The use of currencies internationally

inSight

16 Apr 2009

The use of currencies internationally

The international status of currencies changes slowly.

When a currency is widely used outside its home country, it is generally referred to as a regional or an international currency. Essentially the classical domestic functions of money – as a unit of account, medium of exchange, and store of value – are also conducted outside the domestic markets, taking the form of, for example, trade invoicing, reserve holdings, and exchange-rate anchor for other currencies. What factors contribute to the use of a currency outside its home jurisdiction? First and foremost, it must be perceived as sound, and market participants must be willing to hold it as a store of value. It should also be convertible so that it can be acquired by non-residents.

Clearly, many currencies meet these criteria, but few have emerged as truly international. Therefore, there must be other factors that matter. One has to do with size: a large and competitive economy, which is open to international trade and finance, will naturally generate a large quantity of foreign-exchange transactions with at least one leg in the home currency. Size also matters in terms of the presence of an open and developed financial market which supplies assets denominated in the local currency that are in demand by foreign investors. It is also argued that network externalities, in the jargon of economists, are important. When other economies are using a currency outside its home jurisdiction, it creates over time an inertia in favour of continuing to use that currency for international transactions.

Historically only a few currencies have acquired a truly international status. In the post-war period, the US dollar has been the dominant reserve currency, despite periodic speculation and discussions about the loss of its international pre-eminence. In recent years, the euro has become the second-most-widely used international currency, with some predicting that the euro will rival the US dollar, leading to a "bipolar" system in the future. In a way, the emergence of the euro can be considered an extension of the wide acceptance of the deutschmark, but the introduction of the euro certainly expanded the "habitat" of the currency. It seems to me that the significance of the major currencies in international trade and financial transactions does vary over time, albeit slowly.

The optimal international currency system has again become a central issue of policy discussion since the onset of the recent global financial crisis. With their rising economic power, the Asian economies have tremendous potential to become an important driver of global growth, along with the US and euro area, in years to come. In such a "tri-polar" world – as some may term it – it is perhaps desirable in the long term to have an international currency system that reflects the importance of different regions in the global economic structure. Such a system might help to increase global financial stability by diversifying risks in trade and investment.

Already one of the largest economies and trading partners in the world, China continues to rise rapidly as an important force in global trade and production. Meanwhile, the renminbi is gaining flexibility within a framework that was established in July 2005 and has been continuously refined since then. There are also indications of an increasing use of the renminbi outside Mainland China, although this is from a low base and so far pretty much limited to regions that are closely linked to the Mainland. Being the currency of an economy of growing strength and which is undergoing progressive financial liberalisation, it is natural to expect that the use of renminbi in other jurisdictions will be more widely accepted over time. But I am sure a wider use of renminbi in the region or even beyond will have to be a gradual process and carefully controlled to ensure that the possible risks involved are properly managed. In this regard, Hong Kong provides a useful testing ground for cautiously implementing liberalisation measures.

Joseph Yam
16 April 2009

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