In a paper published on the eve of the IMF annual meetings amid growing signs that US President Donald Trump is turning his back on multilateralism, Professor Barry Eichengreen and two European Central Bank economists warn, in their own capacity, that this could spark a move by disenchanted partners away from holding dollars.
A deterioration in the relationship between the US and countries that hold dollar reserves could lead those central banks to reconsider their reliance on the dollar. Security alliances go a long way toward explaining why the US dollar so dominates the reserve portfolios of traditional US allies such as Germany, Japan, South Korea, Saudi Arabia and Taiwan.
Eichengreen, an economics professor at the University of California Berkeley and an author of a number of books on global currency systems, said that being in a military alliance with a reserve currency-issuing country boosts the share of reserves held by 30 percentage points.
In a hypothetical scenario where the US withdraws from the global stage but the level of global reserves remains unchanged, the estimates suggest a roughly 30 percentage point reduction in the share of the dollar in the reserves of US-dependent states, and an increase in the share of other reserve units such as the euro, yen and renminbi.
The estimates also imply that more than $800bn of official dollar-denominated assets — equivalent to almost 6% of US marketable public debt — would be liquidated in this hypothetical scenario, while long-term US interest rates would increase by as much as 80bp, or 0.8 percentage points.
This would be the equivalent of 6% of the stock of US tradeable debt, or 4% of US GDP. “US disengagement would have significant effects on the bond market,” said the authors.
Holding a currency is a way that a country effectively pays back another country that provides a security guarantee. Insofar as the two countries are partners in a security alliance, the reserve holder’s investments in the partner country will be relatively secure. And the leading power, for its part, is likely to retain political leverage.
“If the world becomes a riskier place, countries may choose to increase their reserve holdings,” said Eichengreen and his fellow authors. “On the one hand, dollars need to be sold because their share in the reserves of US-dependent states falls. On the other hand, dollars need to be purchased because countries increase their overall reserve holdings.”
They said the research also implies that China’s growing self-confidence and assertiveness on the international stage could help to support the emergence of the renminbi as an increasingly important international unit.
The research also suggests that deeper European co-operation in domains such as foreign policy and external security could boost the euro’s global standing.The paper is based on historical analysis that shows that when Germany and the US challenged Britain’s economic leadership in the late 19th century, the German mark and, later, the US dollar rivalled sterling as leading international currencies. This is not unlike how China is seen as challenging the US now, and how the Chinese renminbi may challenge the dollar.