09 July 2018

How Global Currencies Work - Past, Present and Future

Barry Eichengreen, Arnaud Mehl and Livia Chitu
250 pages,
ISBN 9780691177007

Reviewer: William A Allen, National Institute of Economic & Social Research

What qualifies a national currency to be accepted as an international reserve currency? How many international reserve currencies can co-exist? In what ways is one international reserve currency supplanted by another? Barry Eichengreen, Arnaud Mehl and Livia Chitu address these questions by reference to history, and speculate about the future.

They challenge an ‘old view’ that a dominant reserve currency will drive out all competitors, owing to network effects, with a ‘new view’ that the world can accommodate several reserve currencies at the same time. It’s pretty obvious that the ‘new view’ reflects the present situation: the dollar accounts for only 63% of those foreign exchange reserves whose currency denomination the IMF has identified; the euro accounts for a further 20%. The authors expect the ‘new view’ to continue to prevail: ‘For the modern-day foreign exchange market, this twenty-first century picture of low costs of information, transactions and coordination is clearly more plausible than the traditional assumption of high switching costs and costly information’. Network effects still exist, but they are less powerful.

Stunning advances in information technology have indeed irreversibly reduced the costs of information, and some of the costs of transacting in foreign exchange. Yet the costs of transacting include the costs of inducing a dealer to take on the risks of holding the position that the transactor wants to sell. There is no reason to think that those risk-related costs have fallen at all. What’s more, recent empirical work has shown that bid-offer spreads in foreign exchange are highly variable, and that they widened spectacularly during the recent financial crisis. The assumption that transaction costs will always be low is an unreliable foundation for a decision about which currencies to hold in one’s reserves.

The book includes a fascinating account of how the dollar supplanted sterling as the leading reserve currency. The authors cite information that they have assembled about the currency composition of seventeen countries’ reserves, in which the dollar overtook sterling in the 1920s. They show that the dollar and sterling were in two other respects roughly at level pegging in the 1920s. One was in international trade financing: one of the United States’ objectives in founding the Federal Reserve was to stop the practice of U.S. international trade being financed in London, and to save the accompanying payments of commissions to London financiers. The other respect was in international bond issues, where the dollar overtook sterling in the late 1920s or early 1930s. Sterling made a relative comeback as a reserve currency in the 1930s, partly because a number of countries pegged their exchange rates to sterling after Britain abandoned the gold standard in 1931 and formalised the sterling area.

After the Second World War, sterling accounted for an initially-large share of foreign exchange reserves, which declined until the 1960s. The authors rightly note that sterling reserves had been largely accumulated during the war, and were generally held reluctantly. Access to them was restricted by the British authorities, and the authors’ claim that ‘Egypt had a choice’ about the disposition of its reserves in the 1950s is inaccurate: when Egypt wanted to use its sterling reserves to finance the building of the Aswan High Dam in 1955, the British refused.

The salient feature of Britain’s post-war financial situation was the government’s enormous debts, which in the end were made sustainable by means of inflation. Prolonged and extensive controls on financial transactions were unavoidable as a means of containing aggregate demand. As the authors point out, when the UK was forced by the United States to remove restrictions on external current account convertibility on 15th July 1947, the result was, inevitably, ‘a disaster’, and controls were reimposed in August. Britain’s financial problems were somewhat ameliorated by budget surpluses, of about 4% of GDP (on present-day accounting conventions) in the years 1948/49 to 1950/51. In 1951, however, after the outbreak of the Korean war and at the urging of the United States, the government embarked on a rearmament programme which added roughly 4% of GNP to military spending.

The authors’ account of reserve management during the Bretton Woods era does not, to my mind, draw adequate attention to the role of gold. Foreign exchange reserves were a kind of residual item, and many countries refrained from exercising their right to convert dollar reserves into gold as a kind of quid pro quo for military support from the United States, which became increasingly anxious as its gold reserves were depleted. Although dollar reserves grew quickly, world monetary gold reserves, even when valued at $35 an ounce, were larger than foreign exchange reserves as late as 1970. The authors note that countries such as West Germany, Switzerland and Japan, which were struggling with the monetary consequences of external inflows, were quite successful at preventing their currencies from becoming reserve currencies.

The book speculates extensively on the possible future of the renminbi as a reserve currency, and devotes an entire chapter to the subject. It comments that:

‘For the renminbi to be successfully internationalized, China will have to undertake more far-reaching policy reforms than did America in 1914 or Japan in 1984. Those extensive reforms will not be completed overnight. Chinese policy makers understand that this process will take a considerable period. But it is important that they remain committed to seeing these challenges through.’

China, like the United States in 1914, would prefer to have its own trade financed in its own currency. A quarter of China’s trade is now financed in renminbi. The authors list the measures that China has taken to liberalise capital transactions. They include the establishment of a network of bilateral swap lines by its central bank, the Peoples’ Bank of China, to make the renminbi available in foreign countries; and China’s membership of multilateral swap arrangements, namely the Chiang Mai Initiative Multilateralisation and the BRICS bank, which is to include a swap facility.

Little information has been released about the bilateral swap lines, but it is not clear that they have been very useful. The swap line with South Korea was opened on 12th December 2008, and the first drawing was proudly announced, but not until 30th May 2014. The Chiang Mai Initiative (pre-multilateralisation) was conspicuously unused during the financial crisis of 2008-09, when it was completely eclipsed by the swap lines set up ad hoc by the Federal Reserve.

It is not clear that China wants its currency to be used for investment, rather than trading, purposes. It does not need the financing that a reserve currency would provide: indeed, inflows into renminbi would aggravate the serious problems it already faces in investing its external assets. Perhaps that is just as well. There is a profound difference between China and the countries whose currencies are used as repositories for large quantities of international reserves. China makes no separation between the judiciary and the executive government; it has no tradition of such a separation. Any body which held large financial claims on China and got into a dispute would have to expect the dispute to be resolved in whichever way the Chinese government found most convenient. This is a major deterrent to the widespread use of the renminbi as a wealth-holding currency, and one that is simply ineradicable in the foreseeable future; it also explains the absence of deep and liquid financial markets in China, to which the authors draw attention.

It should be noted that other countries, notably the United States, use their currencies as instruments of foreign and internal security policy. For many years the United States has exploited foreign banks’ commercial need for access to dollar payment systems to force them to comply with U.S. law, even when operating outside the United States. The law is at least codified, however, and there is a procedure, albeit an unsatisfactory one, for appealing against judgments. The United States is nevertheless taking serious risks with the dollar: official surveillance of payment systems is surely the main stimulus to the growth of crypto-currencies.

Another risk to the dollar is simply that the volume of external claims on the United States will become so large in relation to the capacity of the United States to satisfy them that the dollar will simply lose credibility. China’s foreign exchange reserves are $3 trillion. If, say, $2 trillion are in dollars, then the dollar part is of the order of ten per cent of the United States’ annual GDP. China’s reserves are evidently not liquid.

If the dollar’s future is in doubt, and the renminbi has ineradicable drawbacks, what other reserve currencies could fill the gap? It is surprising, to me, that the authors don’t consider the rupee. India’s economy, like China’s, is growing fast. India, unlike China, doesn’t have an ageing population. And it has an independent judiciary. The changes that India would have to experience for the rupee to become a reserve currency are profound, but far from inconceivable.

It is perhaps unlikely that any currency will be able to command global confidence in the way that the dollar has done for the past hundred years or so. If none does, then the number of currencies used as reserve assets, whether by nations, companies or individuals, will increase, and perhaps gold and other precious metals will make a comeback.

Eichengreen, Mehl and Chitu’s work is well-informed and thought-provoking. For one reason or another, their ‘new view’ is likely to prevail.