Global Currencies: A Multipolar Future?

According to SWIFT data on international and domestic payments, in October 2020 for the first time on record Euro transactions overtook transactions in dollars, thus making the European currency the most used one in payment operations. The share of greenback payments has been slowly falling for some years now, but 2020 seems to have given a strong blow to the Dollar predominance. While other currencies have not been able to take advantage of this phenomenon, the Euro displays a specular pattern to the Dollar.

Many elements might have contributed to such shift, ranging from a weakening of the Dollar [1] – which futures signal is not expected to stop anytime soon – inflation differentials between the two economic blocs, the record trade deficit recorded by the US in recent months [2], and additional fiscal stimulus which is being discussed in Washington.

According to other metrics, the Euro has still a long way to go to overthrown the Dollar: although the use of the greenback as official reserve currency has been on decline for some time now – while the Euro has seen its share marginally rise – the Dollar still represents more than 60% of global reserves. In the meantime, other currencies, as the Yen and the Yuan, have been more successful at eroding the Dollar share. This process would signal a relative strengthening of the European currency: while other currencies are slowly emerging on the global stage, the Euro has proven to be resilient, which could imply a slow transition towards a multipolar system.

Where the Dollar still maintains a stable lead is in the issue of debt securities: although the Euro managed to defend its share of total securities, second-tier currencies have seen their quota eroded by the Dollar. This is due to the competitive advantage of the US financial sector, notoriously more established than foreign competitors. Yet, the recently oversubscribed issuance of EU social bonds to finance the SURE unemployment relief initiative is a sign of an increasing role of the Euro in markets that will become more prominent going forward – especially after COVID-19. The Euro is already the dominant currency for green bonds, which are issued to finance climate-related or environmental projects: 45 per cent of such instruments issued in 2019 were denominated in Euro. The European Commission hopes to finance about 30 per cent of the €750 billion in borrowing through green bonds, which suggests there is a real chance to boost the international role of the Euro by consolidating it as the dominant currency in a market segment that will only grow more and more relevant.

Areas of Influence

To better asses the relative extension of Dollar and Euro areas of influence, we regress national currencies fluctuations [3] on both Euro and Dollar FX movements from 2013 onwards, grouping a country in a currency area if the latter shows the higher regression coefficient [4]. The resulting map shows that, while the Dollar still maintains its dominant position as driver of world currencies, the Euro has managed to develop an influence zone which spans not only Europe and Russia, but also multiple African countries. Such areas would find it convenient to choose the Euro as a reference international currency: cross-border investing and borrowing, as well as trade, would incur less depreciation and appreciation risk.

The analysis of distributions of correlations between national currencies versus the Euro and Dollar, respectively, confirms the hypothesis that two blocks coexist: both distributions display a bimodal pattern, with local currencies polarized either towards a very low correlation or alternately close to 1. This implies that currencies tend to either follow strictly the Dollar (Euro) or not at all, with little compromise between the two extremes, a typical feature of dominant currencies, while by using their correlations with a second-tier currency we would observe distributions resembling Gaussian ones.

A multipolar System?

From a historical point of view, the dominance of the Dollar over the last 75 years has been an anomaly rather than a rule. Multipolar monetary arrangements have been the standard in the Modern age: silver, gold and bimetallic blocs before the gold standard; the coexistence of Pound, Franc and Mark in the 19th century; and the duopoly of Pound and Dollar in the interwar period. Multipolarity does not mean that international currency status will be shared equally by different national units, but rather that it will become more equal than implied by the view of the Dollar as sole dominant currency. While a system of multiple reserve currencies may seem more unstable, possibly being subject to coordinated investors runs, the likelihood of such scenario depends on the stability of policies followed by reserve currencies governments. While in the 1920s such policies were indeed unstable, this was not the case before WWI, when a long lasting stable multipolar system was in place, suggesting that such outcome is not implausible.

The emergence of its currency to the role of global reserve currency would entail both positive and negative consequences for the Eurozone. The pecuniary advantages, often called exorbitant privilege, derive from the revenue and savings generated by foreign demand for safe and liquid assets. On the other hand, it has been argued that the exorbitant privilege might confer more costs than benefits. The three main arguments are that it hinders exporters by strengthening the currency; that it interferes with conduct of monetary policy; and that it makes more likely for a country to fall into a liquidity trap since foreign investors are willing to pay a premium for safe reserve assets in troubled times.

The main risk related to the existence of a single reserve currency as the Dollar is represented by the so-called Triffin dilemma: if the US eliminated its overall balance of payments deficits, it would deprive the world economy of dollars, i.e. of the international liquidity needed for the expansion of global trade and financing. But if the US continued to provide international liquidity, then it would be unable to avoid incurring Current Account deficits, eventually leading to question the stability of its currency. Such conundrum would be mitigated by shifting to a multipolar system.

The traditional view that only one dominant currency can exist at a given time comes from models with strong network externalities. However, history only partially agrees with this vision of natural monopoly and of its persistence. This holds even more today, as modern technologies enable agents to overcome pre-existing incompatibilities and integrate rival systems into extended networks. Indeed, with modern smartphones and computers, exchanging currencies has become trivial even for private citizens, largely reducing the liquidity benefit of directly holding a single dominant currency. Should Europe overcome the challenge posed by Covid-19 and emerge from it more united and stronger, the path for the Euro to further emerge on the global stage would lie ahead.

[1] Following Ito and McCauley (2019), we take the Swiss Franc as the neutral reference currency. Although caution in interpreting results is due, given the co-movement in USD/CHF and EUR/CHF, consistency of results is ensured by using long time series (since 2013); by using other neutral reference currencies (Japanese Yen); and by observing the distribution of coefficients compared to those of non-global currencies.

[2] The use of a constant in the regression allows to account for country specific trends due to inflation and other macro differentials.

[3] The ICE US Dollar Index, which measures the Dollar against a basket of currencies from US major trading partners, slid to its lowest level since 2018 and is down 11% since it’s March peak.

[4] In the Euro area, with the exception of April and May, trade surplus has been in line with previous years.

Antonio Focella – Junior Research Analyst, Algebris Policy & Research Forum

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