Assessing the Dollar's Status as a Reserve Currency in a Multipolar World
This commentary argues that the current competitive climate calls for more “active stewardship” of the dollar as a reserve currency and considers what form that stewardship should take.
In the companion commentary “China’s Ten-Year Struggle against U.S. Financial Power,” Rush Doshi examines China’s blunting strategy to reduce U.S. financial power and efforts to promote and internationalize the renminbi.
The historical benefits that accrue to the United States from the dollar’s status as the world’s dominant reserve currency and international medium of exchange are well established. They include lower transaction costs for U.S. consumers and corporations engaged in international commerce, lower financing costs for borrowers of dollars, less sensitivity to global economic fluctuations for the U.S. economy, and a source of leverage supporting U.S. geopolitical interests. These advantages have always invited pointed international critique, with former French finance minister Valery Giscard d’Estaing famously referring to the dollar’s status as the dominant global currency as an “exorbitant privilege.” One manifestation of its position at the pinnacle of international finance is that the United States could largely ignore such critiques given the absence of rivals to the dollar’s preeminent status. Such a luxury encouraged d’Estaing’s U.S. contemporary, Treasury Secretary John Connally, to proclaim to European Union finance ministers in 1971 that “the dollar is our currency but it is your problem.”
While the swagger of Connally’s expression may have suited a unipolar world in which the United States dominated the global economic order, the competitive environment to the dollar’s position is unmistakably changing. This evolving dynamic reflects at least three factors: the emergence of rival currencies following the introduction of the euro and the ascent of China as a global economic superpower; recent geopolitical developments, in which allies and adversaries alike seem intent on constructing alternative infrastructures to mute the dollar’s dominance and the influence of the United States; and the rapid proliferation of cryptocurrencies and new technologies that seek to alter the conventional monetary architecture. Collectively, these factors pose a new challenge to U.S. policymakers, who must now consider whether a historically passive orientation to the dollar as a reserve currency is sufficient to maintain its status in an emerging multipolar world.
Since the demise of the Bretton Woods monetary regime, U.S. policy toward the dollar can generally be characterized as “benign neglect,” reflecting the status of the United States as a global postwar economic hegemon. This enviable position has allowed U.S. policymakers to concentrate principally on domestic economic factors such as growth, employment, and price stability without explicit attention to the unique role the dollar plays in the global economy. Instead, they have relied on attributes such as ease of convertibility, a stable political system, and the established rule of law to support the dollar’s status. While these factors likely remain prerequisites for maintaining the dollar’s international position, policymakers should ask whether the current competitive climate calls for more “active stewardship” of the dollar as a reserve currency and, if so, what form that stewardship should take.
A REVIEW OF THE COMPETITIVE ENVIRONMENT
Conventional measures of the dollar as a reserve currency show little erosion of its preeminent status. Over 60% of global foreign exchange reserves held by foreign central banks and monetary authorities remain denominated in dollars, roughly 90% of global foreign exchange transactions involve a dollar leg, approximately 40% of global trade outside the United States is invoiced and settled in dollars, and almost 60% of U.S. dollar banknotes circulate internationally as a global store of value and medium of exchange. These measures have not changed substantially in recent years, and indeed in some cases they have increased.
Notwithstanding the dollar’s ongoing dominance, the competitive environment is unmistakably intensifying as a result of economic, political, and technological factors. International competitors such as Russia and China routinely call for a new international financial order and work aggressively to displace the dollar as the apex of the current regime. The addition of the renminbi in 2016 to the basket of currencies that compose the International Monetary Fund’s special drawing rights represented an important global acknowledgment of the increasing international use of the Chinese currency and, perhaps even more importantly, of an evolving international monetary system.
Chinese authorities, however, are not content with mere acknowledgment of their country’s economic ascent but are working intentionally to craft a new financial order with the renminbi at its center. Noteworthy examples of this ambition include the Belt and Road Initiative to promote regional development through a vast network of infrastructure projects and economic zones designed in part to expand the international use of the renminbi; the Chiang-Mai Initiative to establish multilateral currency swap lines across regional central banks and monetary authorities; the development of the Cross-Border Interbank Payment System (CIPS) to offer clearing and settlement services to facilitate cross-border renminbi payments and trade; and the more recent announcement of China’s decision to issue a central bank digital currency. These actions should not be interpreted in isolation but rather as part of a coherent and integrated effort to displace the dollar as the anchor of the international financial system.
China is not alone in its aspirations to mute the role of the dollar and the influence of the United States. Several efforts are underway, for example, to develop alternatives to the primacy of the SWIFT (Society for Worldwide Interbank Financial Telecommunication) network as the dominant medium for the exchange of payment instructions and messages between global financial institutions. Given the preponderance of dollar-based traffic across the network and recent experience in which access has been suspended in conjunction with U.S. sanction regimes, most notably in the case of Iran, these efforts are designed to negate the effectiveness of the dollar as a lever of U.S. geopolitical influence. It is not merely adversaries such as Russia, which has launched a competing messaging service, that are constructing surrogate infrastructures. U.S. allies in Europe are developing a parallel system to SWIFT as a means of enhancing the region’s financial autonomy. Moreover, European countries recently established Instex (Instrument in Support of Trade Exchanges), a barter arrangement designed explicitly to facilitate non–dollar based humanitarian trade with Iran and to circumvent elements of the U.S. sanctions regime. While the durability of these rival platforms and international financial arrangements remains uncertain, the motivations for their development seem clear.
A galvanizing factor behind efforts to alter the global financial system has been the “weaponization” of the dollar, referring broadly to actions of the U.S. government to leverage the dollar’s reserve currency status in pursuit of geopolitical objectives. This dynamic represents a paradox for U.S. policymakers. On the one hand, the dominance of the dollar provides the means to extend the extraterritorial reach of U.S. regulation and policy. On the other hand, indiscriminate exploitation of this privilege risks driving activity away from the dollar to rival currencies and alternative infrastructures, diminishing both the long-term effectiveness of this policy lever and the benefits that accrue to the United States from the dollar’s status as a reserve currency.
Perhaps the most novel development in the competitive environment facing the dollar is the recent proliferation of cryptocurrencies and the application of new technologies that will inevitably challenge the existing monetary architecture. While cryptocurrencies have not yet satisfied two cardinal criteria for money as a stable store of value or a readily accepted medium of exchange, the development in time of “stablecoins” designed to minimize price volatility and democratize use potentially represents a long-term risk to the dollar. While this threat is likely not imminent, a world in which a digital currency issued by a private entity or a sovereign state competes with the dollar internationally as a store of value, an alternative reserve asset, or a medium of exchange is no longer inconceivable.
IMPLICATIONS OF A LOSS OR DEGRADATION IN THE DOLLAR’S RESERVE CURRENCY STATUS
Given this changing competitive landscape, what are the implications of a loss or degradation in the dollar’s reserve currency status? What is at stake? The short answer is a lot, in terms of both financial impact and global influence.
Higher funding costs. A degradation in the primacy of the dollar inevitably portends higher funding costs for the U.S. government, states and municipalities, corporations, and consumers. U.S. borrowers enjoy material benefits from the dollar’s reserve currency status. U.S. Treasury securities represent the world’s premier and most liquid risk-free asset and the foundation for dollar-based credit markets and interest rates. Diversification away from the dollar and out of Treasury securities by foreign central banks and monetary authorities likely would place upward pressure on yields to the detriment of dollar borrowers.
Higher transaction costs. U.S. corporations engaged in international commerce enjoy significant benefits from the volume of global trade invoiced and settled in dollars. Were this share to diminish, transaction costs, such as foreign exchange conversion and hedging activities, would increase, and the higher costs would ultimately be passed on to U.S. consumers.
Less liquid capital markets. The dollar’s status as the world’s dominant currency both contributes to and reflects the fact that U.S. capital markets are the deepest and most liquid in the world. Any degradation in the dollar’s status likely would translate into a deterioration in capital market liquidity. If one measure of liquidity is the ability to transact in scale with little impact on price, a loss in liquidity inevitably would increase costs to participants in U.S. capital markets.
Loss of seigniorage revenues. The issuance of U.S. dollar banknotes (Federal Reserve notes) results in a liability on the Federal Reserve balance sheet on which the Fed pays zero interest. Currency in circulation also represents a drain in reserve balances maintained by depository institutions, which the Fed offsets with purchases of interest-bearing securities. The net interest margin related to these balance sheet activities represents “seigniorage” revenues that the Fed remits to the Treasury. Banknotes in circulation overseas therefore effectively represent an interest-free loan to the United States. Any degradation in the dollar’s status as a reserve currency would likely correspond to a reduction in these overseas holdings and impair this income stream.
Greater sensitivity to global economic developments. While the world is unambiguously becoming more interconnected, the reserve currency status of the dollar provides a degree of insulation to the United States from global economic turbulence. A degradation in the dollar’s status as a reserve currency would increase the sensitivity of the U.S. economy to global developments, at least on the margin.
Loss of global influence. The dollar’s reserve currency status permits the United States to wield enormous extraterritorial influence in support of geopolitical objectives. Any degradation in the dollar’s status likely would erode this influence, which the United States then potentially would need to replace by other means, such as increases in military presence, defense spending, or foreign aid.
POLICY OPTIONS IN AN EMERGING MULTIPOLAR WORLD
While some degradation in the prominence of the dollar is likely inevitable (and perhaps even desirable) in the ongoing transition to a multipolar world, U.S. policymakers should consider more active stewardship of the dollar’s reserve currency status. Strong macro fundamentals and the financial stability of the U.S. economy remain indisputable prerequisites for the dollar but may not prove to be sufficient given the reality of a competitive global dynamic. Waiting for a degradation in conventional measures of the dollar as a reserve currency prior to taking action may be too late, especially given the nature of network effects in maintaining the dollar’s status. Active stewardship of the dollar as a reserve currency could take the following forms.
Supply liquidity to global markets in times of stress. Reserve currency status is earned and not a birthright with unlimited entitlement. It also carries certain responsibilities, one of which is supplying dollar liquidity to global markets, especially in periods of stress. The best recent example of this application was the Federal Reserve’s establishment of reciprocal swap lines with major global central banks during the financial crisis. These arrangements and the corresponding dollar auctions by foreign central banks proved instrumental in supplying dollar liquidity to global funding markets and restoring market function. They have subsequently been made standing facilities and represent an appropriate exercise of stewardship of the dollar’s reserve currency status.
Ensure robust financial market infrastructures. Given the dollar’s role in global trade, capital markets, and settlement, the financial market infrastructures supporting these activities need to be robust and managed strategically. Two immediate actions that should be pursued in support of this interest, both in the domain of the Federal Reserve, would be to work with industry participants to expand the operating hours of the wholesale interbank payment system (known as the Fedwire Funds Service) to 24x7x365 and to upgrade its payment message formats from a proprietary standard to the emerging global standard. It is imperative that the anchor element of the nation’s payment system be responsive to the demands of an increasingly global marketplace in which international commerce is no longer limited by geography or time.
Exercise discretion when pursuing unilateral sanctions. As a general rule, the United States can afford to be more aggressive in leveraging the dollar’s reserve currency status for geopolitical ends when there is broad international consensus for action. In the absence of a coalition, U.S. policymakers should be cautious about taking repeated unilateral actions that impose significant collateral costs on allies (likely with diminishing marginal returns) and may harm the dollar’s reserve currency status. This guidance is admittedly easier to define than to apply and testifies to the indisputable and enduring value of strong, trusted, and reciprocal international relationships in pursuit of geopolitical objectives.
Consider the development of a central bank digital currency. There is both a positive and negative case to be made in support of the Federal Reserve considering the issuance of a digital currency. The positive motivations of a digital fiat currency include potential transaction efficiencies, greater financial inclusion, and enhancements in monetary policy transmission, among other benefits. The negative motivation is that rival cryptocurrencies, commercial or sovereign, could radically redefine the nature of money and undermine the international role of the dollar in the absence of U.S. initiative. Both the positive and negative motivations point in the same direction: the need for greater study and intentionality among U.S. policymakers in a domain that could have significant implications for the future architecture of the global financial system.
International critiques of the dollar’s reserve currency status are not new. What distinguishes recent expressions from those of past generations? The availability of alternatives in rival currencies and new technologies combined with the concerted actions among adversaries and allies alike to establish non–dollar based alternative infrastructures and international financial arrangements.
The force of inertia is powerful, but it should not be relied on to preserve the dollar’s dominant international role, given the intensely competitive environment and an era of profound economic, political, and technological change. U.S. policy toward the dollar as a reserve currency should shift from benign neglect to active stewardship. With exorbitant privilege comes exorbitant responsibility.
Richard Dzina recently retired from the Federal Reserve Bank of New York, where he was Executive Vice President of the Financial Services Group.
 For a more comprehensive review of the status of the dollar as a reserve currency, see Linda S. Goldberg and Robert Lerman, “The U.S. Dollar’s Global Roles: Where Do Things Stand?” Liberty Street Economics, February 11, 2019, https://libertystreeteconomics.newyorkfed.org/2019/02/the-us-dollars-global-roles-where-do-things-stand.html.