Author: Hiroyuki Ito, Visiting Fellow, RIETI
Dollar-centric International Monetary System
Unquestionably, the US dollar is the most dominant international currency and the current international monetary system is based on it. While the US’s share of global trade and global GDP have been declining over the last few decades, the US dollar share of foreign exchange reserves has been stable, and has even been on the increase for the last decade. Many countries try to stabilise their currencies’ exchange rates against the US dollar, meaning many belong to the US dollar-zone in the world economy.
When the new coronavirus (COVID-19) pandemic triggered global economic crisis in March 2020, while prices of many financial assets plunged, the US dollar appreciated. When the Global Financial Crisis (GFC) broke out in September 2008, the US dollar appreciated in the immediate aftermath of the crisis. These two episodes demonstrate both the important role the US dollar plays as an international currency by providing a safe haven, and how the current international monetary system is built upon the dollar. The wide use of the US dollar also means a lack of local currency use for international transactions.
This characteristic is particularly evident among economies in the Asia region. Ito and Kawai (2021) examine the degree to which the US dollar is dominant and how limited the use of local currencies is.
International Finance in East Asia
We started our comparison of the ASEAN+3 economies with others using the famous ‘monetary trilemma’ hypothesis – policymakers face a trade-off between choosing two out of three policy goals: exchange rate stability, monetary independence, and financial openness. This hypothesis was popularised by Fleming (1962) and Mundell (1963) and has been one of the most important theoretical foundations in the field of international finance.
Using the updates of the “trilemma index” from Ito and Kawai (2014, 2021), the development of the combinations of the three policies can be observed. From that, we found that the ASEAN countries have gradually increased the level of financial openness over the last five decades. Along with that, some economies have chosen the path of retaining monetary independence but giving up a certain level of exchange rate stability, while other economies have decided to retain exchange rate stability but give up some degree of monetary independence.
We also estimated to what extent countries stabilise the exchange rate movements of their currencies against the dollar. In other words, we observed to what extent sample countries belong to the so-called dollar zone. According to the estimates, ASEAN countries have persistently belonged to the dollar zone through the sample period of 1970 through 2018.
Consistent with that, East Asian economies have relied heavily on the dollar as an invoicing currency in international trade, which also applies to large economies such as China, Japan, and Korea. Interestingly, among Asian economies, trade bound for other Asian regions or the EU has been invoiced mainly in US dollars, showing the important role the dollar plays as a vehicle currency in international trade.
In other international transactions involving international debt securities and bank loans, the US dollar share has been persistently high for the ASEAN+3 economies while the role of the Japanese yen has been declining.
All these findings suggest that the US dollar is the predominant currency in the Asia region, and also that local currencies are not widely used for international transactions. High reliance on the dollar for international transactions and the inability to get financed in their own currencies are a characteristic of developing countries: that applies to not only the ASEAN economies but also China and Korea, and even Japan to some extent. Dollar-centric international finance keeps the economies vulnerable to spillover effects emanating from the United States. As long as developing and emerging market economies are exposed to the global financial cycle (Rey, 2013), a change in the economic conditions or economic policy of the United States could easily sway the economic conditions of the peripheral economies.
In order to shield themselves from US shocks, economies in the Asia region should consider adopting a regional currency or a basket of currencies (such as the European Currency Unit before the introduction of the euro) specialised for international settlements. That could also allow the economies in the region to have access to liquidity when they face financial instability. However, given the political and geopolitical situations in the Asian region, realistically, it is not feasible to introduce a regional currency or basket any time soon.
The ASEAN+3 can and should promote regional currency cooperation in a way that would encourage the use of local currencies or some key regional currencies (like the yen, yuan, and won) in the region. For example, economies in Asia can encourage each other to settle bilateral trade in yen, yuan, or won. They can also encourage mutual holdings of sovereign bonds denominated in the currencies of the parties or the key Asian currencies.
Government authorities in the region should also support the further development of foreign exchange markets for the three key Asian currencies, the Indian rupee and the development of local currency denominated international bonds. These policy interventions could contribute to deepening financial markets for major Asian currencies, which would then be able to provide liquidity (not necessarily in US dollars) during a time of a financial instability. Lastly, government authorities should maintain consistent communication and exchange of information to establish a regional current unit (i.e., ACU) or a regional currency basket.