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Abstract
Against the backdrop of the recent financial crisis and the ongoing rapid changes in the world economy, the fate of the
dollar as the premier international reserve currency is under scrutiny. This paper attempts to answer whether the Chinese
renminbi will eclipse the dollar, what will be the timing of, and the prerequisites for this transition, and which of the two
countries controls the outcome. The key finding, based on analyzing the last 110 years, is that the size of an economy—
measured not just in terms of GDP but also trade and the strength of the external financial position—is the key fundamental
correlate of reserve currency status. Further, the conventional view that sterling persisted well beyond the strength
of the UK economy is overstated. Although the United States overtook the United Kingdom in terms of GDP in the
1870s, it became dominant in a broader sense encompassing trade and finance only at the end of World War I. And since
the dollar overtook sterling in the mid-1920s, the lag between currency dominance and economic dominance was about
10 years rather than the 60-plus years traditionally believed. Applying these findings to the current context suggests that
the renminbi could become the premier reserve currency by the end of this decade, or early next decade. But China needs
to fulfill a number of conditions—making the reniminbi convertible and opening up its financial system to create deep
and liquid markets—to realize renminbi preeminence. China seems to be moving steadily in that direction, and renminbi
convertibility will proceed apace not least because it offers China’s policymakers a political exit out of its mercantilist
growth strategy. The United States cannot in any serious way prevent China from moving in that direction.
Background
Currency is an iconic expression of a country’s economic dominance. Even if the economic benefits of
currency dominance are questionable, countries and their governments do seem to prize that status. Some
of the benefits could be psychic, captured, for example, in the Archbishop of Canterbury’s insistence that
“I want the Queen’s head on the banknotes…” (quoted in Goodhart 1995). Others could be political.
Indeed, Britain tried to salvage some prestige for its postempire status via its currency. Harold Wilson,
Britain’s prime minister, said in 1964 that “To turn our backs on the sterling area would mean a body
blow to the Commonwealth and all it stands for.”1
Even if currency status is not prized for one’s own currency, at the very least, countries seem to
resent the currency dominance of others. This resentment could be based on the perception of economic
gain for the other: Charles de Gaulle, for example, complained bitterly of America’s privileged use of
“dollars, which it alone can issue, instead of paying entirely with gold, which has a real value, which must
be earned to be possessed, and which cannot be transferred to others without risks and sacrifices” (Frieden
2006, 345).
The fate of the dollar has once again become ragingly topical. Questions relating to reserve
currencies have periodically obsessed the profession, typically under two conditions. First, when the
policies of the principal reserve currency (the dollar) threaten to erode confidence in it (for example, in
the 1960s and 1970s), captured in French President Georges Pompidou’s famous metaphor: “We cannot
keep forever as our basic monetary yardstick a national currency that constantly loses value…. The rest of
the world cannot be expected to regulate its life by a clock which is always slow.” Second, reserve currency
issues become topical when potential rivals to the dollar emerge (as with the euro in the early 2000s).
With equal periodicity, though, the issue has been quietly consigned to forgetfulness. Now, the issue
has resurfaced in the aftermath of the global financial crisis with somewhat greater intensity because of
a combination of the two developments. First, there is the view that the crisis was occasioned in part by
reckless US policies that were in turn aided and abetted by the dollar’s reserve currency role, which allowed
the recklessness to be financed by outsiders. Joseph Stiglitz made this case in his speech to the United Nations in 2009: “The system in which the dollar is the reserve currency is a system that has long been
recognized to be unsustainable in the long run.” The second reason relates to the rise of China with the
possible ascendancy of the renminbi to reserve currency status and the competition that it poses to the dollar.
Similar doubts about the dollar arose in the 1960s, which led to the creation of special drawing
rights (SDRs), the international money created through the International Monetary Fund (IMF). But then
there was no challenge to the dollar: Indeed, the SDR was created in anticipation of the fear (which never
materialized) that there would be too few dollars to satisfy growing international demand for them. In the
early 2000s, the euro represented a challenge to the dollar, but there was no systemic crisis that created
theoretical angst about the status quo. Today, there is both the angst and the emergence of a potential rival,
which makes discussions about reserve currency and the fate of the dollar much more salient.
The recent economic crisis has led some—including most famously the governor of the People’s
Bank of China—to question the legitimacy and effectiveness of having the dollar as the international
reserve currency. There are calls to strengthen the role of the real currencies such as the euro, artificial ones
such as SDRs (Williamson 2009, and Ocampo 2010), or both as an alternative to the dominant status of
the dollar.
The question that I will be addressing is not the normative one of the desirable composition and
configuration of reserve currencies but a positive one: whether changes in the world economy will lead to
or be accompanied by any changes in the status of different currencies as international reserve currencies.
In particular, I will attempt to answer whether the dollar will be eclipsed by the renminbi, what will be
the timing of this transition, and the pre-requisites that will have to be met for the transition to occur.
Definition
Before one answers these questions, one needs to define reserve currency and assess the benefits (and costs)
of being an international reserve currency. Paul Krugman (1984) and Menzie Chinn and Jeffrey Frankel
(2007) provide a very useful summary.
An international currency is simply one that is used outside one’s own country. The greater the use,
the more it merits the description of a reserve currency. Foreign governments and/or foreign private agents
seek to use the currency of another country because of the three functions that a foreign currency can
perform. These are summarized in table 1, developed originally by Peter Kenen (1983).
Although much of the research on international reserve currencies has focused on reserve holdings
by foreign governments, it must be emphasized that reserve currency status reflects use not just by
governments but also by the private sector for trade and financial transactions. Hence, a meaningful
distinction made by Edwin Truman (2007) is between a “reserve currency,” which relates to official
transactions, and an “international currency,” which includes transactions involving foreign private agents.
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The quantitative dimensions of the official holdings of reserve currencies are discussed below but
it is worth recalling some of the basic numbers relating to international or private-sector dimensions
of reserve currencies. Between 1860 and 1914, nearly 60 percent of world trade was denominated in
sterling even though the United Kingdom accounted for about 30 percent of world trade (Schenk 2010a).
More recently, when the dollar has ruled, 45 percent of international debt securities were denominated
in dollars (end-2008); the dollar was used in 86 percent of all foreign exchange transactions (2007); 66
countries used the dollar as their exchange rate anchor (2008); for many countries, 70 to 80 percent of
their trade is denominated in dollars; oil and most commodities are priced in dollars; and in the shadowy
world of crime and illicit transactions, “the dollar still rules” (Eichengreen 2010). In some ways, one could
argue that private-sector actions are indeed the deep determinants of reserve currency status.2
Benefits and Costs to Country Issuing Reserve Currency
Countries exhibit a certain ambivalence about their reserve currencies because there are both benefits and
costs associated with reserve currency status.
Benefits
Convenience for the Country's Residents
A country’s exporters, importers, borrowers, and lenders are able to deal in their own currency rather than
foreign currencies. Thus, the transaction costs of obtaining another currency and the psychological costs
of having to move or convert from domestic to foreign currencies are lowered or eliminated. When an
American tourist goes abroad, he or she can often and in many places buy goods and services for dollars
because the latter are widely accepted or easily exchanged for local currency. A Thai tourist, on the other
hand, will have had to go to the bank to get the relevant local currency for his expenditures. For banks
and other financial institutions, there may also be some cost advantage to dealing in one’s own currency:
When transactions are denominated in dollars, foreign economic agents have to convert it back to their
local currency to understand the transaction; in contrast, US agents avoid the nuisance of having to do
this conversion. This is all rather like the convenience of dealing in one’s own language.
Seigniorage or Exorbitant Privilege in Good Times
The advantage that comes from having other governments’ citizens hold—or willing to hold—one’s
currency is a narrow definition of seigniorage captured in this quote from columnist Thomas Friedman:
2. As Eichengreen (2010) notes: “It still makes sense for countries to hold their reserves in the same currency that they use
to denominate their foreign debt and conduct their foreign trade, since central banks use the funds to smooth debt and
trade flows and intervene in foreign exchange markets.”
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“The United States has an advantage few other countries enjoy: It prints green paper with George
Washington’s and Ben Franklin’s and Thomas Jefferson’s pictures on it. These pieces of green paper are
called ‘dollars.’ Americans give this green paper to people around the world, and they give Americans in
return automobiles, pasta, stereos, taxi rides, hotel rooms and all sorts of other goods and services. As long
as these foreigners can be induced to hold those dollars, either in their mattresses, their banks or in their
own circulation, Americans have exchanged green paper for hard goods.”
But a broader definition of seigniorage—and indeed the heart of reserve currency status, also
called “exorbitant privilege” (coined by Charles de Gaulle and his adviser Jacques Rueff)—is the ability
to borrow abroad large amounts cheaply in one’s own currency, especially while simultaneously earning
much higher returns on investments (including FDI) in other countries.
Although the empirical evidence is unclear, exorbitant privilege can be interpreted as the ability to
run large current account deficits—and hence run up large debts denominated in one’s own currency at
low interest rates—safe in the knowledge that others will be willing to finance it on account of the special
status for the currency. 3
Seigniorage or Exorbitant Privilege in Bad Times
Perhaps as important a benefit or even more so might be the attenuation of costs in times of financial
crises. Having a reserve currency might imply lower interest costs and more enhanced capital-market
access than would otherwise prevail during a crisis. This helps avoid currency meltdowns and the
associated dislocations that usually accompany severe financial crises. In the recent crisis, the United
States benefited from such a flight to quality, which meant that markets did not start pricing in default
probabilities.
Political Power and Prestige
Having one’s currency as the reserve currency tends to confer power and prestige. In the most recent
global financial crisis, for example, the United States, or rather the Federal Reserve, supplied countercyclical
liquidity to the extent of $600 billion to Europe and several emerging markets. Partly by virtue of
its reserve currency status, the Federal Reserve could essentially use its balance sheet to help the world.
This conferred prestige, and had the United States wanted to, it could have exploited this source of power.
3. The United States has consistently earned more on it investments overseas than it has had to pay on its debts, a
differential of about 1.2 per cent per annum (Cline 2005, 49). A few recent studies speak to the seigniorage gain. One
study finds 10-year bond yields were 70 basis points lower as a result of foreign capital inflows (Bandholz, Clostermann,
and Seitz 2009). Still another suggests that the increase in US treasuries held by foreigners depressed yields by 90 basis
points (Warnock and Warnock 2009).
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Britain's gradual loss of key currency status was simultaneous with its gradual loss of political and military
preeminence as noted in the quote from Harold Wilson above.
History provides at least two other very interesting examples of the use of reserve currency status by
the United States for achieving noneconomic and economic objectives.
The first relates to the Panamanian experience of the 1980s. Panama was effectively a completely
dollarized economy, with the bulk of the money supply comprising dollars. In 1988, following
accusations of corruption and drug dealing against General Manuel Noriega, the United States froze
Panamanian assets in US banks and all payments and dollar transfers to Panama were prohibited. The
economy was afflicted by a severe liquidity shortage and was effectively demonetized, and output shrank
by nearly 20 percent. In the words of a former US ambassador to Panama, these actions had done the
most damage to the economy “…since Henry Morgan, the pirate, sacked Panama City in 1671.” These
sanctions were not enough to overthrow Noriega but the power to inflict pain on others from possessing a
reserve currency was clear (Cohen 1998, 44–46).
Another interesting, if less known example, illustrating the use of currency dominance to achieve
other economic objectives—in this case promoting the interests of a country’s financial sector—dates back
to pre-Fidel Castro Cuba. Andrews (2006, 88) is worth quoting:
Like many other Caribbean-basin countries that fell under the direct and indirect influence of the
United States during this period, Cuba’s domestic monetary system became increasingly dollarized
during the first two decades of the twentieth century. When a financial crisis struck in 1920–21,
Cuban-owned banks collapsed because they had no access to the lender-of-last-resort facilities
of the US central bank. US banks then quickly emerged in a dominant position in the Cuban
financial system. In this way, the United States exerted a major influence over the Cuban financial
system simply by what Strange calls a “nondecision,” that is, by not providing lender-of-last resort
support to Cuban banks. Interestingly, after this crisis, the US Federal Reserve Bank of Atlanta (as
well as that of Boston, between 1923 and 1926) established an agency in Cuba to carry out lenderof-last-resort
functions.
Through nonaction, the power from reserve currency was leveraged to promote American banks,
and through subsequent conscious action the interests of these banks were consolidated.
Costs
Exorbitant Curse Not Privilege
Seigniorage has a flip side. The fact that a currency is considered special makes it attractive to hold,
increasing the demand for it, and causing the currency to appreciate and render exporters less competitive
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on world markets. Bergsten (1975, 2009) has a stronger version of this curse. In his view, the ability
to finance current account deficits more easily can lead to irresponsible government and private-sector
behavior, thereby contributing to financial instability. The US experience in the recent global financial
crisis is a case in point, the argument being that the large current account deficits—stemming in part from
reserve currency status—led to large capital inflows and cheap and easy money, which combined with lax
regulations led to reckless behavior and sowed the seeds for the crisis. Reserve currency status, and the
cheaper financing it afforded, may have been the rope that allowed the United States to hang itself.
Vulnerability from Exorbitant Privilege
Exorbitant privilege also creates a vulnerability to external actions among those who have bought US
assets. China arguably has some leverage over the United States because of its ability to sell its large
stockpile of US treasuries. Many of the sterling bloc countries after World War II were in a position to sell
their sterling holdings, creating instability and complicating UK macroeconomic management. In 1966,
Malaysia held 14 percent of Great Britain’s net liabilities to sterling area countries and was able to threaten
to sell these holdings and destabilize sterling as a way of successfully staving off UK political pressure to
force it to integrate monetarily with Singapore (Andrews 2006).
Burden of Responsibility
This is the flip side of the power that can come from reserve currency status. The monetary authorities in
the country of the leading international currency may have to take into account the effects of their actions
on world markets, rather than being free to devote monetary policy solely to domestic objectives. Truman
(2007) argues that the Federal Reserve probably cut interest rates more than it otherwise would have
in the second half of 1982, and again in late 1998, in response to international debt problems in Latin
America and elsewhere. The United States has also been reluctant to see other countries officially dollarizing
(Argentina) for fear of having to accept any burden of responsibility, even if only implicit.
The best example of the costs of preserving reserve currency status comes from sterling. Strange
(1987) argues that preserving sterling’s international role required higher defense spending and higher
interest rates to keep sterling strong, which also undermined export competitiveness. At several times
between 1949 and 1967 the United Kingdom chose not to devalue sterling, partly because of the fear that
such a move would destroy the sterling bloc and jeopardize the Commonwealth. In the Suez crisis, part
of the United Kingdom’s vulnerability stemmed from wanting to avoid the effects of devaluation on the
sterling bloc and hence on the remains of empire.
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The “Costly” Prerequisites
One point that is not sufficiently emphasized and which lies at the heart of China’s dilemma in elevating
its currency to reserve currency status—or rather, allowing its currency to be elevated—relates to the
demanding prerequisites. Reserve currency status requires as a sine qua non an openness to capital flows
and elimination of domestic financial repression. Put simply, for a currency to become a reserve currency
it must be available for use by outsiders, especially for outsiders to buy assets in the country issuing the
currency. But a domestic growth strategy that is predicated on maintaining an undervalued exchange
rate and generating rapid export growth is difficult to sustain the more open a country is to capital flows:
When foreigners buy a country’s assets, the purchase leads to greater capital inflows making the currency
stronger, and exports less competitive. For China, therefore, there is a tension between the export-led
growth strategy, which requires denying foreigners the ability to buy Chinese assets, and promoting
reserve currency status, which requires allowing unrestricted access to foreigners to buy Chinese assets.
Short History
One way of answering the question of changes in reserve currency status—especially in relation to the
dollar and renminbi going forward—is to turn to history. Which countries have enjoyed reserve currency
status historically and when and why have there been significant transitions?
Figure 1 plots the reserve holdings of the top three reserve currencies at selected points in time
between 1899 and 2009. Until the postwar period, there was never just one reserve currency. Peter
Lindert’s (1969) analysis showed that in the period before World War I, pound sterling was the dominant
reserve currency but by no means the currency hegemon. According to Lindert’s calculations, in 1913
sterling accounted for 38 percent of all official currency holdings, while the comparable share of the
French franc and German mark were 24 and 13 percent, respectively. In 1899, the figures for the three
countries were respectively, 43, 11, and 10 percent. Holdings of nonsterling reserves were especially
pronounced in regions commercially and financially linked to France (for example, Russia) and Germany.
The dollar made its first appearance as a reserve currency in the interwar years. In this period, the
pound and the dollar accounted for roughly equal share of reserve holdings. Although the dollar surpassed
sterling around the mid-1920s, according to Eichengreen and Flandreau (2008), they traded places for the
top spot afterwards: In 1931, when sterling went off the gold standard in the wake of serious economic
problems, sterling reserves fell. But when the dollar went off the gold standard some switching occurred
back into sterling.
After the establishment of the Bretton Woods system in 1945, the dollar was the de facto reserve
asset (even though all currencies were still denominated in terms of gold) and enjoyed a near monopoly
status. The European currencies, including sterling, were not convertible into gold until 1958. But this
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dominance of the dollar is not quite reflected in the data because of the persistence of sterling as a reserve
currency. According to estimates in Robert Triffin (1961), the share of sterling in world foreign exchange
reserves was higher than that of the dollar until 1954 (27 and 26 percent, respectively); thereafter the
dollar’s share rose steadily, reaching 65 percent in 1973. On other measures of reserves (for example,
liquid foreign assets), the dollar had overtaken the pound by 1945.4
The high share of sterling post–World War II is misleading because many if not most of these reserves
were held by countries (mainly UK colonies) in the sterling area. When World War II broke out, the sterling
bloc countries within the British Empire agreed to protect the external value of sterling by essentially
extending credit to Britain and accepting sterling-denominated IOUs. Legislation was therefore passed
throughout the empire formalizing the British sterling bloc countries into a single exchange control area.
Thus sterling balances were blocked and could only be used to buy British goods. That sterling
was in fact a diminished currency, with its elevated status propped up by the sterling area measures, is
revealed by the events of 1947. As part of the Anglo-American agreement negotiated by John Maynard
Keynes after World War II, restrictions on the use of sterling had to be removed in return for the United
States being willing to extend financial assistance to the United Kingdom. When this agreement was
implemented in 1946, residents in sterling area countries rushed to convert sterling into dollars to
purchase American goods. The consequential loss of nearly 40 percent of UK reserves (1 billion out of
2.5 billion) led quickly to the restoration of restrictions on sterling convertibility (Eichengreen 2010).
Holding European currencies as reserves started becoming attractive in the 1960s as the European
countries began to gradually relax exchange controls for capital account transactions, while the United
States generated inflation, and imposed ad hoc restrictions on capital outflows as a way of protecting
the balance of payments.5
This led to the development of the eurodollar market. The German mark and
Japanese yen featured more prominently in official reserve holdings from the mid-1970s onwards, with a
corresponding decline in the dollar, according to IMF data.
Since the early 1990s, the dollar has made a comeback, and the euro—since its introduction in
1999—has increased its share of global reserve holdings (see figure 1). For much of the post-1973 period,
though, the dollar has accounted for a vast bulk of the share of official foreign exchange reserves held by
the world.
In 1970, a new reserve currency was issued by the IMF called the special drawing right. This action
was in response to the belief, spawned by the analysis of Robert Triffin, that there would be an inherent
shortage of international liquidity. The shortage would result because there were limits on the amount of
dollars that the United States—or any reserve currency center—could supply to the rest of the world in
response to the demand for them. If there was too great a supply (as occurred in the United States during
the late 1960s and 1970s, leading to current account deficits) foreigners would lose confidence in the
currency and in its ability to stabilize and hold value. And if the United States responded by reducing
its deficits, there would not be enough dollars in the rest of the world to grease the wheels of trade and
finance. The solution therefore was to create a synthetic reserve asset to supplement the supply of the
reserve currency (and gold). This reserve asset—or international money—was the SDR (see Williamson
2009 for a lucid history of SDRs).
What Determines Reserve Currency Status? A Simple Econometric Analysis
Table 1 relates the desirable prerequisites of the country issuing the reserve currency to its three key
functions. To be an attractive store of value, the issuing country should have low and stable inflation as
well as a stable and relatively strong currency. To be a good medium of exchange and to serve as a unit
of account, a reserve currency must be widely transacted and accepted. A country that is large in output,
trade, and finance will naturally find its currency widely transacted and hence more likely to be widely
accepted.
There is a certain circularity or self-reinforcing quality here: The more transacted a currency is, the
more there will be an incentive to use this currency as a medium of exchange and as a unit of account,
and hence the more it will be transacted and so on.6
Also, the more deep and liquid the financial markets
of a country, the easier it will be to raise money in that currency and hence easier to make payments and
easier to store value.
Putting all these together suggests that any quantitative analysis of the determinants of a reserve
currency must include the size of a country’s economy, trade and external financing, the development
of its financial markets, the confidence that investors have in the currency as a store of value, and how
extensive its use already is.
There is an extensive literature examining the determinants of reserve currency status.7
My analysis will depart from the existing literature in two ways motivated by a historical perspective
on the issue. First, it will span a much longer time period, between 1900 and 2010, compared with
existing contributions that focus on the period after 1973.
Second, I will wield Occam’s razor to narrow the list of determinants to (1) relative size, albeit
measured along three economic dimensions (income, trade, and external finance, which are also the
determinants of economic dominance more broadly as discussed in my forthcoming book (Subramanian
2011)); and (2) persistence or the self-reinforcing characteristic of a reserve currency.
Krugman (1984) provides justification for such a simplification. In his view, the two key
determinants of a reserve currency are: “First, the currency of a country which is important in world
markets will be a better candidate for an international money than that of a smaller country. Second, the
use of a currency as an international money itself reinforces that currency’s usefulness, so that there is
an element of circular causation.” Jeffrey Frankel (1995) makes the same case in favor of size while also
elaborating on the relevant dimensions of “world markets”: “The currency of a country that has a large
share of international output, trade, and finance has a natural advantage”
Simple regression analysis is used here to relate reserve currencies to the three key determinants to
see if there is any strong association between the two variables. I have compiled data on the major reserve
currencies going back to 1899. The analysis is restricted to the major reserve currencies in each period
(sterling, franc, and marks, pre-1913; sterling and dollar for 1929 and 1958; dollar, franc, sterling, yen,
and German mark between 1975 and 2000; and dollar, sterling, yen, and the euro since then).8
I chose selected years for the analysis, depending on data availability and also because I want to
estimate long-run rather than high frequency relationships. Thus, I selected data for every ten years
beginning with the most recent period (2009, 2000, 1990, and 1980) and then chose those years for
which data were available (1900, 1919, 1929, 1958, and 1976). The longest gap is for the period between
1929 and 1958 because data are most shaky for this period according to Eichengreen and Flandreau
(2008). Chinn and Frankel (2007), in contrast, estimate the relationship for annual data from 1973
onwards. They also have a more expanded set of explanatory variables, including inflation differentials,
depreciation, foreign exchange market turnover ratio, etc. As discussed in the text, our specification is
more parsimonious, restricted to GDP, trade, and net debtor/creditor status.
One important technical point that we draw from Chinn and Frankel (2007) is in specifying
the left hand side variable. They suggest that the functional form relating reserves to the underlying
determinants cannot be linear because the dependent variable (currency shares) is bounded between 0
and 1. They suggest using a logistic transformation to take account of this constraint, which I adopt. Thus
the dependent variable is log (share/(1-share)), where share refers to the share of a currency in total global
holdings of reserves. This functional form also captures persistence in reserve holdings that Krugman
(1984) and others have argued is a key determinant of reserve holdings.10
Thus, of the many determinants suggested by Chinn and Frankel (2007), I use only two—size and
persistence. My neglect of the other variables is partly due to limited data availability because it is not easy
to find data on the depth of financial or foreign exchange markets going back in time; and partly due to
the fact that over long periods, differences between reserve currency countries in inflation, for example,
(which affects the attractiveness of a currency as a store of value) is not that significant. And as the results
clearly suggest, ignoring these other factors does not seem to be a major problem because the limited set
of explanatory variables seems to account for a surprisingly large share of the variation in reserve currency
holdings.
Table 2 reports results for two ways of calculating reserve holdings. In the first four columns of
the table, the reserves of each currency are expressed as a share of total official reserves; in columns 5 to
8, reserves are expressed as a share of all reserves whose denomination is accounted for. Results do not
change significantly across these two definitions, except that in the former specification, the net creditor
status variable is statistically more significant. Columns 1 and 5 use all the observations. The specifications
in all the other columns drop the observation for the United Kingdom in 1958, which, for reasons
discussed in the text, was an outlier because sterling was artificially propped up by special policy measures.
In columns 3 and 7, the observation for the United States in 2009 is also dropped.
One caveat about the interpretation of the results: Our sample by construction includes only
those currencies that already have reserve currency status, so there is selection bias. The results should
be interpreted as suggesting something about the relative standing of currencies once they have reached
reserve currency status, not necessarily their likelihood of attaining this status. The findings are described
below.
First, there is a large and statistically strong relationship between a country’s reserve currency status,
and its share in GDP and trade. In columns 2 to 4, and 6 to 8, which are our preferred specifications, the
coefficients of these two variables are significant at the 1 percent confidence level.
Second, there is a positive but less strong relationship between the country’s net creditor status and
reserve holdings. In the specification in column 2, the net creditor variable is significant at the 10 percent
confidence level, and at the 5 percent level in the specifications (columns 3 and 7) excluding the dollar in
2009.
Third, the surprising finding is that these three variables together—which we argued were also the
key determinants of economic dominance more generally—account for reserve currency status. Together,
they explain nearly 70 percent of the variation in reserve currency holdings. In Chinn and Frankel (2007),
the proportion of explained variation is high but that is because of the presence of the lagged dependent
variable on the right-hand side of the regression.
Fourth, again a surprising finding—and one somewhat different from the results in Chinn and
Frankel—is that trade appears to be a much more important determinant of reserve currency holdings.11
The coefficient on trade is substantially larger (between 35 and 60 percent depending on the specification
in table 2) than that for GDP. In Chinn and Frankel (2007), the coefficient on GDP is also significant but
is about one-fourth the magnitude obtained here and they do not find trade to be a statistically significant
determinant.
Figures 2 to 4 show the relationship between reserve currencies and their three main determinants,
respectively. These figures plot the conditional relationship summarized in the regressions (in table 2)
between the share of reserve holdings and the share of the country using that particular reserve currency
in world GDP (figure 2), the share of the country in world trade (figure 3), and the share of a country in
world net exports of capital (figure 4). These figures are not plots of the unconditional relationship. They
correspond to the regressions in column 2 of table 2. Each observation denotes a currency and the year, so
that it is easy to see where each currency-year observation is located relative to the relationship captured in
the line in each of the figures.
The regressions also suggest that the dollar is currently punching above its weight. The regression in
columns 4 and 8 introduce a dummy for the US dollar in 2010. This dummy is positive and significant at the 1 percent confidence level, which essentially means that given United States fundamentals on GDP,
trade and net creditor status, its share in reserve holdings is substantially greater than it ought to be. In
contrast, if a dummy for 2000 for the US dollar is added to the regression, that dummy is not significant,
suggesting that the reserve holdings in dollars were roughly in line with fundamentals in 2000. It is only
in the last decade that the United States has been punching above its weight.
This finding can give rise to complacency or alarm. Complacency because it suggests or reinforces
the fact of persistence and first mover advantage: Once a currency is in, dislodging it from its lofty perch
is difficult. But the finding could also be a source of concern because it shows that fundamentals are
working against the currency, and once some tipping point is reached, the switch away from the dollar
could be swift.
Will that happen? Empire was associated with sterling dominance, Pax Americana with dollar
dominance. In the long march from the cowrie shell to the greenback (via silver, bimetallism, gold, and
sterling), does renminbi dominance await the world?
Yuan or We Won? The Future of the Dollar and Renminbi
Magnitude and Timing
The preceding analysis suggested that economic dominance in a broad sense (comprising GDP, trade,
and net creditor status) is the key determinant of reserve currency status but that there is persistence so
that reserve currency shifts occur after those in broader economic dominance. But how long are these
lags? History provides some clues. In what follows, we will use the estimates of economic dominance
from Subramanian (2011), apply the lags between economic and currency dominance from history, and
thereby project the timing of future currency dominance. But what does history suggest about these lags?
The history of reserve currencies shows that there are in fact two transitions: the rise of a currency
from anonymity to dominant reserve currency status, and the demise of a once dominant reserve
currency. Persistence tends to delay both transitions: A new currency becomes the reserve currency well
after the rise to ascendancy of the economy of that currency and a currency remains a reserve currency
even if not the dominant one, well after the economy of that country declines. As Krugman (1984) puts
it: “The impressive fact here is surely the inertia; sterling remained the first-ranked currency for half a
century after Britain had ceased to be the first-ranked economic power.”
But persistence in relation to the first transition seems to have been overstated. The conventional
view on persistence is based on comparing the period when the United States became the largest economy
(in the early 1870s) and the period when it became the premier reserve currency (around World War II).
The rise of the dollar is supposed to have lagged the rise of the US economy by more than 60 years.
But both the dating points—for economic dominance and currency dominance, respectively—need
to be altered. The econometric analysis suggests that reserve currencies are determined not just by income
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but crucially by trade and by the strength of the external financial position. While the United States may
have overtaken the United Kingdom in terms of GDP in 1870, the United States became economically
dominant in the broader sense, surpassing the United Kingdom, only around the end of World War I. As
late as 1929, the United Kingdom was a larger exporter (in absolute terms) than the United States, and
until the mid-1920s, the United Kingdom was a larger net creditor to the world than the United States
(Subramanian, 2011). So, for the purposes of currency dominance, the relevant economic dominance
clock started ticking for the dollar not in 1870 but around the end of World War I, when the United
States became in Barbara Tuchman’s words, Europe’s “larder, arsenal, and banker.”
In fact, an index of economic dominance that combines GDP, trade, and external financial strength
(using as weights the coefficients that emerge from the regression analysis in table 2) shows more precisely
the timing of the shift from Great Britain to the United States. This index is shown for selected years
from 1870 to 2010 in figure 5. In 1913, Great Britain was more economically dominant in the broad
sense than the United States, while in 1929, the positions had been reversed suggesting that the transition
occurred just after WWI.
Second, the dating of World War II as the salient moment of transition from sterling to the dollar is
also problematic. Barry Eichengreen and Marc Flandreau (2008) have argued that the dollar first eclipsed
sterling in the mid-1920s, and although sterling and the dollar share near equal status during the interwar
years, the persistence of sterling during this period was driven to some considerable extent by politics—
the politics of the United Kingdom as a colonial power. At the 1932 Ottawa Conference, preferential
trading between Britain and its colonies and dominions received fresh impetus, and towards the end
of the 1930s, the sterling area was created. Both these politically-driven developments played a role in
prolonging sterling’s international use.
In fact, if one looks at evidence for the demand for dollars from private international sources, it
appears that the dollar not only started gaining in ascendancy in the early 1920s (as Eichengreen and
Flandreau 2008 point out) but also retained that status in the interwar years. Figure 7, based on data
from Reinhart (2010), plots the share of sterling relative to the share of dollars in cumulative issuance
of international bonds by Argentina, Brazil, and Chile, three countries that were actively raising money
internationally. The figure shows that prior to World War I, nearly all issuance was in sterling. But after
World War I, an overwhelming share was in dollars.
Thus, correcting the relevant dates, the lag between the rise to economic dominance of the United
States (just before World War I) and its establishment as the premier reserve currency was considerably
less than the 60-plus years conventionally believed and closer to 5 to 10 years (from 1919 to the
mid-to-late 1920s).
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Let us apply this to the current situation. These facts and the implications for the possible timeline
of a future handover based on the historical experience are depicted in figure 3 below. Figure 5 suggests
that the index of economic dominance for China surpassed that of the United States in 2010. Figure 7
uses this as a theoretical timeline for the renminbi possibly overtaking the dollar. Unless some extraneous
noneconomic factor intervenes (like it did for the sterling area), by the end of this decade or early in the
next one, the renminbi could be in a position to rival the dollar. If this sounds implausible, it is worth
adding that the differential between the index of dominance of China and the United States in 2020
will be similar to, or even slightly greater than, that between the United States and United Kingdom in
the mid-1920s when the dollar eclipsed sterling. Of course, considerable uncertainty surrounds all these
calculations. But what they hint at is the possibility of a more accelerated rise of the renminbi and a
possible eclipsing of the dollar as the premier reserve currency.12
Now there are two key differences between the possible handover today and the handover of
the past. Then the United States had an open capital account whereas China’s is closed, its financial
markets are still rudimentarily judged against the requirements of a reserve currency in today’s world of
ultrasophisticated financial markets, and the renminbi is less convertible. This would delay the transition
beyond the 10 years suggested by history. There is also the bigger question of whether a nondemocratic
country can inspire the basic trust in rule of law that might be necessary for spreading internationalization
of a currency.
The key finding that trade is a significant determinant of reserve currency status combined with
China’s growing trade dominance portend strongly for the yuan. And it is likely that the route to
renminbi internationalization will be via its increasing use as a currency within Asia because trade links
between China and Asia are increasing especially rapidly. Rising trade will then increase the advantage of
using the renminbi in Asia, which might engender policy changes such as Asian countries linking their
exchange rates to the renminbi, which would further increase the use of the renminbi and so on. Thus, it
looks likely that the road to renminbi internationalization is likely to occur via renminbi regionalization
within Asia.
The historical experience of the other transition—from dominance to demise of sterling is also
instructive. On the one hand, the handover was difficult for the United States for reasons of history,
namely the inheritance of the sterling area from the era of empire. This inheritance became difficult to
eliminate because of the weakness of the UK economy. Any move on the part of holders to diversify
out of sterling balances raised the prospect of devaluation (because the United Kingdom did not have
enough dollars as reserves to meet the diversification demands), which caused problems for the British
government (Schenk 2010a).
On the other hand, though, the United Kingdom and United States were allies, and there was a
conscious and concerted effort by governments to minimize the costs of the transition to the United
Kingdom and internationally (Schenk 2010a). These included lines of credit extended by other central
banks to the United Kingdom to minimize the impact of any move away from sterling.
Today, the environment is quite different. There is likely to be less cooperation between the
governments of the United States and China if there were a similar need to manage the transition. On
the other hand, today the scale of private flows so overwhelm official flows that transitions are likely to
be endogenous and market driven with governments, individually or collectively, less able to control or
influence the transition.
Before the eyebrows go up at the magnitudes and timing implied by either of these scenarios, one
must be careful about their interpretation. These numbers are suggestive about the long run and about the
eventual impact of fundamentals, and they are conditional. Many policy changes will need to occur before
these fundamentals can prevail.