The Future of the Monetary System

The past three years have seen abrupt changes in the global economy, economic policy responses and the realm of geopolitics. Not surprisingly, these changes triggered hefty reactions in financial markets, including bond and foreign exchange markets. As in past periods of economic and geopolitical turbulence, they have also raised the question as to whether the international monetary system may be subject to more long-term and fundamental changes.

The report discusses how macroeconomic imbalances and geopolitics can catalyze change in the current largely USD-based monetary system, how central bank reserves have evolved so far and may be re-assessed going forward and sketches out a vision for a gradually more multi-polar monetary system.

Key highlights:

• The current monetary system has repeatedly been criticized by senior policy makers, both in advanced economies as well as emerging markets due to the stresses created outside the United States from major shifts in US monetary policy.
• History shows that it is not just periods of US dollar weakness (and lax US monetary policy) that can cause problems in the rest of the world, but that periods of tight Fed policy and a strong dollar can be even more disruptive.
• Today, the US dollar represents slightly more than 60% of global FX reserves at central banks, compared to more than 80% in the early 1970s.
• For the foreseeable future, there are no clear candidates to replace the US dollar as lead currency. Neither the euro nor the renminbi qualify as alternative currency "hegemons". Meanwhile, the creation of a global currency remians illusory - that would require an intensely cooperative geopolitical environment.
• Even in the absence of geopolitical and economic calamities, a further diminution of the role of the US dollar in global foreign exchange reserves is likely due to three factors: the diminishing need for FX reserves in a world of floating exchange rates, the active diversification policies of central banks and the increased use of swap lines between central banks.
• While the euro accounts for around 20% of global foreign exchange reserves, behind only the US dollar, and is also freely tradable across borders - a key prerequisite for a lead currency - Eurozone policy makers clearly do not strive for their currency to take on such a role. The absence of a fiscal union and common "safe" asset as well as a banking union are further disadvantages for it to take on a dominant role in the global monetary system.
• In contrast, China is one fiscal entity and its few large banks can be regarded as money center banks. However, the renminbi lacks the third key characteristic which would qualify it as a competitor to the US dollar: international capital mobility. It seems unlikely that China will fully liberalize and open its financial markets for cross-border transactions; such a step would likely be too destabilizing and is the key reason why the share of renminbi in global FX reserves is still so small.
• A new more multipolar monetary system is instead likely to gradually emerge as a result of the increase in bilateral trade of many countries, the deepening of local capital markets in emerging countries and efforts to develop mutual insurance schemes against shocks resulting from shifts in US monetary policy.

Resilient USD-centric monetary system

Since its formal launch at Bretton Woods in 1944, the USD-centric monetary system has undergone profound change, typically in response to systemic crises. However, shifts in US monetary policy continue to amplify business cycles or even trigger crises in other countries. While the US Federal Reserve has developed tools to limit the fallout in cooperation with other central banks, calls for systemic change persist.

Macroeconomic imbalances and geopolitical conflict

Like other countries, the United States is battling a burst of inflation, while the economy slows. Fiscal and external imbalances have worsened substantially. This situation is somewhat reminiscent of the 1970s when trust in the US dollar was significantly undermined. In addition, geopolitical tensions have reached a new post-World War II high point. This combination raises the specter of a potential pivot away from the US dollar.

Rethinking foreign currency reserves

The weight of the US dollar in foreign exchange reserves remains an indicator of USD "hegemony." That said, floating exchange rates, better macro policies in many emerging markets and the availability of central bank swap lines reduce the need for such reserves. Conversely, high reserves have often resulted from central banks' efforts to fight their currencies' appreciation against the US dollar. In the meantime, however, there is some evidence that major central banks are diversifying away from the US dollar and US Treasuries with major reserve holders investing in real assets.

How the monetary system could evolve

At present, there are no clear candidates to replace the US dollar as lead currency, and the creation of a global currency remains unlikely given the current fractious geopolitical setting. However, capital market deepening and increased trade among major emerging markets are boosting the role of their currencies. Moreover, mutual insurance schemes to protect against the fallout from US dollar gyrations and steps to develop an alternative payments system point to a more multipolar currency world.

Axel Lehmann, Chairman of the Board of Directors of Credit Suisse Group AG and Chair of the Credit Suisse Research Institute, said: "Understanding monetary developments and the functioning of the international monetary system are key to a global bank like Credit Suisse and to the broader financial sector, which plays a role in monetary transmission. We hope this report and the insights shared by our authors and guest speakers at the CSRI Fall Conference 2022 make a valuable contribution to current macroeconomic thinking."

Nannette Hechler-Fayd'herbe, Chief Investment Officer for the EMEA region and Global Head of Economics & Research at Credit Suisse, said: "While declaring the demise of US dollar hegemony is premature, its fate as a backbone of the international monetary system depends on a number of factors, with the degree to which US policy makers would be able to maintain macroeconomic stability and trust relative to other countries of supreme importance."

The Future of the Monetary System report is available at https://www.credit-suisse.com/about-us/en/reports-research/csri.html.

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