Recent events in Washington have renewed long-standing questions about the future of the international monetary system. The Trump administration has sent conflicting signals about its preferences and intentions about the dollar, with some US officials having written or spoken of the advantages of a significantly weaker dollar exchange rate and an exorbitant burden on the US economy from the dollar’s reserve-currency role.
At the same time, US President Donald Trump has threatened to impose more tariffs on countries whose governments actively seek to encourage and create alternatives to the dollar for holding reserves and undertaking cross-border payments.
Now President Trump’s 2 April ‘Liberation Day’ tariffs and subsequent financial market gyrations raise further questions about whether the United States remains a reliable economic partner for other countries and whether they can continue to rely safely on the US dollar.
These uncertainties have led observers to contemplate several scenarios. An extreme scenario, which most policymakers and financial market participants still regard as implausible, would involve governments and central banks abandoning the dollar as an international and reserve currency in favour of an alternative, such as the euro or China’s renminbi. This remains implausible because the dollar is deeply embedded in the global monetary and financial system.
Neither the euro nor the renminbi — nor for that matter any other currency — can fully substitute for the dollar as a form of foreign reserves and in other respects. There is a shortage of AAA-rated euro-denominated government bonds available to central banks outside the euro area, while China’s financial markets are not fully open and accessible to the rest of the world.
The less extreme scenario is one in which central banks continue to diversify their reserve portfolios away from dollars. Such diversification has been underway for the better part of a quarter century and could now accelerate in response to the Trump administration’s announcements and heightened policy uncertainty.
When we looked at the situation at the end of 2020, my colleagues and I showed that since the turn of the century, there has been reserve diversification not towards the other three of the ‘Big Four’ currencies — the euro, British pound sterling and the Japanese yen — but towards nontraditional reserve currencies that did not previously feature significantly in central bank balance sheets. A quarter of this movement has been into the Chinese renminbi, but the other three quarters have been into the currencies of small, open, well managed, generally inflation-targeting economies — including the Australian dollar.
The reasons are straightforward. These currencies, like the countries issuing them, are relatively stable, well managed and provide diversification benefits. Some are ‘China plays’, in that the currencies appreciate when the Chinese economy strengthens. They offer China exposure without the issuer having to purchase renminbi.
Bid-ask spreads incurred when buying and selling non–traditional currencies have come down with the development of the issuers’ financial markets and advances in electronic foreign exchange trading. Many of these currencies offered positive yields in the pre-pandemic period when interest rates on the Big Four reserves currencies were at, near or even below zero.
The share of nontraditional currencies in allocated foreign reserves worldwide has continued to rise since 2020. The Australian dollar, the Canadian dollar and the Chinese renminbi remain the leading nontraditional reserve currencies, followed by the Korean won, the Singapore dollar and the Scandinavian currencies.
Interestingly, since the end of 2020, the Australian dollar and Chinese renminbi have both lost market share. The Australian dollar’s share fell from 20 per cent to 17 per cent, and the renminbi’s share fell from 25 per cent to 18 per cent of total non–traditional reserve currency holdings. In contrast, the Korean won gained significant market share, up from 8 per cent to 12 per cent.
Exchange rate fluctuations can have a major impact on the currency composition of central bank reserve portfolios. Addressing this requires removing the effect of exchange rate fluctuations, which lead to capital gains and losses on pre-existing reserve holdings. The result is an adjusted currency share series that more closely captures the impact of incremental reserve asset purchases and sales.
With this adjustment, the decline in the Australian dollar’s share is somewhat less, falling from 20 per cent to 18 per cent of the nontraditional reserve currency total — not much substantial change. For the Chinese renminbi, in contrast, the decline becomes even larger, from 25 per cent to 17 per cent. For the Korean won, the increase is still larger, from 8 per cent to 14 per cent.
There are reasons to view reserve diversification positively. In the same way that biodiversity makes for a robust ecosystem, a global economy with multiple reserve currency issuers may have a more robust supply of international liquidity. Asia, as an important part of the 21st-century world economy, has a significant role to play. That role may not be assumed solely or even mainly by the currencies of large Asian economies, such as the Chinese renminbi and the Japanese yen, but by supporting players such as the Australian dollar and South Korean won.
Barry Eichengreen is George C Pardee and Helen N Pardee Professor of Economics and Political Science at the University of California, Berkeley.
