To challenge a dominant global currency, the economy behind an emerging competitor would need to be large, diverse and institutionally and financially developed, a new paper from the Banque de France says.
Researchers Kai Arvai and Nuno Coimbra argue that to maintain the dominance of a global currency, the economy backing it has to grow at a pace at least on a par with the global average, otherwise it may become susceptible to a challenger.
The researchers built a model of two open-economy countries. They found that as the small country grows and diversifies, it increases its debt capacity, its interest rate falls, while its debt-to GDP rises and the large country’s interest rate increases slightly.
Simple economic prowess is not enough to make a currency globally relevant
But simple economic prowess is not enough to make a currency globally relevant: the institutional capacity and openness of financial markets is important to enable foreign investment. The larger the economy, the deeper the market for its bonds, the researchers point out, on the condition that it is financially developed. This is a limiting factor for Europe, given the lack of a capital markets union.
“As it relates to current global currency dominance, our analysis tentatively suggests that further development and openness of China’s financial markets would be required for the renminbi to challenge the US dollar,” the authors say.
The paper contributes to a large body of literature on currency diversification away from the US dollar. Historical lessons are difficult to draw on, as the only previous episode of global currency transition was from the pound to the dollar in the early 20th century.
But that period also witnessed the US become the de facto global supplier of energy and credit, when the international financial system still hinged on gold convertibility.
