Mark Carney on a future of multiple reserve currencies

In this segment of a speech made last August by the Bank of England’s Mark Carney a roadmap is drawn for the transition to a world of multiple reserve currencies, including the renminbi and digital forms. What’s most striking is the underlying assumption of the imminent rise of China. (full speech, https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/the-growing-challenges-for-monetary-policy-speech-by-mark-carney.pdf)

Changing the Game

While such concerted efforts can improve the functioning of the current system, ultimately a multi-polar global economy requires a new IMFS to realise its full potential.

 That won’t be easy.

Transitions between global reserve currencies are rare events given the strong complementarities between the international functions of money, which serve to reinforce the position of the dominant currency.

And the most likely candidate for true reserve currency status, the Renminbi (RMB), has a long way to go before it is ready to assume the mantle.

 The initial building blocks are there. Already, China is the world’s leading trading nation, overtaking the US at the start of this decade.34 And the Renminbi is now more common than sterling in oil future benchmarks, despite having no share in the market prior to 2018.35

 The greater use of the Renminbi in international trade is also leading to its growing use in international finance. This has been enabled by reforms to China’s monetary, foreign exchange, and financial systems that have liberalised and improve its financial market infrastructure, making the Renminbi a more reliable store of value.36 The Belt and Road Initiative could foster further take up of the Renminbi in both trade and finance.

However, for the Renminbi to become a truly global currency, much more is required. Moreover, history teaches that the transition to a new global reserve currency may not proceed smoothly.

 Consider the rare example of the shift from sterling to the dollar in the early 20th Century – a shift prompted by changes in trade and reinforced by developments in finance.37 The disruption wrought by the First World War allowed the US to expand its presence in markets previously dominated by European producers. Trade that was priced in sterling switched to being priced in dollars; and demand for dollar-denominated assets followed. In addition, the US became a net creditor, lending to other countries in dollar-denominated bonds.

 Institutional change supported the role of the dollar, with the creation of the Federal Reserve System providing, for the first time, a market-maker and liquidity manager in US dollar acceptances. This was particularly helpful for promoting the use of the dollar in trade credit, reinforcing its use as a means of payment and invoicing currency.

Yet the US was, at least at first, an unwilling hegemon. Under the gold standard, the Fed’s absorption of gold inflows exported significant deflationary pressures to the rest of the world.38 Europe was dependent on the recycling of capital flows by the US, which lent much of its surplus back to Europe to enable payments of war reparations and debt. Europe suffered severely when this stopped in 1928. Moreover, the increase in price levels that occurred as a result of the First World War left the global economy with too little gold in total to sustain money supply at the level consistent with full employment. Supplementing gold reserves with foreign exchange to boost money supply led to competition between the UK and the US to provide that service to other countries.

The resulting world with two competing providers of reserve currencies served to destabilise the international monetary system, and, some would argue, the lack of coordination between monetary policy makers during this time contributed to the global scarcity in liquidity and worsened the severity of the Great Depression.

 The experience of the interwar period is a cautionary tale.

 When it comes to the supply of reserve currencies, coordination problems are larger when there are fewer issuers than when there is either a monopoly or many issuers. While the rise of the Renminbi may over time provide a second best solution to the current problems with the IMFS, first best would be to build a multipolar system.

The main advantage of a multipolar IMFS is diversification. Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall.

 A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.

 While the likelihood of a multipolar IMFS might seem distant at present, technological developments provide the potential for such a world to emerge. Such a platform would be based on the virtual rather than the physical.

 History shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the cost and increasing the convenience of international payments. The additional functions of money – as a unit of account and store of wealth – come later, and reinforce the payments motive.

Technology has the potential to disrupt the network externalities that prevent the incumbent global reserve currency from being displaced.

 Retail transactions are taking place increasingly online rather than on the high street, and through electronic payments over cash. And the relatively high costs of domestic and cross border electronic payments are encouraging innovation, with new entrants applying new technologies to offer lower cost, more convenient retail payment services.

 The most high profile of these has been Libra – a new payments infrastructure based on an international stablecoin fully backed by reserve assets in a basket of currencies including the US dollar, the euro, and sterling. It could be exchanged between users on messaging platforms and with participating retailers.

 There are a host of fundamental issues that Libra must address, ranging from privacy to AML/CFT and operational resilience. In addition, depending on its design, it could have substantial implications for both monetary and financial stability.

 The Bank of England and other regulators have been clear that unlike in social media, for which standards and regulations are only now being developed after the technologies have been adopted by billions of users, the terms of engagement for any new systemic private payments system must be in force well in advance of any launch.

As a consequence, it is an open question whether such a new Synthetic Hegemonic Currency (SHC) would be best provided by the public sector, perhaps through a network of central bank digital currencies.

Even if the initial variants of the idea prove wanting, the concept is intriguing. It is worth considering how an SHC in the IMFS could support better global outcomes, given the scale of the challenges of the current IMFS and the risks in transition to a new hegemonic reserve currency like the Renminbi.

An SHC could dampen the domineering influence of the US dollar on global trade. If the share of trade invoiced in SHC were to rise, shocks in the US would have less potent spillovers through exchange rates, and trade would become less synchronised across countries.43 By the same token, global trade would become more sensitive to changes in conditions in the countries of the other currencies in the basket backing the SHC.

The dollar’s influence on global financial conditions could similarly decline if a financial architecture developed around the new SHC and it displaced the dollar’s dominance in credit markets. By reducing the influence of the US on the global financial cycle, this would help reduce the volatility of capital flows to EMEs.

Widespread use of the SHC in international trade and finance would imply that the currencies that compose its basket could gradually be seen as reliable reserve assets, encouraging EMEs to diversify their holdings of safe assets away from the dollar. This would lessen the downward pressure on equilibrium interest rates and help alleviate the global liquidity trap.

 Of course, there would be many execution challenges, not least the risk of fragmentation across Digital Currency Areas.44 But by leveraging the medium of exchange role of a reserve currency, an SHC might smooth the transition that the IMFS needs.