CAIRO – Today’s international monetary system emerged from the Bretton Woods Conference of 1944, when imperial powers still ruled most of the Global South. It was conceived by and for the benefit of just a few wealthy countries, and it has served them well. Though the Bretton Woods system has occasionally been adjusted to reflect the acceleration of globalization and countries’ deepening economic interdependence, it has amplified business-cycle fluctuations, impeded economic catch-up by poorer countries, and perpetuated the dichotomy of developed and developing countries.
If the world economy is to avoid deeper fragmentation in this new age of multipolarity and geopolitical competition, major reforms will be needed to correct the financial system’s structural birth defects. That is why Indonesian Finance Minister Sri Mulyani Indrawati has taken aim at the high costs associated with over-reliance on just a few reserve currencies, making the case, during Indonesia’s G20 presidency in early 2022, for replicating the kind of local-currency settlement (LCS) arrangements that her country has long championed. Doing so would help many countries manage shocks, especially in the context of emerging economies that face potentially severe capital outflows whenever major advanced economies like the United States tighten monetary policy.
This problem is all too common: during the 2013 “taper tantrum” (a market panic following the Federal Reserve’s announcement that it intended to reduce its monthly bond purchases), the Indonesian rupiah suddenly lost more than 20% of its value. And now there are even greater concerns that quantitative tightening and aggressive interest-rate hikes by systemically important central banks will drive massive capital outflows and trigger a new bout of currency gyrations and sovereign-debt crises.
The Great Float
Two of the most consequential adjustments to the original Bretton Woods system came in the early 1970s with the transition from fixed to floating exchange rates, and with the suspension of the US dollar’s convertibility into gold. Although the end of the gold standard improved global liquidity, it created challenges of its own, by increasing the volatility of short-term capital flows and introducing the risk of sudden stops. In extreme cases, vulnerable countries have faced sharp currency depreciations, limited access to external financing, high funding costs, and a higher likelihood of default on their foreign debt. Equally important, especially in the absence of the fiscal discipline imposed by gold convertibility, has been the persistence of global macroeconomic imbalances, which are both costly and difficult to reverse (as many markets’ experiences during the US-China trade war have shown).
When the dollar’s dominance was cemented after World War II, the US emerged as the world’s de facto banker and preeminent supplier of safe assets. Some 60% of the foreign-exchange reserves held by central banks today are held in dollar-denominated instruments, and the dollar is involved in over 90% of over-the-counter transactions in forex markets. According to a recent report by the Asian Development Bank, 80-90% of exports from large emerging economies in Southeast Asia were invoiced in dollars between 2015 and 2020.
The dollar’s unrivaled role in trade payments reinforces its dominance in financial markets, and vice versa. But while the dollar’s supremacy was economically justifiable in the decades following WWII, when the US was the world’s manufacturing hub and largest trading country, it has become less so with the rise of the Global South. This is particularly true in light of increasing technology diffusion and the growing role of intermediate goods through globalized value chains.
Before 2000, the US was the single largest trading partner to over 80% of countries around the world. Today, that number has dropped to less than 30%, because most countries now count China as their single largest trading partner. Changes in global trade dynamics are thus intensifying the quest for a diversification of reserve currencies, with increasing bilateral trade among a growing number of countries in the Global South allowing for returns to scale in the use of their respective currencies in lieu of the US dollar.
Owing to the strong link between invoicing, exchange-rate pass-through, and pricing to market, many exporters now opt for their home currency in the interest of mitigating forex risk. Studies using partial equilibrium models suggest that exports of differentiated products tend to be invoiced in the exporter’s currency, while homogeneous goods are usually invoiced in an international currency, particularly the US dollar. The more differentiated the export product, the lower the elasticity of demand – and the greater the exporter’s power to invoice in its own currency.
According to these models, the increasingly high degree of product differentiation in the Global South should drive competitiveness and enhance countries’ bargaining power to invoice their exports in their choice of currency. But what is true in theory does not capture what is actually happening: the system’s birth defects, and the intrinsic power of network effects, has perpetuated imbalances and undermined currency diversification, with significant consequences for the global economy.
Over time, these structural imbalances have exacerbated macroeconomic challenges in developing countries, heightening exchange-rate risks and intensifying the impact of global shocks – particularly currency depreciations and capital-flow volatility. Moreover, those imbalances are sustaining the balance-of-payments pressures and “perception premiums” that overprice risk in the Global South, excluding many countries from international capital markets or burdening them with debilitatingly high interest-rate spreads.
Sanctions and Secondary Effects
In recent years, weaponization of the dollar to advance US national and geopolitical interests has raised fresh concerns. In this new age of great power rivalries, abusing the dollar’s dominant position may set the stage for a geopolitical Triffin dilemma and drive more sovereign and corporate entities to hedge against the globalization of political and confiscation risk. Several countries targeted by US sanctions are already reducing the dollar content of their trade. And in 2019, even America’s European allies created a special-purpose vehicle, the Instrument in Support of Trade Exchanges, to trade safely with sanctioned Iran.
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Since 2018, the share of Russia’s dollar-invoiced exports to the other BRICS economies – Brazil, India, China, and South Africa – has fallen from 85% to 36%. While the revival of the old rupee-ruble bilateral trade arrangement for energy imports has received the lion’s share of coverage lately, it bears mentioning that the use of LCS for cross-border trade within the BRICS is much broader and has been expanding rapidly in recent years.
Similarly, the use of LCS in bilateral trade is gaining traction across Asia as countries develop institutional arrangements and financial infrastructure to reduce their reliance on the dollar for cross-border payments and investments. Between 2016 and 2019, the central banks of Indonesia, Malaysia, the Philippines, and Thailand entered LCS agreements, granting banks licenses to offer direct trading pairs of local currencies, local-currency accounts, and hedging instruments. Local-currency usage has since increased, reducing these countries’ vulnerability to global shocks.
Moreover, there has been a palpable increase in currency diversification, especially in East and Southeast Asia, where the share of exports invoiced in dollars fell to around 80% in 2019, down from 90% in the early 2000s through the mid-2010s. Transactions in emerging-market currencies have increased significantly over the last two decades, such that they now represent over 25% of global forex turnover, up from about 7% in 2001.
The trend toward currency diversification is reflected in changing dynamics in capital markets. Foreign ownership of US debt fell from 34% in 2015 to less than 24% in 2021, the lowest level in decades. But it has been offset by rising demand from domestic investors, notably US pension funds and the Fed, which now holds around 20% of US debt, up massively from just 4% in 2009.
The escalation of financial sanctions will only accelerate this trend, precipitating further de-dollarization as more countries capitalize on digitalization to expand their use of LCS for bilateral transactions and to develop more hedging instruments. Then-US Treasury Secretary Jack Lew highlighted this risk in 2016, warning that “the more we condition the use of the dollar and our financial system on adherence to US foreign policy, the more the risk of migration to other currencies and other financial systems in the medium term grows.”
The “exorbitant privilege” afforded to advanced economies by issuing global reserve currencies has skewed the distribution of international liquidity. As a handful of countries became the major suppliers of international reserves, the risk of liquidity crises became a problem almost exclusively for developing countries in the Global South, where most of the demand arises. Most of those without large forex reserves are unable to sustain the value of their currency, meet international obligations, or instill confidence in investors. We saw this recently in Sri Lanka, which exhausted its reserves and ultimately defaulted on its debt. In September 2022, its government reached an agreement with the International Monetary Fund for a $2.9 billion loan. Under the original Bretton Woods Agreement, all trade imbalances were to be solved on the deficit side of the balance of payments (as there was no limit on surpluses), and the IMF was tasked with shoring up countries with serious current-account problems by enforcing austerity measures.
The privileges conferred on reserve-currency issuers compound the costs associated with the Bretton Woods system’s inherent inequalities. Owing to high demand for dollar-backed securities, the US can borrow more cheaply than it otherwise could and run deficits without tears. In effect, the rest of the world is constantly recycling its current-account surplus and excess reserves to underwrite America’s structural current-account deficit. And, unlike in the Global South, US deficits (both internal and external) never lead to credit-rating downgrades, wider spreads, and prohibitively higher borrowing costs and/or refinancing risks.
Similar imbalances characterize monetary policy. Decisions made by a handful of systemically important central banks tend to have global repercussions, especially in the case of monetary tightening, which generates aftershocks for developing countries via currency depreciation, higher import prices (thus fueling inflation), rising borrowing costs, diminished borrowing overall, and capital outflows.
According to the Institute of International Finance, net non-resident portfolio outflows from emerging markets exceeded $48 billion between March 2022 – when the Fed began aggressively raising its policy rate – and July 2022, adding to pressure on exchange rates. Most developing market economies’ currencies weakened markedly against the US in 2022. As John Connally, the US Treasury secretary under President Richard Nixon, famously said in 1971: “The dollar is our currency, but it’s your problem.”
Efforts to alleviate that problem have been consistently undercut by historical inequalities. One such effort concerns the IMF’s special drawing rights, the international reserve asset that it created in 1969 in anticipation of future crises. The SDR was supposed to alleviate liquidity constraints; in practice, it has reinforced inequalities by allocating the largest shares of each issuance to advanced economies that do not need them.
SDRs are distributed to member states in proportion to their quotas (voting shares), which are themselves a reflection of the historical imbalances at the system’s birth. Hence, 27 low-income countries, with a combined population of 611 million, have fewer quotas than the United Kingdom, with a population of only 67 million.
A multilateral reserve system that draws on advances in digitalization – including innovative technologies that moderate friction and increase the efficiency of cross-border payment and settlement mechanisms – could help to overcome these structural inequalities and reduce the scale of global macroeconomic imbalances (by promoting equilibrium in global trade). It would also make the international monetary system safer and relieve it of the perennial constraint of a shortage of safe assets, which drives capital outflows from the Global South, often at inopportune times.
But in a “polycrisis” world of heightened geopolitical tensions and monetary competition, the transition to this kind of system must be properly managed. As the current cycle of global financial tightening plays out, systematically reallocating unused SDRs to developing countries would go a long way toward easing the liquidity constraints associated with balance-of-payments pressures. The benefits, in terms of global financial stability, would be significant, both in the short and the medium term, because countries would have more fiscal space with which to avert sovereign debt-servicing crises.
Likewise, extending bilateral currency-swap arrangements to more developing countries and making these arrangements permanent would further reduce liquidity constraints and the risk of procyclical downgrades, which will otherwise increase borrowing costs and exclude countries from capital markets. LCS arrangements should be at the heart of any reforms to deepen regional integration processes and build robust institutions for a balanced multipolar monetary system.
For its part, Indonesia recently extended its LCS arrangements to other members of the Association of Southeast Asian Nations (ASEAN), as well as to China and Japan. The agreement with China, its largest trading partner, created a regional interbank rupiah-renminbi marketplace, and designated several major regional banks as “Appointed Cross-Currency Dealers” to facilitate LCS transactions for exporters-importers and investors. The agreement with Japan, Indonesia’s second-largest trading partner by export volume, has significantly increased the two countries’ LCS transactions. According to the most recent data from Indonesia’s central bank, LCS arrangements reduced Indonesia’s dollar exposure by $2.53 billion in 2021, and were projected to raise local currency usage in trade and settlement by 10% last year.
Another important development that could inform ongoing efforts relates to the Chiang Mai Initiative Multilateralization – a swap arrangement involving ASEAN members, plus China, Japan, and South Korea. Recent changes to the CMIM have unlocked local-currency emergency liquidity support for participating central banks, in addition to dollar-denominated support. Conceived after the East Asian financial crisis as a mechanism to pool participating countries’ foreign reserves and fend off speculative attacks on national currencies, and to mitigate exposure to adverse global shocks, the CMIM has become a vehicle for reserve-currency diversification. Studying its evolution would benefit reform of the international financial system.
In addition to meeting the growing demand for local currencies, such hybrid arrangements could strengthen financial stability, deepen economic and financial integration within regions, and alleviate the need for countries to draw down their forex reserves.
The Conditions for Success
Leveraging LCS arrangements at the regional level is an important step toward building a multipolar currency system. But success hinges on enhancing the attractiveness of these institutional frameworks, such as by strengthening the foundation of macroeconomic stability across the board. Recent experience shows that stable exchange rates across Asian countries have catalyzed the diversification of settlement currencies. And equally helpful would be to accelerate the process of financial-market deepening and regional integration, including through the development of local-currency bond, repo, and derivatives markets to hedge against currency risk. Supporting the growth of bilateral direct-transaction markets is also critical, as this would create domestic forex markets and reduce the transaction costs associated with local currencies, as well as hedging costs through forward contracts.
After all, among the factors underpinning the dollar’s position as the preferred currency in forex transactions are its liquidity, lower transaction costs, and the lack of developed markets for regional currency pairs in the Global South. According to the most recent data, the gap between buying and selling rates for local-currency pairs remains extremely high in developing countries, even though transactions between pairs of emerging-market currencies are becoming easier, reducing the need for “vehicle currencies.” Across Asia, the bid-ask spread for a local currency is more than double against the dollar, and it is even higher elsewhere in the developing world. Reducing these costs to enhance competitiveness would certainly facilitate the emergence of a multipolar monetary system.
In the short and medium term, the IMF could help unlock these swap lines and LCS arrangements by providing guarantees to mitigate counterparty risk. It could also assist the transition toward a multipolar system by strengthening the global financial safety net, which would promote the growth of reserve-sharing arrangements and facilitate the multilateralization of LCS arrangements. And as more countries conduct trade in their own currencies (and as the returns to scale of such trade increase), the international community could draw on financial technologies to smooth the transition toward politically neutral international settlement mediums.
These could take the form of a resource-based anchor or a basket of sovereign currencies – such as the supranational “bancor” (a portmanteau derived from the French words “banque” and “or”) currency proposed by John Maynard Keynes in the early 1940s. Keynes’s idea was for the bancor to emerge as a globally accepted monetary instrument that improves efficiency in the settlement of payment balances and reduces the risk of persistent macroeconomic imbalances. To achieve an equitable burden of adjustment, the bancor would be underpinned by symmetric penalties between surplus and deficit countries.
Furthermore, recent technological advances and financial innovations should be leveraged to increase efficiency and reduce transaction costs in the use of local currencies for the settlement of bilateral trade, bilateral and regional swap arrangements, or multilateralization of LCS arrangements. Central-bank digital currencies (CBDCs) that incorporate features specifically designed to execute cross-border payments hold much promise, and may emerge as an efficient option.
Technology-enabled financial innovations are already achieving significant reductions in settlement times, from 2-3 days to less than ten minutes, and transaction costs have fallen from 6% of transfer value to less than 1%. In addition to shortening the payment value chain and cutting transaction costs, CBDCs can reduce inefficiencies and rents in a networking environment and accelerate the transition toward a multipolar monetary system.
The challenge for the international community, then, is to settle on a common framework for CBDC interoperability, so that multiple currencies can run on a single blockchain.
Preliminary results from experiments undertaken by the Bank for International Settlements (BIS) are encouraging. They show that central banks can draw on a permissioned distributed-ledger technology, restricted to trusted parties, to link their wholesale CBDCs together, allowing banks and payment providers to conduct transactions directly in central-bank money across multiple currencies.
At the same time, collaborative empirical research between the BIS Innovation Hub and ten central banks shows that such arrangements can deliver faster, cheaper, and more transparent cross-border payments and support complex global value chains. Combined with tools such as cryptographic hashing techniques and zero-knowledge proofs, which authenticate confidential information without revealing it or allowing it to be compromised, these developments could integrate both cybersecurity and privacy protection into CBDC designs. This would position these emerging digital alternatives as serious options for a smooth transition to a globally integrated multipolar monetary system.
By alleviating payment-related frictions in international trade and making domestic payment systems more resilient, advances in digital technologies have made that transition possible. The critical task for central bankers and regulators is to strengthen their collaboration to minimize inherent risks and maximize the social and development impact of CBDCs. Even more important, they must work together to design a globally accepted CBDC regulatory framework, to ensure that fragmentation risks do not undermine the significant expected efficiency gains.
The G20 Bali Leaders’ Declaration further emphasizes this point, stressing the benefits of enhanced international cooperation, not least the efficiency gains that would come with a monetary and financial system underpinned by a robust digital and payment infrastructure. To count as a success, any new arrangements must catalyze reserve currency diversification to boost cross-border trade and investment, and deepen the process of global economic and financial integration.
Strengthening the international community’s commitment to democratizing the international financial system is critical and should remain a high priority during India’s G20 presidency. Especially in the interim period leading to the development of a stable international framework that guarantees interoperability between CBDCs, decision-makers at both the regional and global levels must increase the availability of data relating to invoicing. This would inform firms’ choice of currency for trade and investment, and further enhance the multilateralization of LCS arrangements.
Finally, improving the biased credit-rating system, which exacerbates the Global South’s debt overhang, must also be at the heart of any reform effort. The international community should push for a system that is more transparent, consistent, development-oriented, and equitable in broadening access to global financial resources – especially the patient capital that is needed to diversify economies and strengthen their resilience. The low degree of diversification in many developing countries is both a deterrent to long-term financing and a source of risk, because it perpetuates the unhealthy correlation between growth and commodity-price cycles.
With the world shifting irreversibly toward greater multipolarity, revamping the governance of major international financial institutions to account for new realities is critical to renewing their credibility and legitimacy. In the case of the IMF and the World Bank – the most important pillars of the Bretton Woods system – that means amending the quota-allocation mechanisms and raising additional resources with which to deliver robust, swift support to their members.
These institutions should also seek to foster multipolarity by enhancing coordination among multiple reserve currencies, and by facilitating efforts to achieve CBDC interoperability. For the IMF, supporting this transition through real-time risk assessment and current-exchange-rate weighting would reduce the risk of destabilizing speculative episodes, ultimately augmenting its role as the global lender of last resort.
The world has changed dramatically since 1944, and its key institutions must reflect this. Democratizing the issuance of reserve currencies would go a long way toward restoring trust in the international financial system. After the wave of decolonization following WWII, a global initiative to decolonize that system is long overdue – especially in an increasingly multipolar world.