Ad susceptum perficiendum
As the global monetary system is entering into a period of transformation, there is increasing realization in the global financial community of its potential benefits and pitfalls. Along with the widening recognition of the short-comings of the dollar-centered system, there is also the concern regarding the possibility of excessive fragmentation in the international monetary system in case a rising number of national currencies were to be used in international transactions. If the two extremes – the over-centralization and the excessive fragmentation – are to be avoided, is there a “middle ground”, a “juste-milieu” that could serve as a basis for a more diverse but at the same time stable and reliable international monetary system?
One way to look at the potential pathways to the transformation of the international monetary system is to evaluate this process through the prism of the system’s de-monopolization away from the dominance of the US dollar. What appears to be shaping up is a range of scenarios:
- Continued dollar monopoly: a dollar-centered system, with yuan making some inroads but proving to be unsuccessful in undermining the dollar’s hegemony
- A dollar-yuan “duopoly”: the yuan makes headway (mostly within the Global South), with the developing world shifting from dollar dependency towards sizeable reliance on the yuan
- A fragmented system of national currencies (competitive scenario): the undermining of dollar monopoly gives rise to an excessive degree of fragmentation associated with the use of national currencies of a wide array of economies
- A set of regional currencies (“oligopoly”): regional currencies, including a BRICS reserve currency, complementing the dollar and the yuan as potential reserve currencies
The truth of the matter is that all these scenarios that stray away from the status quo of dollar dominance have their caveats. The emergence of new regional currencies may take time and this scenario is unlikely to be a short-term option. A fragmented world of multiple reserve currencies does not appear to be sustainable – as currencies with small shares of the underlying economies in the global economy are unlikely to attain reserve status. Admittedly, it may be expected that after a protracted period of over-centralization in the global monetary system marked by the preponderance of the US dollar there may be a period of “overshooting” in the de-centralization process, whereby the use of numerous national currencies in international transactions instead of the dollar causes excessive fragmentation in the currency space. As the total pie of potential de-dollarization is enormous given the extremely high share of the greenback in cross-border financial flows, many countries will seek to advance their own currencies in international transactions. The problem with this excessive fragmentation, however, will be higher transactions costs and an environment that may be seen by businesses as being more uncertain and cumbersome. There are also issues with the “yuan ascendancy” scenario as it is unlikely to deliver enough optionality for EM and may result in a dollar dependency being replaced by a greater reliance on the yuan.
Despite these caveats, as the dollar’s “exorbitant privilege” gets undermined, its share in global international reserves is set to decline in line with new political realities and economic exigencies. Which of the above de-dollarization scenarios will drive the transformation of the global monetary system will be determined by the economic balance of power in the world economy. In the long run the market structure of global reserve currencies is likely to be determined by countries’ and regions’ economic fundamentals, including their share in global GDP, exports/imports and scale of investment flows. Countries may opt to store a given currency in reserves if it accounts for a notable share of their trade and investment transactions – if this is the case then economic weight/size does matter in the market for reserve currencies.
If the share of national currencies in global reserves is to gravitate in the long term towards the shares of the respective countries in global GDP or trade and trans-border investment, then what we may expect is a reduction in the US reserve share from nearly 60% closer to 25-30% (or even less if the US share in global GDP declines and/or if more weight is ascribed to the share in global FDI and trade), while the share of the Chinese yuan may rise from less than 3% of the global reserves to more than 10% of the total. Parts of the residual 20-25% of the de-dollarization in global reserves may benefit the euro as well as (to a lesser degree) some of the other reserve currencies of the developed world. Other potential beneficiaries may include gold as well as the IMF’s SDRs. There may also be room for the regional and trans-regional currencies from the Global South once they are formed – the economic weight of member countries represented by such currencies will need to be significant in order to attain reserve currency status. A possible long-term trend may then be the rise of regional currencies as the leading reserve asset holdings for the world’s central banks.
The above de-composition of relative shares of reserve currencies in the global economy appears to point in the direction of an “oligopolistic” scenario, characterized by a “peaceful co-existence” of the Western reserve currencies, including the dollar and the euro, as well as an array of “new reserve currencies” coming from the Global South. The latter apart from China’s yuan may include regional currencies that overcome the fragmentation effects of the growing use of national currencies in international transactions. The role of currency baskets such as the BRICS currency basket – widely referred to as R5/R5+ (all BRICS currencies start with a letter “R”) – may prove to be crucial in catalyzing the process of global reserve de-dollarization.
Such a scenario associated with the emergence of new currency reserve alternatives from the developing world is also likely to attain the highest degree of de-dollarization compared to other scenarios referred to earlier. Most likely a high degree of fragmentation in the use of national currencies in international transactions will leave the position of the dollar largely uncontested. There may be somewhat more headway achieved by the yuan, though a potential duopoly would leave the position of the yuan subject to pressure from the US and the West more broadly. The yuan by itself is unlikely to alter the monetary system in a qualitative way – it needs other countries and currency unions to “break the ice”. It appears then, that a breakthrough in de-dollarization can only come from a combination of regional currencies or a platform that brings together the largest emerging markets, such as the BRICS-plus R5+ platform. Ex Uno Plures.