The dollar has no alternative. At least for now

The freezing of Russia’s foreign exchange reserves will have long-term and systemic consequences. The dominant role of the dollar as a reserve currency is unlikely to be affected.

No other country could provide the world with a large liquid government bond market and a fully open capital account. Sanctions may have a significant long-term effect on the demand for reserves. States can reduce their dependence on them by limiting their exposure to financial shocks and partially restricting the movement of capital. This, in turn, would lead to an evolution in the architecture of the international monetary system in which cross-border financial integration is reduced. Jean-Pierre Landau, former executive director of the International Monetary Fund and the World Bank.

The sanctions against Russia imposed after its invasion of Ukraine are unprecedented in scale and, above all, in scope. For the first time in recent history, foreign exchange reserves held by a large central bank have been frozen. The reactions of the Russian authorities show that this was completely unexpected on their part. The text below presents some views on the potential long-term and systemic implications in the context of geopolitical rivalry and growing “globalization”, at least in terms of financial transactions.

Sanctions and the dollar

The first question we will consider is whether the status of the dollar, as the dominant international currency, is at risk. The answer is no for three reasons:

First, the blocking of Russia’s foreign exchange reserves occurs in an unusual situation – during an armed conflict caused by the invasion carried out by a large country. No one would expect standard financial relationships and arrangements to be maintained in these circumstances. In situations such as Japan’s war in Asia in 1937, cross-border payments are blocked. Gold held by occupied or war-torn countries has not been handed over to the aggressor by the central banks that hold it. France and Britain refused to hand over their reserves to the Baltic-annexed Baltic states in 1940. These were extreme and rare circumstances.

All the actions taken by US governments in recent decades demonstrate their commitment to promoting and maintaining the dollar as a secure asset. Many Fed instruments aim to ensure liquidity in the public finance market – some are specifically designed for official foreign holders. The hidden state guarantee in favor of Fanni Mae and Freddie Mac (who serve as the main instrument for foreign exchange reserves) was reaffirmed when necessary. With the possible exception of the Trump administration, successive US financial secretaries have been adamant that “the strong dollar is in the interests of the United States.”

Last but not least, there is no attractive alternative to the US dollar and therefore there is no real tool for diversification. The power of the United States to impose sanctions stems directly from the central role of the dollar. For any international corporation or financial institution, life without dollars is impossible. Therefore, each of their operations potentially falls under US jurisdiction. Avoiding and opposing sanctions means finding alternatives to the dollar. So we return to an old and still very important question: are there any?

International old and new money

Money is related to scale and externalities. They affect in the form of network externalities – the more people accept a currency, the better it is as a medium of exchange; and as external effects of liquidity, true accumulation of value remains tradable and valuable when needed. In the current world economy, an important issue is a causal link between these two functions.

The dominant currency paradigm theory (Gita Gopinat – IMF Deputy Managing Director, and Eric Stein – Chief Investment Officer at Eaton Vance, 2021) attributes the dollar to a leading role in global payments and finance and its function as a currency for international financial flows. In the same vein, Professor Barry Eichengreen (a currency analyst and professor of economics and politics at the University of California, Berkeley) sees a logical sequence in the emergence of a world currency based on his analysis of interwar history: (1) invoicing and trade settlement, (2) use in private financial transactions (vehicle currency), (3) use by central banks as reserves.

If this sequence is still valid, there is a real possibility of alternative reserve currencies. China is a major world trading power. He has the leverage to insist on the use of his currency as a medium of exchange and a unit of account. Beijing can use its progress in the development of digital currencies. This scenario would allow mobile and online payment platforms Alipay and China’s telecommunications company Tencent to expand their international operations by gradually shifting their denomination from local currencies to yuan. China is the most advanced in developing the central bank’s digital currency. The introduction of e-yuan, which has already passed its pilot phase, is often interpreted as an offensive to promote its internationalization.

According to the opposite approach, the dominance of the dollar is due to its unique role as a means of preserving value, as the most secure asset. There is no other way to set aside several hundred billion with almost complete security and liquidity. This function is central to the financially globalized world, where both private and public entities must protect their liquidity. From this role as a means of preserving value derive other functions, reversing the causal relationship that may have been prevalent in other periods. As the dollar is a reserve asset, it is also convenient to use for invoicing and payments. It serves as a global unit of account. Significantly, 70% of Chinese officials’ overseas loans are still denominated in dollars and only 10% in yuan.

If we accept, as we believe, this second approach is correct, then there is no other money that would displace the dollar in the foreseeable future. The reserve currency certainly brings privileges and power. But there are also requirements that no other country can meet: a large and liquid treasury bond market (which Europe does not have now) and a fully and unconditionally open capital account (which China will not have). Localized exchange and barter agreements, such as those developed by China, may help, but will not relieve these two basic requirements.

A quick review of other possible alternatives confirms this diagnosis. Currencies such as the Australian dollar are mentioned as possible reserve instruments. Although fully open and accessible, the size of the Australian treasury bond market is only 2.5% of that of the United States.

There have been repeated attempts to turn special drawing rights into a real alternative to reserves, a course actively promoted by China since the global crisis. They are largely stagnant due to size and affordability (the possible use of special drawing rights is closely limited by design).

Some observers have highlighted the potential of cryptocurrencies, pointing to their role in channeling funds to Ukraine following the Russian invasion. However, they cannot process large-scale transactions (transactions to Ukraine are tens of millions of dollars a day). Despite some compelling technological features, cryptocurrencies are still far from important as reserves. Managers are aware of the peculiarities of these monetary systems. Their daily operation is based on initiatives and incentives of private operators, whose activities are purely voluntary and profit-driven. It is doubtful that they would entrust public reserves to groups of “miners” scattered around the world.

Globalization and the search for reserves

Sanctions are likely to have long-term effects – not on the composition, but the demand for reserves. The international monetary system can eventually be adjusted by moving to a new architecture, where financial integration is reduced and therefore the need for reserves is less.

Leaving aside the reciprocal relations between the United States and China – known to Larry Summers as the “financial balance of terrorism”, it is useful to look at the situation of other emerging countries. About twenty countries have foreign exchange reserves of more than $ 100 billion, most of the emerging economies. They are facing a new “tail risk” of sanctions – the likelihood is small but huge. We know that there is no way to diversify these risks. The only way to ensure is to reduce the exposure. In terms of climate, this means reducing emissions and concentrations of carbon dioxide to low levels, and emerging economies should reduce their dependence and need for foreign exchange reserves.

Until 2015, there has been a steady increase in foreign exchange reserves and a plateau since then. This evolution almost reflects (with a delay of several years) the trends in gross cross-border capital flows and international exposures, which expanded until 2010 and then stabilized as a result of the global crisis.

This is not accidental. The countries’ demand for reserves is a direct result of their financial integration with the world. The only exception is China. Reserves have traditionally been seen as a tool for managing the exchange rate, but they also play a greater role. In many emerging economies, the manufacturing and financial sectors are partially “dollarized”. As a consequence of the liberalization of the capital account, both corporate and financial institutions can borrow and lend in foreign currency. Therefore, they would face a mismatch of maturity and liquidity in dollars. Foreign reserves allow central banks in these countries to act as lenders of last resort in foreign currency and to protect internal and external financial stability. These policy choices can be reversed if and when reserves pose new risks. Financial globalization essentially stopped long before the invasion of Ukraine.

New forms of sanctions, even very rare ones, could lead to further retreat and segmentation of the global financial system. The consequences of them reveal a basic and forgotten truth: the movement toward greater financial globalization is supported by the long-term similarity of goals, standards, and understanding between countries. By providing (and taking advantage of) reserve currency by increasing it in times of crisis such as 2008 or 2020 through swap lines, the United States provides the world with a global public good – widespread access to a secure asset that can be used as a buffer. against financial shocks. Whether this balance can be maintained in a geopolitically divided world is a key question for the future.

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