The ongoing trend toward a bifurcation of global monetary systems is following none of the traditional geopolitical division lines of the West versus the Rest. Instead, it is tracing the broader vector of competition between national currencies.
Two camps, two innovation spaces
Two sets of monetary-policy actors are emerging within this competition to-date: states forced to adopt private technological innovation as part of their constrained monetary systems and states viewing private monetary technologies as an existential challenge to their internal and international power bases.
In the former camp, several states such as El Salvador, Venezuela and Panama have embraced the potential for using stateless technologies (private payments-clearance networks) and currencies (cryptocurrencies) as possible additions to their financial systems. Some countries, such as Iran, have taken a less direct but relatively open path toward adopting cryptocurrencies as state-supported mediums of exchange. All are distinguished by the presence of either push (international sanctions and limited ability to access international banking networks, in the cases of Venezuela and Iran) or pull (fully dollarized economies, such as El Salvador and Panama) factors working in favor of cryptos adoption. Other countries, such as Ukraine, Uganda and Zimbabwe, hope to see new financial technologies develop into viable service platforms for their weak banking and payments systems.
In the latter camp are the United States, China, India, the eurozone, the United Kingdom, Indonesia, Russia and many smaller countries. These actors are pushing toward a less understood part of the monetary-innovation frontier that is potentially more disruptive than cryptocurrencies: central bank digital currencies (CBDCs). Their sudden interest in monetary innovation stems from their central banks’ desires to preserve monopoly control over their domestic monetary policies and use CBDCs to accelerate their challenges to the US-dollar (USD) hegemony. The domestic monetary challenges to which these states are responding may be different. Russia and China share a long-term objective to insulate both countries’ financial systems from the risks of USD weaponization. For India, Brazil, South Korea, Thailand and Indonesia, the attractiveness of CBDCs rests with decoupling their goods trade from the USD dominance over trade settlements. The eurozone and UK seek to open up trade and investment channels free from the extra-jurisdictional nature of the dollar-based financial world and close the doors on the proliferation of private currencies—cryptos that dilute states’ powers in taxation and monetary-policy administration. Hong Kong, Singapore and the Bahamas are international financial-services centers seeking to capture the next phase of the financial-services frontier before their larger competitors. Sri Lanka hopes digital currencies will lower costs and improve transactions security involving its main export, tea.
Challenging the dollar
The CBDCs’ advance poses an existential contest over the dollar’s continued supremacy as the world’s reserve currency. This contest is now developing, with challengers including both state (national central banks via digital currencies) and private (cryptocurrencies) institutions. This is the first time in modern economic history when global competition against the “green buck” is being waged across multiple non-aligned and non-ideologically defined fronts.
In May, the International Monetary Fund’s (IMF’s) Currency Composition of Official Foreign Exchange Reserves (COFER) survey published new data on the USD’s share of global foreign-currency reserves held by central banks. At the end of 2020, it stood at 59 percent, the lowest in 25 years and down from 71 percent since 1999, the year the euro launched. Peak dollar dominance in official reserves was marked in the 1970s at more than 85 percent.
The July 2020 IMF working paper “Patterns in Invoicing Currency in Global Trade”1 looked at global trade flows across a set of countries accounting for roughly 75 percent of world-trade flows. Fifty-eight of 100 countries saw their shares of exports invoiced in dollars fall over time; only 36 countries witnessed their shares of trade invoiced in dollars increase. In contrast, the share of exports invoiced in euros “has increased for more countries (65) than it has declined (26)”.
Data from a November 2020 IMF working paper “Reserve Currencies in an Evolving International Monetary System”2 shows that the USD’s share in global foreign-exchange markets, cross-border banking claims and outstanding internal debt securities remained relatively stable over 1999-2019.
So global evidence is mixed on just how much pressure the US hegemony over global monetary systems is facing. Competition with the USD, primarily from the euro area and China, is heating up, making it more imperative for the US and its challengers to deploy digital—not electronic—currencies.
What makes or breaks a reserve currency?
Economic research offers four key factors that define a reserve currency: economic hegemony of the issuing country; credibility of the issuer as a securer of the reserve currency as a store of value; demand for the reserve currency in global trade and financial transactions; and volume of reserve-currency-denominated financial instruments and commitments outstanding (inertia).
Network effects related to financial and trade flows “exacerbate this inertia and create strong path dependence”.3 Studies show that these factors’ efficacy has changed over time. Following the collapse of Bretton Woods, inertia sustaining the dollar’s dominance as a reserve currency strengthened through the mid-1990s. Since then, the euro’s introduction and developing economies’ rise have undermined this factor’s strength. The importance of networking effects diminished as transactions technologies and financial markets evolved, risk-hedging costs in currency markets declined, and global banking institutions became more geographically diversified. The global financial crisis added to this dynamic by accelerating the regionalization of financial and trade flows.
Cryptocurrencies’ rise in the 2010s, alongside growing the global economy’s financialization, significantly accelerated changes in the patterns of traditional currencies’ functioning. Cryptocurrencies promise user autonomy from centralized banking and monetary-system constraints. Based on data from Chainalysis, published in its annual Global Crypto Adoption Index, the use of cryptocurrencies rose 881 percent worldwide in 20204.
Countries with higher-density use of crypto alternatives to official fiat currencies are far from minnows in the global monetary order. The top 20 cryptocurrency-adoption states include India, Kenya, Nigeria, the US, China, Brazil, South Africa and Russia. While it’s uncertain how China’s recent ban on cryptos trading and mining will play out, a range of major monetary authorities are being forced to react to crypto-assets’ rise. And this reaction is much broader than considerations of the risks of illicit financial flows. Cryptocurrencies are seen as potential challengers to state-monopolized monetary systems—coming when most central banks have run into the quicksand of zero-interest-bound monetary policies.
With inertia and networks’ rationale for continued USD dominance waning, and with the US’ credibility as an impartial arbiter of transactions under pressure, the Federal Reserve (the Fed) cannot afford not to restrict further advances of cryptos and the emergence of competing CBDCs.