inherited from Bretton Woods. Its presence in banking and non-banking transactions even increased after the global financial crisis of 2007-08.
The IMF report shows a reduction in the degree of “dominance” with the dollar’s share of central bank reserves falling since the turn of the century, down 12 percentage points from 71% in 1999 to 59% Last year. Not in favor of the British pound, the Japanese yen or the euro – despite the rise the latter has seen in its first decade of existence (Figure 1). Instead, in favor of what the IMF’s work calls “non-traditional reserve currencies” (Australian dollar, Canadian dollar, Swiss and others), including the renminbi, which reached 2.6% of the total.
Figure 1. Currency composition of world foreign exchange reserves 1999–2021
Source: Arslanalp et al. (2022).
Note: The “other” category includes the Australian dollar, Canadian dollar, Chinese renminbi, Swiss franc and other currencies not separately identified in the COFER survey. China became a COFER reporter between 2015 and 2018.
Four gravitational factors favor the maintenance of the central position of the dollar in international financial markets, in commercial invoices and payments, and in public and private foreign exchange reserves – call it “network effects – complementarity and synergy”. The relative expansion of other currencies depends on their ability to compensate for these factors.
First, the larger installed base for dollar-denominated transactions favors the currency. Increased liquidity and reduced transaction costs in “non-traditional” foreign exchange markets – including platform technology improvements – have helped reduce this disadvantage.
Moreover, no other monetary system offers the volume of investment grade government bonds equivalent to that of the United States. This volume allows central banks to accumulate reserves and private investors to use them as a “safe haven”, which has been reinforced by “quantitative easing” since the global financial crisis. In this regard, the announcement made by the then President of the European Central Bank, Mário Draghi, during the euro crisis in 2012 – that he would do “whatever it takes” as liquidity provider of last resort for euro-denominated assets issued in the euro area – was important. Furthermore, the European Recovery Fund was created last year. The global supply of liquid and safe-haven assets that can be used as central bank reserves has tended to expand, in favor of the euro.
Third, it should also be noted that “non-traditional currencies” have been favored by a partial search for yield in the management of reserves. Central bank balance sheets – advanced and emerging economies – have taken on enormous proportions in recent times. Now, some of them separate what would be the appropriate tranche for “liquidity management” (the reason why there are reserves in liquid and low-risk assets, for the purpose of stabilization), from a another “investment tranche” (possibly allocated to less liquid but more profitable assets). The search for diversification has helped “non-traditional” reserves.
The fourth argument in favor of the dollar would be the absence of regulations restricting liquidity and the availability of assets, including capital controls. Despite the sanctions already applied in cases like Iran, Venezuela and Russia, there is a difficulty here for Chinese bonds compared to those in dollars and the other three major currencies.
Since the global financial crisis, China has sought to expand the use of the renminbi in international trade and as a reserve asset at other central banks. This was followed by a proliferation of currency swap lines with other countries.
However, as we have already noted here, while trade transactions and reserves of central banks and other global public investors may strengthen the renminbi’s position as an alternative currency to the dollar, euro, yen and pound sterling, the qualitative leap towards the internationalization of the Chinese currency as a reserve currency only occurs when confidence in its convertibility is sufficient to convince unofficial (private) investors to hold reserves denominated in it. It is no coincidence that the currency exchange lines with China have been little used, while those of the countries with the Federal Reserve were activated when necessary to stabilize flows.
The issuer of reserves must accept that large quantities of its currency circulate in the world and, therefore, that foreign investors have some say in determining long-term domestic interest rates and the exchange rate. By all indications, Chinese financial authorities do not appear to see the abandonment of controls as a priority on the immediate horizon. They will likely seek to expand the use of the renminbi to the extent that this can be done without giving up controls and, therefore, without the ambition of building a parallel regime or replacing the existing one.
In recent weeks, the flow of foreign portfolio capital into China illustrates the stakes and the potential costs for China of a hasty exit from the existing regime. The data disseminated by the Institute of International Finance (IIF) Last Thursday also revealed an unprecedented large outflow of portfolio capital (debt and equity) from China following the Russian invasion of Ukraine and sanctions. At the same time, these flows remained stable in the other emerging economies (Figure 2). The timing suggests that there was some correlation not with internal difficulties with the country’s real estate sector or other reasons, but rather with the war in Ukraine and the sanctions. We do not believe it is appropriate for China to issue any sign of abrupt exit from the system in which it currently operates, nor of possible collaboration with Russia to help the latter circumvent the sanctions imposed on it. .
Figure 2 – China sees large outflows, while rest of emerging markets hold up.
Source: IIR (2022).
The relative dominance of the dollar seems to be diminishing, but at a very gradual pace.
Otaviano Canuto, based in Washington, DC, is a Principal Investigator at Policy Center for the New South, lecturer in international affairs at the Elliott School of International Affairs – George Washington Universitynon-resident principal investigator at Brookings Institutionprofessor affiliated with UM6P, and principal at Center for Macroeconomics and Development. He is a former vice president and former executive director of the World Bank, former executive director of the International Monetary Fund and former vice president of the Inter-American Development Bank. He is also a former Deputy Minister of International Affairs at the Brazilian Ministry of Finance and a former Professor of Economics at the University of São Paulo and the University of Campinas, Brazil.