The future of reserve currencies in a multipolar world

Ever since the end of World War II, the US dollar has occupied a uniquely dominant position in the global financial system, as the preferred currency to be held as a reserve asset by central banks. Representing 58% of the value of foreign reserve holdings worldwide, no other currency comes close to challenging the US currency¹.

The world’s financial system has not always been so unipolar. In the late 19th century, during the era of the gold standard, the British pound was the dominant global currency, but there was still a role to be played by other currencies – such as the French franc.

“I regard the second half of the 20th century as a historical anomaly,” said Professor Barry Eichengreen, International Economist, UC Berkeley. “It was the one period where the international monetary and financial system was so heavily dominated by a single currency, since the US was the only country in the world that had the necessary liquidity.”

Despite the US dollar’s strength as a reserve currency, there is a long-term trend of the greenback giving ground to other currencies. Since the turn of the century, the US dollar has lost around 10 percentage points of its share of global foreign exchange reserves².

This gradual erosion of the US dollar’s dominance is in line with Prof. Eichengreen’s expectations. But one unexpected outcome is the currencies that central banks are turning too.

Instead of replacing US dollars with the currencies of the world’s largest economies, like China’s renminbi and the EU’s euro, central bankers are holding more currencies from smaller economies with a strong credit rating. These include the Australian dollar, the Canadian dollar, and the South Korean won.

All these currencies provide diversification benefits to central banks, via exposure to small but open economies. And advances in digital trading technologies have made it easier than ever before to hold these assets.

Why have the euro and the renminbi failed to gain ground against the dollar? Each currency has its own explanation.

Financial markets are holding back the EU. The bloc’s economy is large, but its capital markets are not integrated. Only a few of the eurozone’s members have a AAA credit rating, and the bonds of these countries are typically held by the region’s own banks to meet capital and liquidity requirements.

The region’s pool of assets is not deep or liquid enough to support a large role for the euro as an international reserve currency, said Prof. Eichengreen. As a result, the euro has consistently hovered around 20% of global total reserves.

In 2020, the European Central Bank issued bonds to raise capital during the pandemic. This was the first time that the ECB did this and the scale of the issuance raised hopes that the EU was in a position to issue enough euro-denominated debt to boost its position as a reserve currency. But it appeared to be a one-off as the central bank has refrained make similar moves in response to more recent events – such as Russia’s invasion of Ukraine and the subsequent energy crisis.

Away from the euro, the renminbi is another contender. Although it only has 2.3% of global reserves, it is backed by the world’s second largest economy and there are expectations that it could take a much larger share.

But the Chinese currency suffers from similar issues to the euro in that its financial markets do not have sufficient liquidity to support the demand associated with reserve currency status. Furthermore, China’s financial markets are not completely open to foreign investors.

There are also political constraints on the internationalisation of the renminbi, said Prof. Eichengreen: “Every leading international and reserve currency in history has been the currency of a republic or democracy, where there are checks on arbitrary action by the government.”

He also discussed the possibility that the slow rebalancing of the global financial system away from the US dollar could dramatically accelerate, due to a dramatic event that eliminates the confidence in US dollar-denominated assets.

The biggest risk here is the US fiscal situation, with the country’s public debt viewed by many to be on an unsustainable trajectory. Official forecasts suggest that the country’s debt to GDP ratio could swell to a record high of 116% in 2034 and hit 172% by 2054³.

Prof. Eichengreen acknowledged concerns towards US fiscal policy – especially how political polarisation makes it harder to implement consolidation. But at the same time, he believes that it is still possible for policymakers to come together and create a strategy that puts US fiscal policy on a more sustainable path.

“I don’t think the fiscal cliff is immediate, though it could exist further down the world. Nor do I think it is inevitable,” he said.

In the absence of a tipping point, current trends will likely continue: countries will develop more efficient payments systems and more liquid financial markets, making it increasingly attractive for central banks to hold reserve assets in an ever broader range of currencies. The gradual decline of the US dollar’s will likely continue, but for the time being, it remains the currency of choice for central bankers.