By Kindred Winecoff
Jeffrey Frankel summarizes some of his recent research on how some currencies become internationalized, and speculates on the implications of his work (and that of others like Eichengreen) for the rise of the renminbi as an international currency.
He highlights two previous occasions change in reserve currencies: the shift from the pound sterling to the dollar in the 1930s-1940s, and the rise of the yen and German mark during the 1970s-1980s. (He mentions the rise of the euro since 1999, but the euro mostly just replaced the mark.) Frankel suggests that shifts in global reserve currencies come about when the following conditions are met:
1. A large volume of trade in the rising country.
2. Creditor status for the rising country.
3. Perceptions that the currency of the rising country will maintain its value.
4. Deep, liquid, open financial markets in the rising country.
China definitely meets the first two criteria, probably meets the third, and definitely does not yet meet the fourth although it has taken some baby steps in that direction over the past few years. But I'd add another criterion to the four above: A reserve currency becomes a reserve currency when it's already a reserve currency. In other words, the attractiveness of a currency is partly about the national characteristics that Frankel describes and partly about network externalities.
The usefulness of a reserve currency is largely a function of who else uses it as a medium of exchange. If lots of other folks use it, it makes sense for you to use it too. If few others use it, there's not much point in your using it. Therefore, currency usage is determined by a preferential attachment decision rule: currencies that attract a lot of usage by foreign entities tend to attract even more usage; currencies that attract little usage tend to continue to attract little usage.*
For this reason, the reserve status of a currency tends to be pretty durable. As long as the currency network remains intact, central nodes tend to remain central nodes and peripheral nodes tend to remain peripheral nodes. It generally takes a major crisis for the network to disintegrate, thus it generally takes a major crisis for a displacement to take place, even if Frankel's four conditions are otherwise met. The shift from the pound sterling (under the gold standard) to the dollar required several world wars and a global depression. These extreme events obliterated the network that had emerged during the first age of globalization (large pdf), and allowed the formation of the post-war reserve system based on the dollar.
In other words, I believe Frankel's criteria are necessary for a shift in global reserve currency, but are not sufficient. Previous systemic changes required major crises. There have been few of these; in the past half-century perhaps only a partial one: The dollar's status weakened a bit with the collapse of the Bretton Woods system of exchange rates pegged to the dollar, which was in turn pegged to gold. This led to the emergence of the German mark and Japanese yen as important currencies, though clearly still subordinate to the dollar. The dollar's centrality remained through the "Bretton Woods II" system, in which industrializing economies exported capital to industrialized countries (particularly the United States) to facilitate growth and employment through exportation.
This monetary system actually reinforced the central role of the dollar in the international monetary system, but eventually culminated in the subprime crisis. Was this shock large enough to further the process of reserve diversification by disrupting the currency network? There are reasons to think so. The initial financial shock was probably the largest in history, and it emanated from the country at the center of the system: the United States.
In hierarchal complex networks, major systemic change generally requires a large attack on the central nodes. For these reasons many expected -- and some hoped -- that the subprime crisis would lead to a reorganization of the international monetary system and the rise of a new reserve currency. Some hoped that the Chinese yuan would increase in global importance, others that special drawing rights at the IMF -- which are comprised of a basket of currencies -- would emerge as a central international reserve asset. Still others anticipated a greater role for the euro; while the European debt crisis now makes this look exceedingly unlikely, it never had much of a chance, as Kathleen McNamara wrote in a 2008 article in RIPE.
So there are also reasons to be skeptical about a shift away from dollar dominance. Unlike the British in the interwar period, the US has proactively worked to stabilize the international monetary system. The Fed opened currency swap lines with almost every important central bank in the world from 2008-2010, ensuring that the financial system had ample liquidity. For the most part these actions have been successful, and as of year-end 2010 the dollar was as central to the international exchange network as it had been in 1998.** In other words, the US's actions prevented the network from unraveling the way it did during the interwar years.
In addition, there is no other country that is well-positioned to take over. The Chinese yuan is not yet convertible. The Japanese and Swiss economies are not large or dynamic enough. The euro is not stable enough. And that's... about it. So despite major upheavals in recent years, I do not expect major shifts in the international monetary system any time in the near future.
*Credit to Thomas for first making this point to me.
**I took a look at the data in a previous post, from which the picture at the top of this post is taken.