Gopinath on dollar dominance in international trade

In Chapter 2 of the Hoover Institution's Currencies, Capital, and Central Bank Balances, edited by John Cochrane, Kyle Palermo, and John Taylor, IMF Chief Economist Gita Gopinath "shows how private international financial intermediaries tend to focus on certain currencies, with the US dollar currently the dominant currency of choice. The dollar is often used for invoicing even when trade is between two non-US entities." A couple things that stuck out to me from her chapter, Dollar Dominance in Trade and Finance, are below.

Dollar dominance in trade, finance, and central bank reserves

1. Trade

The Mundell-Fleming economic paradigm states that the importance of a country's currency in international trade is tied closely to its share in world trade. This does not actually happen because the assumption that countries export goods in their own currencies is faulty. The dollar's share as an invoicing currency is 4.7 times its share in world imports and 3.1 times its share in world exports.

Even Japan and the UK invoice only 40 and 51 percent of exports in their own currencies. US invoices 93 percent of imports and 97 percent of exports in dollars.

2. Asset markets

Dollar liabilities of non-US banks are ~$10 trillion, roughly the same magnitude as dollar liabilities of US banks.

The vast majority of syndicated cross-border loans are made in dollars -- from a low of 61% in developed countries to 97% in Emerging Americas. Euro is second with 24% and 20% in Developed Countries and Emerging Europe.

Data source: BIS locational banking statistics

3. Central bank reserves

$10 trillion in official central bank reserves (2017Q4) -- dollar share is 63 percent, followed by euro at 20 percent.

[Update for 2019Q4: $6.7 trillion of dollar reserves out of $11.8 trillion total ($11.1 trillion allocated)]

Central banks keep dollars not just for trade but also so they can be the lender of last resort to their banking system.

Data source: IMF COFER (Currency composition of Official Foreign Exchange Reserves)

What makes a currency dominant?

In short, history and network effects.

1. History: How does a currency become dominant?

First, the historical evidence described by Eichengreen (2010). How to make a dominant currency

1. Encourage its use in invoicing and settling trade;
2. Encourage its use in private financial transactions;
3. Encourage its use by central banks and governments as a form in which to hold private reserves.

This process will lead to a high demand for the currency, which will decrease the interest rates (raise the price) on safe assets in that currency.

Once you get to preferred currency status, a feedback mechanism can keep it in place: "Why do exporters invoice in dollars? Because it is cheaper to finance in dollars. Why is it cheaper to finance in dollars? Because exporters invoice in dollars."

2. Network effects: How does a currency remain dominant?

Comments made in the discussion were insightful on this point:

Adrien Auclert: "In principle, going forward, we might see the equilibrium switch again, with the euro or the renminbi becoming the new dominant currency. But what this static model misses is that existing assets and liabilities have long maturities. So in a sense, the anchor of history is likely extremely strong--it would take a really long time for all assets and liabilities to be redenominated in any new currency, and the staggered nature of contracts makes such a coordination very large to imagine."

Robert Heller: "in Silicon Valley, we talk all day long about network effects. Isn't the dollar's dominance similar to network effects? The dollar almost took over the world, and it's very difficult for a second competitor to come up and to compete with the currency once it's dominant, just simply because of network effects."

There is interaction and reinforcement between low interest rates, dollar trade invoicing, dollar liabilities in global supply chains. So we have coordination difficulties, network effects, and lock-in by historical events. Dollar dominance seems established for the foreseeable future, but beware information cascades.