Banking, Trade, and the Making of a Dominant Currency

This paper argues that a currency’s role as the unit of account in which international trade is invoiced and its role as a safe store of value are complementary, and that the feedback between them can entrench a single dominant currency even between economies with identical fundamentals. The starting observation is that a financial claim is only meaningfully safe if it buys a known quantity of goods, so if a household’s imports are priced in dollars and those dollar prices are sticky, dollar deposits are its safest asset in real terms. Demand for safe dollar claims therefore rises with the dollar invoice share. Beyond what the US Treasury supplies, the marginal safe dollar claim must be manufactured by banks in other countries – and those banks’ collateral is local-currency project revenue, which backs dollar promises inefficiently because the local currency can depreciate. In the model’s collateral constraint, an amount of local collateral sufficient to back one unit of safe local-currency claims backs only 1/E-bar units of safe dollar claims, where E-bar is the most depreciated exchange rate. Firms with the inferior technology can only be drawn into producing dollar collateral if they are paid for it, that is, if dollar borrowing is cheaper than local-currency borrowing – so the dollar’s “exorbitant privilege” emerges endogenously as the price that clears the market for safe dollar claims, with Proposition 1 pinning the wedge exactly at (Q-dollar minus beta)/(Q-home minus beta) = E-bar. This reverses the usual informal reasoning: rather than taking the uncovered-interest-parity violation as exogenous and using it to explain why foreign firms borrow in dollars, the paper takes the dollar invoice share as the primitive and derives the UIP violation from it. The paper then closes the loop in three steps. Letting exporters choose their invoice currency at a quadratic cost, the first-order condition makes the dollar-invoiced share proportional to the UIP gap, so any positive dollar premium induces some dollar invoicing, because more predictable dollar revenues are better collateral for cheap dollar borrowing. Embedding this in a continuum of emerging markets whose dollar invoice share is an anchor plus a feedback coefficient times other countries’ invoicing choices generates strategic complementarity, multiple equilibria when the feedback is strong, and a discrete jump in the dollar’s global role as the US share of emerging-market imports gradually rises. Finally, putting a symmetric euro alongside the dollar – equal external safe-asset supply, equal exchange rate volatility, symmetric invoicing costs – yields asymmetric dominant-currency equilibria in which one currency is used heavily for both invoicing and bank funding and the other is not used at all, with an intermediate parameter range where a single dominant currency is the only possible outcome. The model cannot say which currency wins (“taken literally, the model says that the outcome is indeterminate”), so the authors propose history as the selection device. The empirical work is explicitly preliminary: across the ten countries with both import-invoicing and BIS locational banking data, the dollar’s share of foreign-currency bank liabilities lines up strongly with the dollar’s share of foreign-currency-invoiced imports, with a regression R-squared of 0.72, rising to 0.82 on the eight countries for which the liability measure can be narrowed to loans and deposits from non-bank counterparties. Throughout, the authors are candid about the model’s simplifications: exchange rates are exogenous with no expected appreciation, the money-demand formulation is described as “arguably an ad-hoc way” of capturing invoice-currency safety, the central bank reserve link is asserted rather than modelled here, and the analysis speaks to average cross-currency return differentials rather than to higher-frequency phenomena like the forward premium puzzle.

Jeremy C Stein | Macro Paper Warehouse

Banking, Trade, and the Making of a Dominant Currency