Dominant currencies: the role of size and safety
How does a country obtain the status of a dominant global currency provider, and how can it lose this position? In a recent paper, , we focus on two key aspects: safety and size, and how they relate to each other. We highlight two channels how interest rate spreads arise between two countries. First, safety is important because a defaulting bond has little resale or collateral value. Second, the larger the country, the deeper the market for its bonds, conditional on its level of financial development. This increases its liquidity and the probability that investors match with lenders in order to finance their investment opportunities.
Interest rate differentials are then composed of both a risk and a liquidity premium. While abundant supply of bonds is good from the perspective of liquidity provision, there is a trade-off as the country’s risk premium increases at the same time. As in the Triffin dilemma (Triffin, 1961), a country that acts as the global liquidity provider needs to be prudent not to overextend itself.
We develop a model in which a government strategically defaults on its debt obligations when repayment is too costly relative to default. Investors anticipate this possibility and demand higher or lower interest rates depending on the distribution of the underlying shocks. In larger economies, idiosyncratic shocks originate from more and more sources and therefore become less granular and less important. This is equivalent to a diversification of risk.
We also discuss which features in an economy determine whether there is growth with or without diversification. The first feature is the correlation of shocks. A large economy with a low shock correlation across units enjoys a lower aggregate shock variation. This decreases the likelihood of an aggregate tail-event that could lead to a default. An optimal debt area therefore requires a low correlation of shocks. Furthermore, we also formalize how these idiosyncratic shocks are aggregated. The aggregation depends on how much the nation-wide government cares about variation across units. Growth together with low shock correlation and institutional features that increase the cost of default (hence reduce the incentive for governments to default on their external debt) can therefore decrease the risk premia. Extending the evidence in Di Giovanni and Levchenko (2012), Chart 1 suggests indeed that countries with exceptionally large GDP volatility are small, or – if they are larger – have a low degree of diversification in the economy, as they are large commodity producers (the highlighted countries in red).
We embed this framework in a two-country open economy model in which investors can save in bonds of two countries and governments behave strategically. The relative size of both countries matters for interest rate spreads. As the small country grows and diversifies, it increases its debt capacity: default becomes less likely, its interest rate falls and debt-to-GDP rises, while the larger country’s interest rate increases slightly. A previously dominant country can lose its exorbitant privilege if it is eventually overtaken by another rising country in terms of size and safety. The paper highlights several key factors that determine when a challenger could be ready to assume that role, and when it might not. The challenging country would need to have sufficient size, diversification, institutional quality and financial development.
Liquidity and yield differentials
To introduce interest spreads beyond pure risk premia, we also consider that bond holdings can be liquidated or used as collateral to finance investment opportunities. The safer the bond and the larger and more developed the financial market is, the higher its value for investors. If financial markets are insufficiently developed, size might not be enough to make its asset markets liquid enough to replace the current dominant currency, as shown in Chart 3. Still, the position of the dominant country erodes as the other country grows.
