Reserve Currencies in an Evolving International Monetary System

Alina Iancu; Gareth Anderson; Sakai Ando; Ethan Boswell; Andrea Gamba; Shushanik Hakobyan; Lusine Lusinyan; Neil Meads; Yiqun Wu

doi:10.5089/9781513560298.087.A001

Author: Alina Iancu, Gareth Anderson¹, Mr. Sakai Ando https://orcid.org/0000-0003-2785-4375, Ethan Boswell, Mr. Andrea Gamba², Shushanik Hakobyan, Ms. Lusine Lusinyan, Mr. Neil Meads³, and Mr. Yiqun Wu

¹ https://isni.org/isni/0000000404811396, International Monetary Fund
| ² https://isni.org/isni/0000000404811396, International Monetary Fund
| ³ https://isni.org/isni/0000000404811396, International Monetary Fund

Publication Date:: 17 Nov 2020

ISBN:: 9781513560298

Language:: English

Keywords:: Foreign exchange reserves; international currency; currency composition of reserves; international debt and cross-border bank claims; DPPP; DP; reserve currency share; currency composition; currency denomination; transfer service; invoicing currency; reserve currency status; dollar share; deutsche mark; reserve currency configuration; benefit currency; currency usage; currency shift

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Despite major structural shifts in the international monetary system over the past six decades, the US dollar remains the dominant international reserve currency. Using a newly compiled database of individual economies’ reserve holdings by currency, this departmental paper finds that financial links have been an increasingly important driver of reserve currency configurations since the global financial crisis, particularly for emerging market and developing economies. The paper also finds a rise in inertial effects, implying that the US dollar dominance is likely to endure. But historical precedents of sudden changes suggest that new developments, such as the emergence of digital currencies and new payments ecosystems, could accelerate the transition to a new landscape of reserve currencies.

Abstract

Chapter 1 Introduction

The international monetary system has evolved over the past decades in response to major structural shifts in the global economy prompted by trade and financial integration, technological developments, and geopolitical events. More recently, the sustained growth and rapid integration of emerging market and developing economies (EMDEs) have increased their economic heft and created a less-concentrated structure of global output and trade and a more multipolar global economy (IMF 2016).

Yet the currency composition of international reserves has remained remarkably stable. The US dollar has been the dominant reserve currency for the past 60 years, notwithstanding the collapse of the Bretton Woods system in the 1970s and the emergence of new reserve currencies such as the euro and the renminbi over the past two decades. The dollar’s reserve currency status has been supported and reinforced by its global use for trade invoicing and cross-border investment, among others, and as an exchange rate anchor.

This paper investigates the drivers of reserve currencies at the global and country level, how these drivers have changed over time, and how they differ across advanced economies (AEs) and EMDEs. In addition to aggregate data from the IMF Currency Composition of Official Foreign Exchange Reserves (COFER) database, the paper compiles and uses a novel database of individual economies’ reserve holdings by currency.¹ The paper finds that inertia and financial links are important drivers of reserve currency shares, and their importance has increased since the global financial crisis (GFC) of 2008–09.

The paper complements the empirical analysis with a discussion of ongoing trends and uncertainties that could accelerate the transition to new reserve currencies. A number of possible factors could lead to an eventual change in the status quo. For instance, the COVID-19 pandemic could yet alter the global economic landscape; rising geopolitical tensions could trigger strategic shifts in reserve holdings; or technological advances, in particular the emergence of digital currencies and advances in payment systems, could speed up the transition to alternative, and perhaps less stable, configurations of reserve currencies.

The paper is structured as follows. Chapter 2 outlines what constitutes a reserve currency and provides a short description of current and past trends. Chapter 3 introduces the conceptual framework underpinning the empirical analysis and presents the findings using both global and country-level data. Chapter 4 considers potential triggers for future shifts, and Chapter 5 offers conclusions.

Chapter 2 Current and Past Reserve Currencies

Countries hold foreign exchange reserves to finance balance of payments needs, intervene in foreign exchange markets, provide foreign exchange liquidity to domestic economic agents, and for other related purposes, such as maintaining confidence in the domestic currency and facilitating foreign borrowing. As such, reserves are generally denominated in currencies widely used for international payments and widely traded in global foreign exchange markets.¹,²

The accumulation of foreign exchange reserves by the official sector is but one of many examples of the international use of currencies. Other countries’ currencies can be also used by the private sector for external trade invoicing and settlement, cross-border investment, and as a vehicle for financial transactions. Different international uses are complementary and tend to reinforce each other. For instance, widespread use by the private sector for trade invoicing and financial transactions often goes hand-in-hand with official sector use as exchange rate anchor and reserve currency, which, in turn, can bolster credibility and reinforce private sector use. Also, more trade invoicing is often associated with a greater denomination of financial claims (Gopinath and Stein 2018; Chahrour and Valchev 2017).

The US dollar is currently the dominant reserve currency, with a share of 61 percent of global reserves at the end of 2019. The euro comes second with 21 percent of reserves, and other currencies’ shares are much smaller still (Figure 1). The dollar’s leading role as a reserve currency is consistent with its wide international use: it stands out as the currency most traded in the foreign exchange market (44 percent of turnover), and most used for trade invoicing (54 percent of global trade) and financial claim denomination (for example, 51 percent of cross-border bank claims) (Figure 1).

The US dollar has held this dominant position for more than 60 years, notwithstanding significant shifts in the international monetary system (IMS) (Figure 2). Some of these shifts have included, in chronological order, the creation of the SDR in the 1960s to help address the so-called Triffin dilemma³; the collapse of the Bretton Woods system in the 1970s that diminished the link to the dollar in exchange rate arrangements; the emergence of Japan in the 1980s as a global creditor; the introduction of the euro in 1999; trends toward greater reserve diversification following the GFC⁴; and China’s efforts to boost the internationalization of the renminbi and promote its reserve currency status over the last decade. Despite all these changes, the dollar’s share in global reserves has remained above 50 percent, while its share in global foreign exchange turnover has been remarkedly stable at close to 45 percent since 1989 (Figure 3). And while other currencies, particularly the renminbi, have been reportedly gaining some ground in trade invoicing,⁵ the dollar’s use for financial asset denomination, in particular EMDEs debt, has been on the rise.

The IMS has often been dominated by a few currencies that were used widely for significant periods of time. In recent decades, these currencies have been the US dollar and, to some extent, the euro (Figures 2 and 3). The transition from one dominant currency to another has taken anywhere between several years to many decades, but there have also been periods without a dominant currency (Box 1).

^{Box 1.}

International and Reserve Currencies in Retrospect

The use of national currencies as reserves is a relatively new phenomenon linked to the development of nation states and central banks. Even under the gold standard, balance of payments differences were primarily settled in gold, with national fiat currencies accounting for a relatively limited share of total reserves.¹,² The growing use of national fat currencies as reserves was supported by the collapse of the gold standard together with the recognition of various benefits of holding fat currency over commodities.³

Historically, transitions from one dominant “international” currency to another took anywhere from several years to many decades.⁴ In the 18th century, policy errors and a lack of fiscal backing contributed to the Dutch florin’s abrupt (in just over a decade) loss of status as the dominant international currency, while the rise of Britain as an industrial and commercial power supported the concurrent rise of London as a financial center and of pound sterling as an international—and reserve—currency (Quinn and Roberds 2014). In the 20th century, the US dollar replaced the sterling as the dominant international currency only many decades after the United States overtook Britain economically.⁵

There have been periods with no clearly dominant international currency. For example, prior to the classical gold standard, silver, gold, and bimetallic blocs coexisted; in the 19th century, the British pound, French franc, and Deutsche mark all accounted for significant fractions of global foreign exchange reserves (Lindert 1969); and in the interwar period, the British pound and US dollar contributed equally to the stock of global liquidity and were equally important as invoicing and settlement currencies (Eichengreen and Flandreau 2009, 2010; Chiţu, Eichengreen, and Mehl 2012). However, the 20th century has been characterized by long periods in which one currency has been used in a significant way internationally at a time—first the British pound, and after the inter-war transition, the US dollar.

Currently, not all reserve currencies fulfill all international roles. For example, the Japanese yen, British pound, and Swiss franc are used internationally mainly for investment purposes, while the renminbi has been little used for investment purposes but increasingly so for trade invoicing. The European Currency Unit (ECU—a basket of European currencies) has predominantly played the role of an anchor currency and was neither a vehicle nor an invoicing currency. But the most used reserve currencies (currently the US dollar and, to some extent, the euro) have been widely used internationally for both trade and finance.

¹Flandreau and Jobst (2009) document how, prior to the industrial revolution, the “international” monetary system was a European-dominated intercity system based on privately issued bills of exchange.²Lindert (1969) estimates that, despite rapid growth, foreign exchange reserves accounted for less than 20 percent of total reserves by the end of 1913.³ For instance, currency holdings offered interest income and lower transportation and transaction costs, and provided increased flexibility in the face of temporary balance of payments deficits amid competition for gold reserves. Meanwhile, growing dependence on credit from international financial centers bolstered the ability of some currencies to serve as collateral for short-term credits.⁴Ghosh, Ostry, and Tsangarides (2010) assess the literature on the interwar sterling-dollar switch, and discuss the likelihood of a switch in reserve currencies (notably, a tipping point of the dollar). Neither historical experience nor simulation analysis suggest that an abrupt change in the stock of US dollar assets held as reserves was likely, but the possibility of a sudden and disorderly tipping point could not be ruled out definitively.⁵ Although the precise timing of transition has been debated intensely, it was clearly many decades after the United States overtook Britain economically. The United Kingdom lost its position to the United States as the world’s largest economy in 1872 and the largest exporter in 1915. The switch in net debtor/creditor positions started in 1914, and as the US dollar emerged as a convertible net creditor currency, its use in trade and finance widened (for instance, according to Eichengreen, 2019, the US share of Argentina’s imports rose from 15 percent in 1913 to 25 percent in 1927).

Chapter 3 Drivers of Reserve Currencies

This chapter uses an empirical model to investigate the main drivers of reserve currencies, how their importance has changed over time, and how they differ across AEs and EMDEs. Understanding these drivers could help tackle the question of how and when (if at all) a transition to a new reserve currency configuration might occur, which is discussed in Chapter 4.

This paper overcomes an important gap in the existing literature by compiling and using a novel database of individual economies’ reserve holdings by currency—to the authors’ knowledge, the most comprehensive database based on official data published by individual central banks. Compared to earlier papers, it also considers a broader range of specifications to check the robustness of the results.

Conceptual Framework

The existing literature emphasizes four key elements in determining reserve currency status:

The economic size/dominance of reserve issuers: In theory, the larger the economy and its role in international trade and financial networks, the more likely its currency will be used for those international transactions and as a reserve asset.
The credibility of reserve issuers: Reserve assets should, in theory, offer a stable store of value over time, and be widely used and traded, emphasizing the importance of reserve issuers’ policy credibility and their financial markets’ depth and liquidity.
The transactional demand of reserve holders: Central banks’ reserve portfolio decisions are likely to be influenced by the intended uses of reserves, particularly for trade- and finance-related payments or foreign exchange market intervention.
Inertia: Reserve currency status tends to change very slowly, inducing inertia. There is a strong inertial bias in favor of using whichever currency has been the reserve currency in the past. Network effects exacerbate this inertia and create strong path dependence.

The literature on the drivers of reserve currency shares at the global level indeed finds a significant role for the economic characteristics of reserve issuers, such as their global reach and credibility, as well as inertia (Li and Liu 2008; Eichengreen, Mehl, and Chiţu 2016; see Annex 1 for a detailed discussion of the existing literature). The literature also concludes that, after the collapse of Bretton Woods system, the inertial effects became stronger, while the network effects, captured by the reserve issuer’s economic size, seem to have weakened, possibly reflecting lower switching costs due to advances in financial and transactions technology. A few studies offer evidence of the geopolitical or strategic considerations influencing countries’ choice to hold reserves in a given currency.

Studies using aggregate reserves data cannot capture reserve holders’ potential transactional demand (the intended uses of the reserves). The literature using individual country data fills this gap but is relatively sparse due to the lack of publicly available data. Studies using confidential COFER country-level data find that reserve holders’ potential transactional demand for international payments and foreign exchange market intervention drive the currency composition of their reserves (Heller and Knight 1978; Dooley, Lizondo, and Mathieson 1989; Eichengreen and Mathieson 2000), but such data remain inaccessible for public use.¹

Empirical Investigation

Data and Methodology

The analysis in this paper relies on aggregate data from the IMF COFER database, Eichengreen, Mehl, and Chiţu (2016), and individual country data collected from a select group of central banks.

Aggregate reserve currency shares cover the period 1947–2018 and are sourced from Eichengreen, Mehl, and Chiţu (2016) before 1995 and COFER since 1995.² The COFER database contains data reported to the IMF on a voluntary and confidential basis. As of the end of 2019, there are 149 reporters accounting for roughly 94 percent of global reserves.³ Individual responses are confidential, and only the aggregate data are publicly available.⁴

Aggregate data may mask significant shifts within individual countries’ portfolios, potentially over-emphasizing inertia. Indeed, the variation in individual countries’ reserve currency shares is significantly higher than in the aggregate data (Figure 4). Furthermore, the use of country-level data allows for the examination of more granular drivers—for instance, trade or financial links to the reserve issuer or its currency and the de facto use of the reserve currency as an anchor. It can also provide additional insights into how aggregate shares may evolve in the future.

Individual country reserve currency shares are compiled using various central bank publications for 57 economies—19 AEs and 38 EMDEs—over the period 1999–2018. Lack of trade and financial data for some countries further limits the sample to 10 AEs and 32 EMDEs, accounting for 28 percent of global reserves in 2018.⁵

Country-level data confirm the main trend observed in the aggregate data: the average share of US dollar-denominated reserves slipped somewhat following the introduction of euro but recovered after the GFC and the eurozone debt crisis (Figure 5). In addition, the average share of euro-denominated reserves is higher in AEs compared to EMDEs, most likely due to the country composition in each sample, but has trended down for both groups of countries over the sample period.⁶ The share of British pound has been relatively small at about 4–6 percent in the last decade, while the Japanese yen experienced a slight surge after the GFC in AEs and remains negligible in EMDEs.

The empirical analysis aims to identify factors that are important in explaining reserve currency shares. In line with the existing literature, the core specification based on aggregate data considers the three factors typically found to be important drivers of aggregate reserve shares:

lagged reserve currency share to capture inertia
reserve issuer’s share in global GDP to proxy for “network effects” pertaining to its global reach/size
average appreciation of the reserve issuer’s currency against the SDR in the previous five years to capture its credibility.

In addition to inertia, country-level regressions consider factors that could drive individual countries’ transactional demand for reserves, including:

trade links captured by the share of country’s trade with the reserve issuer
foreign exchange alignment proxied by the country’s exchange rate comovement with the reserve currency, following Ilzetzki, Reinhart, and Rogoff (2019)
financial links captured by the share of country’s external public debt or cross-border bank claims denominated in reserve currency.

The methodology in this paper improves on previous studies. Results from aggregate data are based on fixed effects model (for currencies and countries), as the unobserved effects appear to be systematic (that is, correlated with predictors).⁷ For disaggregated data, the model is estimated separately for AEs and EMDEs as different drivers of reserve holdings could be expected, but also because of different data availability; for example, for financial links this paper uses external public debt data for EMDEs and cross-border bank claims for AEs.⁸ The authors undertake a number of robustness tests to check the sensitivity of the results to alternative specifications (see Annexes 2 and 3 for a detailed discussion of the methodology and results).

Results

The econometric analysis of reserve currency shares reveals that (1) the drivers of reserve currency shares vary across AEs and EMDEs; (2) inertial effects are important throughout the entire period and increasingly important in recent decades; and (3) financial links are becoming more important, while trade links do not appear to be a robust driver of reserve currency shares (Annexes 2 and 3).

Drivers of reserve configurations vary between AEs and EMDEs and over time. Financial links seem to be particularly relevant for EMDEs, while trade links appear more important for AEs, possibly reflecting the large concentration of non-euro area European countries in the AEs sample, with the bulk of their trade with eurozone countries and reserve holdings predominantly in euros.

On inertial effects, holding a large share of a given reserve currency in a given year appears to be a good predictor of reserve shares the following year, especially if the currency has been long in use as a reserve currency. Inertial effects are weaker in the disaggregated data, pointing to shifts in some countries’ reserve portfolios, but have become more important since the GFC (Figure 6), particularly in EMDEs. Inertial effects appear to dominate economic and geopolitical effects, such as the reserve issuers’ economic size and geopolitical influence,⁹ and the credibility of its currency. Credibility, in particular, seems to matter only up to a point—once a reserve currency becomes “dominant,” short-term episodes of depreciation are less important (Annex 2).

Contrary to previous studies, trade links/networks do not seem to be a robust driver of aggregate reserve shares. Reserve issuers’ centrality in global trade networks has some limited explanatory power (Annex 2). When using disaggregated data, the authors also find that trade links with reserve issuers generally fail to explain the observed reserve shares (Figure 7).¹⁰ It could be that a country’s trading partners are less relevant for reserve currency considerations in a world where export prices are set in a dominant currency, most likely the US dollar, rather than the producer’s currency (Gopinath and others 2020). Unfortunately, the lack of comprehensive data on currencies used for trade invoicing does not allow for a further investigation of this link.

In contrast, financial links appear important and have become more significant over time (Figure 7). The currency denomination of external public debt and cross-border bank claims is an important driver of reserve shares, and increasingly so since the GFC. Moreover, the currency denomination of public debt is an especially important determinant of reserve holdings in EMDEs, particularly those in Africa and Asia (Figure 8). The currency denomination of debt also matters for aggregate reserve shares. But other measures of financial depth/reach of a currency, such as its share in foreign exchange turnover or cross-border bank claims do not matter. This may indicate threshold effects—deep financial markets are likely a precondition for reserve currencies, with incremental changes less relevant.

Chapter 4 What Could Alter the Status Quo?

The findings in Chapter 3 and the empirical literature suggest that the currency composition of reserves is influenced by a range of slow-moving factors (historical ties, trade, and finance). But large, sudden changes are not unprecedented historically (Box 1). This chapter offers a discussion of trends and uncertainties, including those related to the COVID-19 crisis, that could affect the status quo and lead to different currency configurations of reserve holdings with significant implications for the IMS.

Current Trends

The sustained economic growth and rapid trade integration of EMDEs— particularly China—have led to less-concentrated global output and trade growth and gradually shifted the world’s economic center of gravity (Figure 9). Financial integration has also become more pronounced, with global capital flows, measured as the sum of gross capital inflows across all countries relative to the global GDP, three times as large in recent years than in 1970s. These trends have not (yet) affected the role of the US dollar as the dominant reserve and international currency. Further, the COVID-19 crisis has led to a global fight to safe assets, and to the dollar in particular, supported by the US Federal Reserve’s actions to provide liquidity.¹

Going forward, China could overtake the United States as the world’s largest economy by 2030, while the share of EMDEs in global GDP is expected to exceed 50 percent by 2030. Despite this ongoing shift to a more multipolar global economy, the high degree of inertia in the currency composition of global reserves suggests that the US dollar will remain the dominant reserve currency for the foreseeable future.²

Uncertainties Going Forward

There are many uncertainties regarding current trends, particularly related to the COVID-19 crisis, that could have a lasting impact on trade and financial relationships, with implications for the currency composition of reserve holdings and the IMS.

Financial Considerations

The empirical analysis in Chapter 3 highlights the growing importance of financial links and suggests that reserve issuers may be able to increase the prominence of their currencies as a reserve asset if they are able to materially expand their use in cross-border banking and debt markets.

Consider the following thought experiments. If the share of cross-border bank claims in euros were to increase by 30 percentage points over the next 20 years, the share of euro-denominated reserves of an average country in the sample would go up by about 5 percentage points, according to estimates from the country-level regression.³ Similar extrapolation suggests a greater impact of increased financial links for the reserve portfolios of EMDEs: if the share of euro-denominated public debt were to increase by 30 percentage points over the next 20 years at the expense of debt denominated in US dollars, the average share of the euro in EMDEs’ reserve portfolios could increase almost two-fold, from 23 percent to 40 percent (Figure 10).

The debt landscape, in which new creditors—including China—have become increasingly important (Horn, Reinhart, and Trebesch 2020), was evolving rapidly before the pandemic. Such shifts could accelerate in a post-pandemic world. Given the large scale of EMDEs’ financing needs, it is plausible that EMDEs’ renminbi-denominated debt could rise in future—consistent with a larger share of reserves held in renminbi.

Trade Links

The empirical analysis in Chapter 3 suggests that trade links have become less relevant as a driver of reserve currency configurations. Whether this trend persists depends on how trade patterns evolve in future.

The pandemic has highlighted the fragility of global supply chains and countries’ interest in ensuring the future security of critical supplies. Such factors could lead to more diversified supply chains and/or localized production to avoid overreliance on a single dominant supplier country in the future, with implications for the demand for reserves.⁴ This paper’s findings suggest that, post crisis, lower trade shares with reserve issuers could lead to lower reserve shares. However, this potential development in trade links could be countered by any reserve issuer’s ability to elevate the status of its currency as an invoicing currency.

Credibility

The existing literature and the authors’ empirical analysis find that credibility matters. The US dollar’s dominance has been related, in part, to a lack of credible alternatives. For instance, stalling use of the euro as a reserve currency has been linked to institutional gaps in the European monetary union—including a lack of risk sharing—exposed during the eurozone debt crisis (Maggiori, Neiman, and Schreger 2019) (Box 2). If the euro or other currencies were to overcome such impediments, they could provide more credible alternatives to the US dollar, and the currency composition of reserves could shift.⁵

Despite significant inertia observed in the past, the dominance of a single reserve currency might not be a sustainable equilibrium going forward. In the short term, swift actions by the US Federal Reserve during the COVID-19 crisis may have reinforced the credibility of the US dollar.⁶ But if the US economy continues to decline in size relative to the global economy, the demand for reserves might eventually outstrip the supply of US dollars, prompting the official sector to look for alternatives. Rising demand for reserve assets, particularly in the context of a global shortage of safe assets (Caballero, Farhi, and Gourinchas 2017), may create incentives for other potential suppliers to take proactive steps to develop new reserve currencies.

In light of the COVID-19 pandemic, the credibility of any reserve currency may depend on how the issuing country performs in bringing the pandemic under control and restarting its economy while managing the rising levels of debt. Failure to contain the spread of the virus and enact sound policies to avert a longer-lasting downturn and maintain the country’s economic health could lead to a depreciation of the issuer’s currency. This paper’s findings suggest that this would lead to a lower share in global reserves.

Exchange Rate Anchor

The number of countries with exchange rate pegs has declined in recent years, lowering the need to hold the reserve currency for foreign exchange intervention purposes. Reluctance to change fixed exchange rate arrangements, owing to fears of inducing instability, may have contributed to previously observed persistence, but such ties have loosened over time with an increasing use of alternative monetary frameworks (Figure 11).⁷ This could partly explain why the empirical analysis does not find a positive relationship between anchoring and reserve currency shares. It is also possible that the effect of exchange rate regimes and anchoring is poorly identified given the small sample size.

Geopolitics as a Trigger of Currency Switches

Geopolitical or strategic considerations may trigger changes in reserve holdings beyond those driven by economic factors. For example, decisions to hold reserves in any currency may also be motivated by foreign policy considerations and security ties or military alliances.

Although it is difficult to pin down the geopolitical effects in the empirical analysis (Annexes 2 and 3), the authors cannot rule them out, given the historical evidence. In fact, a recent example of a significant and sustained shift from one reserve currency to another point to a possible correlation with the introduction of sanctions (Box 3). More specifically, in the Spring of 2018, the Bank of Russia implemented a significant reallocation of its reserve portfolio away from the US dollar, mostly into renminbi, following the imposition of US sanctions.

Going forward, spillovers from trade tensions and the COVID-19 pandemic, including as reflected in recent oil price movements, export bans on medical supplies and equipment, and less cooperation between countries, could result in strategic changes in reserve holdings of individual countries.

A deliberate push to internationalize currencies could also drive change. National policies have played a role in supporting the internationalization of currencies for economic as well as political benefits, including international prestige and the enhanced ability to project military power abroad. More recently, China has been actively promoting a wider use of the renminbi for trade and investment, which was supported by the addition of the renminbi to the SDR basket in 2016.⁸ Between 2010 and 2014, 37 central banks have reportedly added the renminbi to their reserve portfolios (Liao and McDowell 2016), with the share of renminbi in global reserves reaching 2 percent in 2019. The next stage in the internationalization of the renminbi could depend, to some extent, on the landscape of China’s economic and political ties that emerge after the COVID-19 crisis.

Technology as a Disruptor

The current configuration of reserve currencies could be altered by the rapid pace of financial innovation, underpinned by technology. Advances in financial and payments technologies can reduce switching costs and informational asymmetries, and thus further reduce the strength of existing network effects and inertia. Technology might also facilitate the circumvention of capital controls and sanctions, potentially facilitating the use of alternative currencies.⁹ In the short term, the two most potent channels are (1) the emergence of digital currencies and (2) changes in existing networks, including payment ecosystems.

Digital Currencies

Digital currencies can take on various forms and can be issued by both the public and private sectors. The implications of digital currencies for reserve holdings would depend on which kind of digital currency prevails.

Many central banks are seriously considering issuing a central bank digital currency (CBDC). A recent BIS survey of central banks indicates that about 80 percent are engaging in work related to CBDCs, and 40 percent have progressed to experiments or proof of concept (Boar, Holden, and Wadsworth 2020).¹⁰ In 2020, China became the first large country to put a CBDC into limited use; testing of a digital renminbi by banks, government, businesses, and individuals is currently under way in 28 provinces. Reserve implications of a CBDC issuance would depend on country and global circumstances. A CBDC issued by current issuers could increase the demand for reserves denominated in these currencies, whereas a CBDC issued by smaller countries with highly credible policy frameworks could make their currencies easier to use as reserves.¹¹

Recently, the idea of a universal CBDC has also gained prominence. A synthetic hegemonic currency, backed by a basket of CBDCs, could provide more efficient domestic and cross-border payment services, benefiting from the credibility of multiple central banks that support it (Carney 2019). Such an architecture could change the demand for reserves denominated in currencies in the basket based on their relative weight.

Private digital currencies (PDCs) could also emerge as important international currencies.¹² In 2019, Facebook announced plans to launch Libra, a single-currency private stablecoin with potentially global reach, which could become the first example of a global stablecoin (GSC).¹³ The launch of a GSC could increase the demand for fiat reserve currencies it is backed by. But GSCs do not need to be backed by existing fiat reserve currencies and could themselves attain reserve currency status. It is also conceivable that more than one global stablecoin could become a reserve asset.

Digital currency competition may differ from traditional currency competition by differentiating along associated networks and users rather than being based on macroeconomic performance (Brunnermeier, James, and Landau 2019), hence possibly altering the traditional drivers of reserve currency configurations. But, while these “digital currency areas” may cut across borders in ways that existing currencies do not, variations in regulatory frameworks could lead to increased fragmentation of currency use.

Payment Systems

Most existing cross-border transfer and payment systems face challenges (Box 4). Alternative systems, using technologies such as distributed ledgers, could overcome existing constraints and inefficiencies. New payment systems (and some existing ones) may offer the opportunity to settle in multiple currencies, reducing the need for vehicle and invoicing currencies going forward and moving the IMS toward decentralization.¹⁴ Other new systems may be centered around one established international currency and boost its position among regional or global reserve currencies.

Digital platforms could offer alternative networks for emerging (fiat or digital) currencies to tap into. For instance, as discussed above, some digital assets might gain rapid traction if they are able to tap into large pre-existing networks or attract users with bundled services. Both features could be accomplished by Big Tech companies with operations transcending national borders.

Longer-Term Considerations

With accelerating digitalization and technological innovations, the impact of technology on international reserves and global configurations could become more prominent over time. In addition to creating new classes of assets, reshaping the financial industry, and transforming reserve management— trends that are already underway—technology can affect reserve holdings by transforming the traditional drivers of reserve configurations (such as network effects, trade and financial linkages, geopolitics, and institutions and the legal system) and their impact on reserves.

Future reserve currency configurations will be shaped by many factors which are explored in Box 5 using a well-established scenario planning approach.¹⁵ Scenarios are narratives that illustrate how an unpredictable future might play out; they are not forecasts or predictions but help generate perspectives sufficiently different from those currently held. The scenarios outlined in Box 5 illustrate how technology can either strengthen the role of a dominant currency or facilitate a shift toward a multipolar world. They also highlight the importance of other factors, such as the credibility, scale, and stability of traditional and nontraditional reserve assets, as well as emerging considerations, such as climate change risks. The scenarios particularly underscore the importance of credibility and trust, which generally benefit currencies of countries offering geopolitical neutrality and/or strong institutions. However, it may no longer be unthinkable to see currencies issued by a more socially responsible and accountable private sector to replace those from the public domain, or to simply see a trend toward greater decentralization of economic power as well as reserve currencies.

Reserve configurations may also be less stable in the future, particularly due to the prominence of cyber risks. The scenarios highlight risks ranging from cyberattacks to network and technology vulnerabilities to “shortage” of personal data (the asset underlying a new form of money in Scenario 3, Box 5). And, while risk insurance and regulation may take a different shape in the future, they would still be needed in an interconnected world.

^{Box 2.}

Evidence on Eurozone Credibility

Following the GFC and Eurozone debt crisis, there was an observable decline in the share of euro in reserve currency portfolios (Figure 2.1), consistent with a broad reappraisal of risks. This trend is in line with the evidence from individual countries’ reserve portfolios on significant and sustained shifts from one reserve currency to another.¹ Prior to the GFC, the authors observe a roughly similar number of shifts away from the US dollar toward the euro (3) as from the euro toward the US dollar (2). Since 2008, the number of shifts has generally increased, but with significantly larger number of shifts away from the euro. Indeed, 5 out of 8 significant and sustained shifts away from the dollar have been toward currencies other than the euro, including the Australian dollar, Japanese yen, and Chinese renminbi (Figure 2.1).

Despite such shifts, it is noteworthy that the euro shares have held up in countries with strong economic and political ties with the eurozone, for example, the European Union countries outside of the eurozone, which are in the European Exchange Rate Mechanism (ERM) II and maintain a peg against the euro, or are obliged under European Union membership to eventually adopt the euro.

¹ Defined as the decline in three-year average over previous (non-overlapping) three-year average share, which is both greater than a 5 percentage point decline and greater than 2 standard deviations for a three-year moving average time series of the currency share.

^{Box 3.}

Russia’s Reserve Holdings and US Sanctions

In recent years, Russia’s reserves have seen a large shift away from the US dollar. Publicly available data highlight a gradual decline in the US dollar’s share of reserves over 2006–14, from 49 to 44 percent, with significant fluctuations starting in 2017, possibly mirroring developments in US-Russian relations. There was a particularly sharp decline in the US dollar share in Russian foreign exchange reserves in 2018 following the issuance of US sanctions against Russia (Figure 3.1).¹ A simple event study analysis, using quarterly data from 2006 through 2018, supports the hypothesis that sanctions may have been correlated with shifts in reserve shares. The comparison of dollar shares before and after the 2018 episode, after applying year fixed effects to partially control for economic and other factors, suggests that tensions in 2018 were associated with a statistically significant 26 percentage points decline in the dollar share.²

¹ In April 2018, the United States issued new sanctions against Russian individuals and business entities, in response to events in Syria and Ukraine.² Data scarcity and identification issues (including from the presence of multiple episodes at short intervals, some leading to increased, some to an easing of, tensions) suggest that the results should be interpreted as a correlation rather than a causal relationship.

^{Box 4.}

Payment Systems: Challenges and Promises

Existing cross-border transfer and payment systems face multiple legacy issues. They rely on correspondent banking relationships, which can be complex, slow, expensive, and nontransparent.¹ Part of the issue relates to reliance on legacy technology. For instance, correspondent banking transfers typically rely on legacy real-time gross settlement systems (RTGSs) run by central banks that require downtime for end-of-period batch processing and that each bank in a correspondent relationship be “open” to process a transaction.

Change is coming. For example, the SWIFT global payments initiative aims to improve payment speed and transparency,² while many RTGSs are moving to new messaging standards offering increased interoperability and transparency.³ The European Central Bank has launched a new TARGET instant payment service (TIPS), which helps reduce credit risk by providing instant settlement. Canada’s payment system CLUE already allows trading in seven international currencies, which will be expanded to 18. However, these initiatives offer partial solutions by integrating recent technologies into existing infrastructure.⁴ And, while alternative payments and money transfer services are disrupting incumbents in the retail space, those services use traditional wholesale payments infrastructure to settle their transactions and hence may not significantly alter international currency usage.⁵

¹ These problems have resulted in the withdrawal of several correspondent banking relationships (Erbenová and others 2016). For US banks, the cost of cross-border transfers is estimated to be 10 times the cost of domestic payments, with 34 percent of the cost attributable to trapped liquidity in correspondent bank accounts (McKinsey & Co 2016).² SWIFT established a new standard for participating institutions—SWIFT gpi (global payments innovation)—to improve speed, security, and transparency in cross-border payments across the correspondent banking network.³ For an overview, see BoC, BoE, and MAS (2018).⁴ The G20 has tasked the Financial Stability Board with coordinating a three-stage process to develop a roadmap to enhance cross-border payments by October 2020. The reports for the first two stages have been published, which include exploring the potential role of new payment infrastructures and arrangements as one of the focus areas (FSB 2020b, 2020c; CPMI 2020).⁵ For instance, while PayPal, Apple Pay, or Alipay offer cross-border retail payment capabilities, such services rely on the funding and debiting of user accounts through standard bank account debiting and crediting or credit card payments. In effect, such services offer improved end-user experience, but do not alter the existing international currency usage.

^{Box 5.}

Technology and Reserve Currency Configurations: Long-Term Scenarios

This box explores the implications of technology on reserve currencies over the long term, using a scenario-planning approach, which is particularly well suited for the highly uncertain and increasingly digitalized environment emerging as a result of the COVID-19 pandemic. In the three scenarios that follow, technological developments, combined with economic and geopolitical factors, bring about changes in the configurations of reserve currencies by 2045.

Scenario 1. The rise and fall of a global Central bank digital currency (CBDC). The scenario is cast in the context of growing geopolitical divisions, which put a premium on transactions via a neutral currency. A bloc of countries gains advantage by moving first in developing comprehensive digital platforms, supported by strong governance and institutions. The continued trend of growing importance of data services provides an additional comparative advantage to the first-mover countries, which have the technology and infrastructure to offer and export such services. Favorable climate conditions further provide a more cost-effective environment for the provision of digital services (for example, sufficiently cold and relatively stable climates for data centers against the backdrop of accelerating climate change). This bloc of countries issues a CBDC and invests heavily in data infrastructure and cyber defense, generating a growing supply of the CBDC-denominated financial instruments. The CBDC—seen as a trustworthy and credible reserve currency because it provides safety and access and is backed by high-tech secure platforms with low transaction costs—emerges as a major reserve currency. With central banks around the world holding more of the new CBDC, its share in global reserves rises well above the levels consistent with the size and fiscal backing of the economic bloc. Speculations about the extent of overvaluation of the CBDC expose the system to large capital outflows and an unraveling of the CBDC’s position as a major currency.

Scenario 2. A world of multiple private digital currencies. This scenario starts off in a global setting wherein increased anxiety about governments’ capacity to deliver on their socioeconomic objectives erodes credibility of public institutions, including fiat currencies. In parallel, big technology companies continue to grow, offering more services and platform payment instruments. Their efforts to enhance privacy and corporate governance pay off, and people increasingly prefer private payment platforms to fiat currencies. Over time, as more people use the private payment instruments, these become digital currencies—full-fledged private currencies that fulfill all the roles of money. A few large digital currency areas emerge, on the basis of digital interconnectedness. Governments retreat from most of their roles as technology corporations expand the scope of their services. National central banks lose relevance. AI is used to establish exchange parities between digital currencies by facilitating price finding. To maintain credibility of the system, a technology consortium is set up to supervise the digital networks and provide emergency liquidity financing by pooling digital currencies across currency areas. Traditional reserve assets thus cease to exist and are replaced by holdings of private digital currencies.

Scenario 3. A new form of money based on personal data that becomes a global currency. In response to growing concerns about the misuse of personal data, privacy laws are tightened, giving individuals full control over their personal data. To access and use such data, companies begin to purchase data off individuals using “data tokens”—a payment instrument issued as a claim on their goods and services. Technological advances allow for enhanced methods of data collection and increase the supply of data, leading to AI-based processes and products, which in turn create a greater demand for data. Technology also makes it possible to privately value and monetize data and transfer it securely to willing buyers on a decentralized marketplace in exchange for data tokens. These tokens thus become a global digital currency widely used by both individuals, to supplement their traditional income, and product providers. The use of fat monies is very limited, and the effectiveness of the monetary policy is significantly reduced. Instead, fiscal policy becomes the main tool for domestic macroeconomic stabilization, using data token-based fiscal instruments. Countries hold reserves in data tokens, along with real assets, particularly gold, to mitigate against the risks of cyberattacks or loss of credibility of the system.

Based on an IMF scenario planning workshop held in January 2020. The authors thank Alberto Behar and Sandile Hlatshwayo for their outstanding facilitation of the workshop, and Itai Agur, Sakai Ando, Tamim Bayoumi, Karla Chaman, Ana Corbacho, Sonja Davidovic, Christopher Erceg, Aquiles Farias, Vikram Haksar, Dong He, Kristina Kostial, Istvan Mak, Maria Soledad Martinez Peria, Johan Mathisen, John McCoy, Marcello Miccoli, Raunak Mittal, Martin Mühleisen, Gomiluk Otokwala, Herve Tourpe, Camilo Tovar Mora, and Jeromin Zettelmeyer for their excellent contributions to the workshop.

Chapter 5 Conclusion

This paper investigates the drivers of the currency composition of international reserves using both COFER data of aggregate reserve shares and a newly compiled panel data set of individual countries’ reserve holdings by currency. Findings suggest that inertia in reserve currency shares remains important and in fact has grown in significance since the GFC. With continued financial globalization and maturing global value chains, financial links have also become a more significant driver over time, while the significance of trade links has waned. The authors also find that drivers of reserve currency shares vary between AEs and EMDEs, with financial links appearing to be particularly relevant for EMDEs.

This paper’s empirical evidence suggests that, extrapolating recent trends, the US dollar’s dominance as a reserve currency is expected to endure. However, the COVID-19 pandemic raises significant uncertainties concerning key trends in economic drivers of reserve configurations going forward. At the same time, rising geopolitical tensions could trigger sudden strategic adjustments in reserve holdings. Furthermore, technological advances, particularly the emergence of digital currencies and advances in payment systems, could alter the importance of traditional drivers of reserve currencies, speed up the transition to alternative reserve configurations, result in the emergence of new reserve currencies, and even lessen the stability of future reserve currency configurations.

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Reserve Currencies in an Evolving International Monetary System

Author: Alina Iancu, Gareth Anderson, Mr. Sakai Ando, Ethan Boswell, Mr. Andrea Gamba, Shushanik Hakobyan, Ms. Lusine Lusinyan, Mr. Neil Meads, and Mr. Yiqun Wu