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The writer is professor of economics and political science at the University of California, Berkeley
The decision by the US and allies to freeze Russia’s foreign reserves has unleashed an intense debate about the future of the international monetary system.
That debate is vigorous because the stakes are high and because it is at least 75 years, and the second world war, since similar decisions were taken — and after which the system was transformed. The debate is confusing, however, because it overlooks what has actually been happening to the global monetary system.
Repeated references to “dollar dominance” notwithstanding, the share of dollars in global identified foreign exchange reserves has been trending downward for 20 years, from a bit over 70 per cent at the turn of the century to just 59 per cent in the third quarter of 2021.
This trend is not a result of currency shifts or interest rate changes affecting the value of different reserve assets. It also does not reflect dollar aversion on the part of a handful of banks accumulating large reserve balances. Rather, it is the result of an effort by numerous central banks to diversify away from the US currency.
Now comes the surprise. The diversification is not towards the euro, sterling and yen, the other longstanding constituents of the IMF’s special drawing rights basket, a multicurrency reserve asset. The collective reserve share of these currencies has remained substantially unchanged for two decades.
Moreover, just a quarter of the shift has been into China’s renminbi, which was added to the SDR in 2016. Fully three-quarters has been into the currencies of smaller economies such as Canada, Australia, Sweden, South Korea and Singapore, as a working paper for the IMF that I co-authored shows.
What explains these currencies’ rise? First, their markets have become more liquid. Historically, only a handful of countries possessed deep and liquid markets open to the rest of the world. Foreign exchange dealers were able to find counterparties in only a handful of currencies. In practice, this was mainly the dollar but also the euro, sterling and yen. These were the units used as vehicles for international transactions and that central banks therefore held as reserves.
But the costs of transacting in subsidiary currencies have fallen with the advent of electronic trading platforms and new technologies for automated market-making and liquidity management. We see this in bid-ask spreads on subsidiary currencies, which are now as low — sometimes even lower — than on the euro, yen and pound.
Second, central banks have become more active in chasing returns. Reserve portfolios are larger, raising the stakes.
Third, and relatedly, low yields on the bonds of major reserve-issuing countries have intensified the search for alternatives. Non-traditional reserve currencies regularly offer attractive volatility adjusted returns relative to their traditional counterparts.
Thus, we are already seeing movement towards a more multipolar international monetary system — just not the tripolar system dominated by the dollar, euro and renminbi anticipated by many observers.
Recent events are likely to accelerate diversification. In Russia’s case, admittedly, all consequential reserve issuers except China have actively participated in the reserve freeze. Russia’s long-under way move into non-SDR reserve currencies has not therefore provided it with a haven.
However, now that the sword of a reserve freeze has been unsheathed, one can also envisage a scenario in which the US freezes a country’s reserves but other governments don’t go along. In this case, additional reserve diversification by the target country could have insurance benefits.
What about faster diversification towards the renminbi? Anyone contemplating moving reserves in that direction will have to consider the possibility that China could become subject to secondary sanctions. Moreover, Putin’s actions are a reminder that authoritarian strongmen can act capriciously when there are few domestic counterweights to restrain them. That President Xi Jinping has shown little inclination to interfere in the operations of the People’s Bank of China is no guarantee that he will maintain that stance in the future. It is no coincidence that every leading reserve-currency issuer in history has had a republican or democratic form of government, with checks on executive power.
Russia’s reserve managers have no choice but to turn to the PBoC so long as it continues to grant them access. But for other central banks, an ironic result of the US decision to weaponise the dollar may actually be to slow international take-up of the renminbi.
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