Philip R Lane: "Multiple Reserve Currencies and the International
Monetary System"
Panel remarks by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the Seventh
High-Level SNB-IMF Conference on the International Monetary System, Zurich, 10 May
2016.
* * *
The world is in an important transition phase: the share of emerging economies in global
GDP is far higher now than a decade ago. Over time, these countries are adopting a more
liberal approach to international financial integration, building a larger set of
domesticcurrency financial markets that facilitate participation from overseas investors and permitting
greater outward flows from the domestic private sector. In turn, the asymmetric configuration
of the global financial system that characterised the decade following the Asian crisis (large
external surpluses, accumulation of foreign currency reserves, the acquisition of foreign debt
assets but the issuance of foreign equity liabilities on the part of emerging economies) is due
for replacement but the exact properties of the new configuration is not yet clear (Lane and
Milesi-Ferretti 2008).
In terms of the overall level of reserves, we know that traditional factors such as the level of
trade openness and the exchange rate regime have been joined by financial factors, such as
the size of the domestic financial system, the extent of capital account openness and the
scale of foreign currency liabilities in determining the appropriate level of reserves. For
instance, Obstfeld, Shambaugh and Taylor (2010) were prescient in emphasising the size of
domestic financial liabilities that could potentially be converted into foreign currency as a
driver of reserves, in view of recent developments in various emerging markets and the
emphasis in the April 2016 IMF World Economic Outlook on gross capital outflows as an
increasingly important driver of the financial account for these economies.
In related fashion, the empirical work on the composition of reserves identifies both trade and
financial linkages as significant in explaining currency shares: all else equal, a country that
trades a lot with the euro and issues a lot of euro-denominated debt will hold more euro
reserves, compared to a country that is more closely linked to the US and issues a lot of
dollar liabilities. Related work includes Eichengreen and Mathieson (2000), Lane and
Shambaugh (2010) and Benetrix et al (2015).
The rise of China as a share of global GDP and the internationalisation of the RMB means
that the share of the RMB in reserves will surely rise over time, especially for Asian
economies. Still, the quantitative scale of this shift will depend on the success of the Chinese
government in establishing the RMB as a major international currency. At the core, RMB
sovereign debt must be classified as a safe asset by global investors if the RMB is to play a
substantial role as a reserve currency.
While an outsized role for the US dollar in the international financial system is sure to persist
due to an array of incumbency advantages, it is still useful to speculate about the properties
of an international financial system with multiple reserve currencies. Given the importance of
scale effects in building deep and liquid financial markets, it is likely that the number of major
reserve currencies is likely to remain quite small, with the dollar, the euro and the RMB
playing the most significant roles. An additional factor in limiting the number of reserve
currencies is that a reserve-issuing bloc must be large enough and sufficiently anchored by
domestic fundamentals to tolerate substantial exchange rate volatility.
At one level, an expanded stock of global reserve assets promises significant benefits. For
those living in reserve-issuing blocs, the enhanced ability to issue domestic-currency
liabilities to foreign investors helps to underpin financial stability. At a global level, to the
extent that a world of multiple reserve currencies is also a world of multiple funding
currencies, the current tension between trade-weighted and financially-weighted exchange
rates is mitigated. In similar fashion, we might expect to observe an increase in the popularity
of basket pegs and basket reference benchmarks for managed float regimes.
An expanded supply of reserve assets also reduces the risk of over-valuation of these
assets, which can distort resource allocation by suppressing term premia in reserve currency
markets. The impact of a high level of foreign purchases on long-term rates is well
documented for the dollar but is also evident in the market for euro-denominated debt
(Carvalho and Fidora 2015).
A wider set of reserve currencies may also enhance risk management. While the
appreciation of the dollar during the 2008 global financial crisis turned out to be an important
stabilising factor for those holding dollar reserve assets, it is possible to imagine scenarios in
which the dollar depreciates against the euro or the RMB during a period of international
turmoil, such that a diversified portfolio of reserve currencies may provide enhanced
protection against a wider array of risk factors.
At the same time, a system of multiple funding currencies may pose headaches for central
banks. If there is a mismatch between the foreign currency liabilities of a country and its
foreign currency assets, a central bank may need access to swap lines among the major
reserve currencies. If such swap lines are not available, then a country in distress may turn
to the IMF to resolve a currency-specific liquidity crunch. To avoid such scenarios, there
needs to be sufficient cooperation among the issuers of the major reserve currencies
together with the IMF in recognising the importance of reliable currency swap arrangements.
The availability of timely and comprehensive data on the foreign-currency positions of the
private sector is also essential for efficient reserve management in a multiple-currency world.
A world of multiple reserve currencies is also a world in which membership of a monetary
union carries significant benefits. First, the ability to borrow and lend in a common currency
and access to the liquidity facilities of a common central bank limits the need to accumulate
foreign currency reserves. The provision of eurosystem liquidity provided an important buffer
mechanism in coping with the sudden stops of private capital flows during 2008-2012.
Second, the depth of currency swap markets for the euro against other major currencies (and
the ECB swap lines with other major central banks) meant that non-euro foreign currency
liabilities could also be managed effectively during the crisis.
Finally, the role of the euro as a reserve currency would be enhanced by a widening in the
pool of euro-denominated safe assets. To this end, the proposal for European Safe Bonds
(or ESBies) that would consist of the senior tranche of a diversified portfolio of the sovereign
debt of the member countries would be an important advance in constructing an area-wide
safe asset.
References
Benetrix, Agustin, Philip R. Lane and Jay C. Shambaugh (2015), "International Currrency
Exposures, Valuation Effects and the Global Financial Crisis," Journal of International
Economics 96, 98-109.
Carvalho, Daniel and Michael Fidora (2015), "Capital Inflows and Euro Area Long-Term
Interest Rates," Journal of International Money and Finance 54(C), 186-204.
Eichengreen, Barry and Donald Mathieson (2000),"The Currency Composition of Foreign
Exchange Reserves: Retrospect and Prospect," IMF Working Paper No. 00/131.
Lane, Philip R. and Gian Maria Milesi-Ferretti (2008), "The Drivers of Financial
Globalization," American Economic Review (Papers and Proceedings) 98(2), 327-33.
Lane, Philip R. and Jay C. Shambaugh (2010), "Financial Exchange Rates and International
Currency Exposures," American Economic Review 100(1), 518 - 540.
Milesi-Ferretti, Gian Maria (2009), "A $2Trillion Question," VOXEU (January 28 2009).
http://voxeu.org/article/2-trillion-question.
Obstfeld, Maurice, Jay C. Shambaugh and Alan M. Taylor (2010), "Financial Stability, the
Trilemma and International Reserves," American Economic Journal: Macroeconomics 2(2),
57-94.