Could the dollar lose its status as the key international currency for international trade and international financial transactions, and if so, what would be the principal contributing factors? Speculation about this issue has long been abundant, and views diverse. After the introduction of the euro, there was much public debate about the euro displacing the dollar (Frankel 2008). The monitoring and analysis included in the ECB’s reports on “The International Role of the Euro” (e.g. ECB 2013) show that the international use of the euro mainly progressed in the years prior to 2004, and that it has largely stalled since then. More recently, the euro has been displaced by the renminbi as the debate’s main contender for reducing the international role of the dollar (Frankel 2011).
This debate has mainly argued in terms of ‘traditional’ determinants of international currency status, such as country size, economic stability, openness to trade and capital flows, and the depth and liquidity of financial markets (Portes and Rey 1998). Considerations regarding the strength of country institutions have more recently been added to the list. All of these factors influence the ability of currencies to function as stores of value, to support liquidity, and to be accepted for international payments. Inertia also plays a role (e.g. Krugman 1984, Goldberg 2010), raising the bar for currencies that might uproot the status quo.
We argue here – building on discussions we began during the World Economic Forum Summit on the Global Agenda 2013 – that the rise in global financial-market integration implies an even broader set of drivers of the future roles of international currencies. In particular, we maintain that the set of drivers should include the institutional and regulatory frameworks for financial stability. The emphasis on financial stability is linked with the expanded awareness of governments and international investors of the importance of safety and liquidity of related reserve assets. For a currency to have international reserve status, the related assets must be useable with minimal transaction-price impact, and have relatively stable values in times of stress. If the risk of banking stress or failures is substantial, and the potential fiscal consequences are sizeable, the safety of sovereign assets is compromised exactly at times of financial stress, through the contingent fiscal liabilities related to systemic banking crises. Monies with reserve-currency status therefore need to be ones with low probabilities of twin sovereign and financial crises. Financial stability reforms can – alongside fiscal prudence – help protect the safety and liquidity of sovereign assets, and can hence play a crucial role for reserve-currency status.
The broader emphasis on financial stability also derives indirectly from the expanded awareness in the international community of the occasionally disruptive international spillovers of centre-country funding shocks (Rey 2013). We argue that regulatory reforms can play a role in influencing these spillovers. Resilience-enhancing financial regulation of global banks can help reduce the volatility of capital flows that are intermediated through such banks.
On financial stability and reserve-currency status
International reserve assets tend to be provided by sovereigns, notably due to the fiscal capacity of the state and the credibility of the lender of last resort function of the central bank during liquidity crises (see also De Grauwe 2011 and Gourinchas and Jeanne 2012). Systemic financial events can be accompanied by pressures on the government budget, however. While provision of a fiscal backstop to the banking sector is not the best ex ante approach to policy, fiscal support will tend to be forthcoming if the risk and estimated welfare costs of a systemic fallout are otherwise deemed too high. Yet, banking sector risks – and inadequate capacity within the banking sector to absorb these risks – can end up exceeding a government’s ability to provide a credible fiscal backstop without adversely affecting the safety of its sovereign assets. The fiscal consequences of bailouts may result in increased sovereign risk and the loss of safe-asset status, with implications for the status of the currency in question in the international monetary system.
To increase the likelihood that sovereign assets remain safe during systemic events, the sovereign can undertake financial and fiscal reforms that decouple the fiscal state of the sovereign from banking crises. Such reforms should achieve, in part, a reduction in the likelihood of and need for bailouts through increased resilience and loss absorption capacity of the financial system, and by ensuring sufficient fiscal space for credible financial-sector support (see also Obstfeld 2013).
A number of current reform initiatives already take steps in this direction. These include:
- Reforms to bank capital and liquidity regulation, which reduce the likelihood that financial institutions, and notably systemically important ones (SIFIs), become distressed;
- Initiatives that seek to counteract the procyclicality of leverage, and to strengthen oversight; and
- Recovery and resolution regimes for distressed systemically important financial institutions (SIFIs) are being improved.
Importantly, initiatives are underway to improve recovery and resolution in the international context. While a global agreement on cross-border bank resolution is currently not in place, bilateral agreements among some pairs of countries are being forged ex ante to facilitate lower-cost resolution ex post.
- Further, the resilience of the system as a whole is being strengthened, to better contain the systemic externalities of funding shocks. Examples include:The strengthening of the resilience of central counterparties and other financial market infrastructures; and
- The foreign-currency swap arrangements among central banks to provide access to foreign-currency funding liquidity at times when market prices of such liquidity are punishingly high.
Nevertheless, the financial system contains vulnerabilities – globally, as well as in individual currency areas. The negative sovereign-banking feedback loop may be weakened in many countries, but has not been fully severed. Moreover, reforms are not necessarily evenly implemented across countries. Fiscal capacities to provide credible backstops of the financial sector during stress vary widely. The consequences of recent reforms for the future of key international currencies are therefore open. Scope remains for countries vying for reserve-currency status to use the tool of financial stability reform to protect the safety and liquidity of their sovereign assets from the contingent liabilities of financial systemic risk.
Financial stability reforms matter for spillovers and capital flows
International capital flows yield many advantages to home and host countries alike. Yet the international monetary system still faces potential challenges stemming from unanticipated volatility in flows, as well as occasionally disruptive spillovers of shocks in centre-country funding conditions to the periphery. With the events around the collapse of Lehman Brothers, disruption in dollar-denominated wholesale funding markets led to retrenchment of international lending activities. Capital flows to some emerging-market economies then recovered with a vengeance as investors searched for yield outside the countries central to the international monetary system, where interest rates were maintained at the zero lower bound. After emerging markets were buoyed by the influx of funds, outflows and repositioning occurred when markets viewed some of the expansionary policies in the US as more likely to be unwound.
While macroprudential measures – and in extreme cases, capital controls – are some of the policy options available for addressing the currently intrinsic vulnerabilities of some capital-flow recipient periphery countries (IMF 2012), we point out that these vulnerabilities can also be addressed in part by financial stability reforms in centre countries. Consider, for example, the consequences of the regulatory reforms pertaining to international banks that are currently being proposed or implemented. Improvements in the underlying financial strength and loss-absorbing capacity of global banks could have the beneficial side-effect of reducing some of the negative spillovers associated with unanticipated volatility in international banking flows – especially those to emerging and developing economies. Empirical research suggests that better-capitalised financial institutions, and institutions with more stable funding sources and stronger liquidity management, adjust their balance sheets to a lesser degree when funding conditions tighten (Gambacorta and Mistrulli 2004, Kaplan and Minoiu 2013). The result extends to cross-border bank lending (Cetorelli and Goldberg 2011, Bruno and Shin 2013).
While financial stability reforms may reduce the externalities of centre-country funding conditions, they retain the features of international banking that promote efficient allocation of capital, risk sharing, and effective financial intermediation. By enhancing the stability of global institutions and reducing some of the amplitude of the volatility of international capital flows, they may address some of the objections to the destabilising features of the current system.
Cross-border capital flows that take place outside of the global banking system have recently increased relative to banking flows (Shin 2013). Regulation of global banks does very little to address such flows, and may even push more flows toward the unregulated sector. At the same time, however, regulators are considering non-bank and non-insurer financial institutions as potential global systemically important financial institutions (Financial Stability Board 2014).
We have argued that the policy and institutional frameworks for financial stability are important new determinants of the relative roles of currencies in the international monetary system. Financial stability reform enhances the safety of reserve assets, and may contribute indirectly to the stability of international capital flows. Of course, the ‘old’ drivers of reserve currencies continue to be influential. China’s progress in liberalising its capital account, and structural reforms to generate medium-term growth in the Eurozone – as examples of determinants of the future international roles of the renminbi and the euro relative to the US dollar – will continue to influence their international currency status. Our point is that such reforms will not be enough. The progress achieved on financial stability reforms in major currency areas will also greatly influence the future roles of their currencies.