This is the second installment of a series on global currencies. The first part details the forces eroding the U.S. dollar’s reserve status.
Half a century ago today, on August 15, 1971, U.S. President Richard Nixon took a momentous step.
After World War II, the U.S. had used its leverage as the last advanced economy standing to make the dollar the foundation of a global system of exchange rates. The postwar dollar was backed by huge gold reserves built up in part through American sales of munitions to Europe during the war. The system, known as Bretton Woods for the New Hampshire site of its enactment, played a key role in the reconstruction of devastated economies in Europe and Japan.
But by 1971, those recovering economies had become a threat to the gold-backed dollar. Rising exports from Europe and Japan eroded the U.S. share of global trade, reducing demand for American currency. Combined with excess U.S. spending, this convinced financial markets that the dollar was overvalued against its $35 per ounce gold peg. Starting in the 1960s, dollars were redeemed for gold at a faster and faster clip, a “gold run” motivated by the belief that the dollar’s peg might break, leaving dollar holders short.
Finally, 50 years ago, Richard Nixon suspended dollar redemptions for gold. Though the process took a few more years to play out, this effectively ended the gold standard and the fixed Bretton Woods exchange system that relied on it.
The significance of this moment is arguably exaggerated in the sweep of financial history – the “gold standard” that Nixon ended had lasted less than three decades, under extremely unusual circumstances. In its place eventually came the relatively free-floating exchange rates we know today, in which the relative value of currencies changes based broadly on the economic clout and political stability of the issuing nation.
As it happened, despite the rise of Europe and Japan, this new currency regime still favored the (now unbacked) U.S. dollar. For the half-century since, it has remained the dominant currency for global trade, and the overwhelming choice of foreign central banks looking for a stable store of value. As we discussed in the first installment of this series, this has given the U.S. a variety of economic and political advantages, often referred to as the dollar’s “exorbitant privilege.”
But now, the status quo of dollar dominance is eroding. Post-pandemic inflation has reignited worries about the dollar’s declining reserve status, but it’s a much longer-term trend: In May, the dollar’s share of central bank reserves fell to a 25-year low of 59%.
The dollar’s lost share has been taken up in large part by growth in reserves held as euros, Japanese yen, and Chinese yuan. There’s also another competitor, though it’s still just a glimmer on the horizon: Crypto advocates have long argued that bitcoin or another digital asset could serve as a global reserve currency, and recently much more mainstream figures, including the former head of the Bank of England, have supported the idea of a supranational digital reserve instrument.
Reserve status is not a winner-take-all competition. The circumstances that led to nearly a century of dollar dominance were an anomaly, and experts generally don’t expect any single currency or instrument to become similarly dominant in the 21st century.
But which of the candidates have the best chance of stealing significant reserve market share from the dollar – along with a share of the power and privilege that come with it?
The Euro
The euro has many huge advantages as a potential global reserve currency. Despite a legacy of economic mismanagement by a few member states like Greece and Spain, the Eurozone is by and large made up of healthy, well-regulated economies, with a total GDP slightly higher than China’s. And while the European Central Bank is certainly not without its flaws, it is generally governed in a steady and fairly predictable manner. It has also weathered one truly terrifying crisis in 2010, managing to pull together a bailout package and ward off the euro’s dissolution, considered a real possibility at the time.
So it’s no surprise the euro is already the world’s second-biggest reserve currency, with roughly €2.5 trillion ($2.94 trillion) in central banks globally.
But there are barriers to further growth in euro reserves.The biggest of these is not economic, but political. Power over interest rates and other aspects of euro monetary policy is in the hands of the Governing Council of the European Central Bank, which is made up of a six-member Executive Board and the governors of all 19 Eurozone central banks. That means major conflicts between member states on monetary policy could lead to governance gridlock or breakdown, which creates risk relative to the more unitary U.S. Fed.
Another problem for the euro’s reserve currency potential, according to Stanford economist Darrell Duffie, is that the European Central Bank for many years did not issue Europe-wide bonds. The central banks of member states issue euro-denominated bonds, but they don’t mirror the strengths and weaknesses of the Eurozone as a whole. Each country’s bonds have their own independent yields, for instance. That adds to the complexity and risk of using them as reserves. Bonds, rather than currency, make up the bulk of international central bank reserves, so the lack of true “euro bonds” has constrained the euro’s reserve role.
This situation changed during the pandemic, however. The European Union announced last October that it would begin the first large-scale issuance of Europe-wide debt to fund pandemic relief. The bonds have been generally well-received by markets, and the European Commission plans to borrow 900 billion euros ($1.06 trillion) over the next five years. Though the bonds will go to a variety of buyers, that’s enough to significantly displace dollar-denominated bonds in central banks, which currently total close to $7 trillion.
More importantly, the issuance sets a precedent. “Whether there will be a lot more of them or not is hard to foresee,” says Duffie. “But because this kind of breaks the ice, it may mean there’s more in the future.” That wouldn’t simply add assets to the market for reserves – Duffie argues that shared debt issuance would increase European political cohesion, reinforcing the utility of the bonds as stores of value.
(A note: Despite its past glories, the British pound is not generally part of the discussion of reserve shifts, in part because of the U.K.’s relatively small economy – one fifth the size of China’s and half the size of Japan’s.)
The Yen
The situation of the yen is maybe the most counterintuitive when it comes to reserve status, and it casts crucial light on the challenges facing China’s yuan. Broadly, despite its economic strength, Japan’s financial system still has certain isolationist tendencies rooted in its export-driven postwar rebuilding strategy. Above all, most Japanese debt is held domestically, limiting the available supply of yen-denominated reserves.
“It’s never been Japan’s ambition” to have a global reserve currency, says Alicia Garcia-Herrero, Chief Economist for Asia-Pacific at investment bank Natixis. “If you have a current accounts surplus, like Germany and Japan, you don’t need an international reserve currency, because you don’t have anything to finance. You buy assets.”
In other words, if a nation is a net exporter, it may simply not have enough international debts for its bonds to serve as global reserves. Japan’s high domestic savings rate, which has averaged a stunning 30% over the last 40 years, also means there’s huge demand for government bonds at home.
It’s a strange insight when turned back on the dollar: one reason USD is a dominant reserve currency is because Americans can’t seem to live within their means.
The Yuan
The yuan is something of a boogeyman of the dollar these days – a threat looming just offstage, more rumor than light.
China has been trying to make its currency appealing as a global reserve and trading instrument for at least a decade, and as the world’s second-largest economy, it’s got the muscle. The push for reserve status has included creating offshore bond markets in Hong Kong, a troubled attempt to balance global yuan flows with the CCP’s desire for domestic capital controls. More recently, some observers argue China’s “digital yuan” project is an attempt to gain a technological edge that would increase the yuan’s share of trade transactions and, in turn, its viability as a reserve.
But these efforts face an array of challenges so great that most experts don’t foresee the yuan succeeding as a reserve currency any time soon.
One major obstacle is a global lack of faith in Chinese political stability and rule of law, which was highlighted recently by a sudden, broad crackdown on financial technology by the ruling Chinese Communist Party. Bitcoin miners were caught in that net, but the crackdown also crashed big portions of the Chinese stock market, as well as Chinese stocks listed abroad. That included some companies, such as Luckin Coffee, that were found to be engaging in large-scale accounting fraud.
This led Joseph Sullivan, an economist on Donald Trump’s White House Council of Economic Advisers, to call the CCP an unwitting ally to the dollar’s reserve status. Such interventions and collapses cast doubt on China’s commitment to free markets, its regulatory rigor and, in turn, the fundamental strength of the Chinese economy. The potential consequences are fresh in the memory of the finance industry: a similar stock market crash in June of 2015 was quickly followed by China’s central bank devaluing the yuan to boost export competitiveness.
This all stems from a likely irresolvable conundrum at the heart of China’s reserve-currency ambitions: Tight control over its currency has been a major pillar of its long rise as an economic power, but is incompatible with global reserve status.
This is where Japan is an illustrative comparison. Since the reforms of the late 1970s, China has modeled its development largely on Japan’s postwar rebuilding, above all its emphasis on domestic investment to build an export-based economy. There are very tight controls on the flow of capital out of China because the Communist Party wants domestic capital to be invested within China, whether to build factories for Apple contractors or fund AI development.
But to become a functional reserve currency, the yuan would have to be freely tradeable. Nations need their reserves to be quite liquid, partly so they’re ready for sudden, big shifts in market conditions – like, say, the coronavirus pandemic, which set off a flurry of U.S. bond sales. To get there, China would have to do what’s known as “open its capital accounts,” or allow free flows of capital in and out of its borders.
But “they don’t plan on opening their capital accounts anytime soon,” according to Emily Jin, a research assistant at the Center for a New American Security. “Their nightmare situation is they open an account and they immediately, the next morning, have massive capital outflows.” This could be exacerbated by recent stock market woes, since major outflows would be driven by Chinese investors looking for bigger or more reliable returns overseas.
China’s first attempt to square this circle was to create a two-tier system starting around 2010, involving offshore markets for yuan bonds. “China tried to create a tradeable yuan overseas, and then their own yuan at home,” says Garcia-Herrero. “It didn’t work. And the reason it collapsed in 2015 was a giant stock market correction.”
Now, Garcia-Herrero believes China’s central bank is trying to do something similar by creating the digital yuan, an electronic currency completely and directly controlled by the state bank.
“I have to say they are creative,” she says. “They’ve come up with another way to avoid compulsory convertibility. [With a CBDC], they know all the transactions. So if they thought someone was withdrawing too much, they can just take it back.” Garcia-Herrero doesn’t expect the plan to work, however, because of widespread awareness of this potential abuse, and continued distrust in Chinese leadership.
Some have argued that the digital yuan would also increase the yuan’s international appeal through technological innovation – a digital currency may offer speed or other utilitarian advantages over an old-fashioned dollar. But Emily Jin at CNAS doubts that a merely technical upgrade would have a long-term impact: “It might have lower frictional costs, but that’s not the only reason people park their money in USD.”
This tangle of conflicting forces has badly hampered China’s quest for reserve status. The yuan currently makes up a 2.3% share of global reserves – followed closely by the Canadian dollar, which makes up 2% of reserves. Canada’s economy is just 1/8th as large as China’s, and Canada has made no concerted effort to improve its reserve status.
Bitcoin, etcetera
Finally, what’s the potential for bitcoin to become a worldwide reserve instrument?
The primary argument for bitcoin as a reserve instrument parallels the case for personal adoption of bitcoin as a store of value. Just as a domestic central bank can debase currency held by citizens by rampantly printing money, a foreign central bank can do the same to bonds held by foreign governments. Many bitcoin advocates point to unsustainable global debt levels and argue that defaults on sovereign bonds will become widespread this century. In this scenario, bitcoin reserves would become a kind of backstop, a “hard” asset that would still be standing in the case of a wave of bond defaults.
The idea suddenly seemed tantalizingly real when El Salvador recently became the first country to say it would hold bitcoin (though not as part of a formal central bank reserve). More profoundly, that a small, poor, and politically unstable nation without its own currency led the way seems to align with the case for countries holding bitcoin. Because it already relies on the U.S. dollar as its primary currency, El Salvador is particularly subject to the whims of foreign central banks, and doesn’t manage its own money supply. Other small and unstable nations could similarly benefit from using a neutral currency.
There are other scenarios that could lead to nation-state adoption of bitcoin reserves. Greg Foss, CFO of Validus Power and a longtime credit trader, recently posited that oil-producing countries like Saudi Arabia and Russia could transition to accepting bitcoin as payment. Because these countries have at best ambivalent relationships with the U.S., they’re motivated to reduce the power and influence America derives from the dollar – including, in the case of Russia, the power to impose international financial sanctions on individuals. Because oil is so heavily traded, bitcoin’s adoption for oil payments would make holding it more necessary for both nations and a huge number of other players.
The example of oil illustrates the deeper geopolitical appeal of bitcoin. Oil-producing nations trade with a variety of more or less adversarial states, making accepting the customers’ own currency less appealing. Currently, that leaves the U.S. as essentially a trusted third party to the transaction via dollars. But a neutral medium of international exchange like bitcoin makes such exchanges possible without enhancing America’s geopolitical leverage by relying on it to move value.
That said, there’s only a weak relationship between a currency’s use for trade and its usefulness as a reserve instrument, and experts say bitcoin has significant flaws as a reserve. The most obvious at the moment is its price instability, with daily percentage swings still regularly in the double digits.
A steady exchange rate isn’t the most important feature of a reserve instrument: economist Barry Eichengreen has argued that even significant amounts of inflation wouldn’t in itself be enough to unseat the dollar, for instance. Advocates also argue that broader adoption will stabilize bitcoin’s price over time. But for now, that volatility is simply untenable for a serious reserve instrument.
The grassroots ecosystem around bitcoin may also be a problem. “We know [bitcoin] is a great trustless system,” says Yaya Funasie, a former CIA analyst who studies bitcoin and geopolitics for the Center for a New American Security. “But trust isn’t just in the protocol, but in the world around it. You’re also now elevating the importance of the miners, the developers … The protocol says X, but if we get into an issue and developers want to fork, what’s the legal recourse?”
Conversely, bitcoin would be unappealing for official use in nations that already have their own nominally healthy currency, because it would limit their power to control their money supply. For better or worse, frequent, active intervention in monetary policy is a constant theme of monetary history, and giving that up is a nonstarter for the likes of the U.S. or Japan.
“The death of the nation-state has been greatly exaggerated,” Fanusie quips.
Far more likely, Fanusie believes, is the international adoption of central bank digital currencies, or CBDCs, which aside from being digital are entirely distinct from cryptocurrencies. They can be even more tightly controlled by central banks than paper currency, which is worrying to critics but appealing to current incumbents like China and the U.S. One of the more appealing possibilities of CBDCs would be their utility for creating a digital synthetic currency consisting of a basket of other currencies. This has potential stabilizing effects for global trade and currencies, and is the gist of a proposal made by Mark Carney, the former head of the Bank of England, for a “synthetic hegemonic currency.” The implications of such a system would be significant, but again, quite distinct from any application of bitcoin.
The final tally
So, in the last analysis, what’s the dollar’s biggest rival?
Short answer: the euro. It’s already a strong second place to the dollar, and built on a legacy of relatively responsible banking. European political integration, though slow, is ongoing, and the ECB could easily issue more Eurozone bonds.
But that’s just based on current conditions. It’s possible, however unlikely, that China could choose to abandon its current impracticable balancing act and let the yuan float, abandoning its domestic economic priorities. A resurgent U.K. economy could make the pound a player again. The arrival of CBDCs would change international trade and accounts in ways that are hard to predict.
But cryptocurrency is the greatest unknown of all. If you’d told me two years ago that even a single country would be holding bitcoin in 2021, I might not have believed you – yet here we are. El Salvador’s move, however tentative, has highlighted the idea of bitcoin adoption for a lot of other similarly-situated states, and it seems very likely at least some will make similar moves in coming years.
More broadly, development and adoption are happening so fast in crypto that it’s simply impossible to predict where we go from here. Fundamental geopolitical forces suggest there is a role for a neutral non-state currency. The biggest question may be whether incumbents like China and the U.S. will allow it to grow – or strangle it to strengthen their own positions.