In the wake of Russia’s invasion of Ukraine last March, the United States and its European allies froze $300 billion of Moscow’s foreign currency reserves. As the Kremlin scrambled to find an alternative to dollars for its central banking — most notably Chinese renminbi — some observers wondered: As more countries seek to “dedollarize,” could the greenback’s global dominance start to slip?
That’s unlikely for now, according to new research into the deep foundations of the dollar’s nearly 80-year run as the world’s reserve currency.
What is the source of the greenback’s enduring attraction? In a nutshell: It’s the extraordinary liquidity of the dollar money market, according to a new paper by Antonio Coppola, Arvind Krishnamurthy, and Chenzi Xu of Stanford Graduate School of Business. This means debt issuers can be confident that they can relatively easily get their hands on dollar-denominated assets from global investors to pay back lenders.
This idea challenges other narratives in which trade is the central force in currency dominance. Instead, the trio of researchers find that financial innovations — such as the securitization of assets, growth of repurchase agreements, and central-bank liquidity swaps — are key to currency dominance. “Invoicing trade in dollars is a by-product,” says Coppola, who is a postdoctoral fellow at the Stanford Institute for Economic Policy Research (SIEPR) soon joining Stanford GSB as an assistant professor of finance.
Krishnamurthy is a senior fellow at SIEPR, and Xu, a faculty fellow.
“People often think of money as being cash in your wallet,” says Xu, an assistant professor of finance. “But actually, money is any instrument that allows you to repay any debt. So, there are many money-like instruments — like Treasury bills, repos, or high-grade corporate bonds — that firms or governments can use to clear these obligations.”
A solid source of liquidity
The quantity of dollar-denominated debt outstanding far outstrips the United States’ relative wealth and its contribution to global GDP. Around 60% of global foreign exchange reserves are held in dollars; half of all international loans, debt securities, and trade invoices are estimated to be denominated in dollars.
As more firms and governments issue debt in dollars, this further adds to the stock of money-like instruments corporations can use to settle their liabilities. In other words, dollar debt begets dollar debt, bootstrapping itself. “There is a virtuous cycle going on, as some of this issuance further contributes to this supply of liquidity, leading to further dollar denomination and even more liquidity,” Coppola explains.
As a consequence, the dollar is the principal currency of global finance and trade. This confers extensive privileges on the U.S., in the form of cheaper borrowing costs that help it pay interest on the national debt, which recently hit its $31.4 trillion borrowing limit. “There is a natural reason beyond political desires to want the dominant currency because, economically, it is very profitable,” Xu says.
Other currencies have enjoyed this exalted status. Throughout the 17th century, the Dutch florin reigned supreme. The quantity of florin swelled as it became popular with merchants because it was backed by gold and silver at the Bank of Amsterdam, but the loss of safety eventually led to its demise.
From there, the British pound rose to prominence. Its rise was propelled by the introduction of formal contracts for short-term debt, the growth of international banking, and the Bank of England’s role as a solid lender of last resort to the financial sector. Sterling’s role as the main global currency ended after the first World War.
The dollar achieved its dominant status following World War II. What flipped the equilibrium? The paper finds that the U.S.’s initial supply of liquid public debt seeded the dollar’s outsized role in the world economy. “What we’ve seen historically is that a government being able to create a stockpile of safe debt is what kick-started private firms then issuing debt in dollars,” Xu says.
Everybody into the pool
Building on this initial stock of government-issued liquidity, innovation in the U.S. financial system allowed private firms to add to the pool of dollar-denominated assets. In more recent decades, securitization — the pooling of assets that are packaged into interest-yielding products — allowed for further private-sector debt issuance. Liquidity was also increased by the expansion of repo markets where firms trade debt for cash.
Swap lines — agreements that enable central banks to exchange currencies with one another — have further reinforced the dollar’s dominance. The Fed has provided dollar liquidity around the world during crises including the 2008-09 financial meltdown, the early days of the COVID-19 pandemic, and before that, the Bretton Woods era.
“Historically, the U.S. financial system was very different, much more fragmented. It had much smaller pools of liquidity that didn’t really talk to each other,” Xu says. “This is one element that held the U.S. back from gaining dominance earlier, despite the U.S. GDP exceeding British GDP by around 1870.”
The findings ultimately explain that market liquidity — seeded by government debt and reinforced by private issuers — is the principal reason why the U.S. dollar enjoys global dominance.
The study has important implications for the ongoing debate about the potential rise of the Chinese renminbi as a distant challenger to the dollar. Coppola, Krishnamurthy, and Xu find that the renminbi is unlikely to topple the greenback until China makes substantial progress in opening its capital markets to foreign investors and nurturing financial innovations.
“The Chinese system currently lacks the elements which we view as central in supporting a currency’s role in global dominance,” Coppola says. “We view financial innovation and the opening up of capital markets to foreign investors as the first and necessary step for China to take to promote the role of the renminbi as a global reserve currency.” China’s massive Belt and Road infrastructure project is primarily about invoicing trade in renminbi. But for now, the dollar is the only game in town.
This story was originally published Feb. 16 by Stanford Graduate School of Business Insights.