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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.

CIP deviations, the dollar, and frictions in international capital markets

This is a survey chapter, written for Volume V of the Handbook of International Economics, rather than a paper presenting new results; its claims are drawn from the literature it reviews and its own descriptive statistics. (The full text used here is the freely available NBER working-paper version of May 2021.) The organising fact is the dollar’s outsized role in global finance: the United States is about 15 percent of world trade and 25 percent of global GDP, but the dollar accounts for roughly 50 percent of cross-border loans and international debt securities, 90 percent of FX transactions, 60 percent of official reserve holdings and 50 percent of trade invoicing. Because “the global market for dollar funding is highly fragmented” and many participants who need dollars cannot reach dollar-rich lenders directly, large global banks have to intermediate – and since the Global Financial Crisis their balance sheet constraints have tightened, partly through regulatory reform. The most visible symptom is the failure of covered interest rate parity, measured by the cross-currency basis: the difference between the cash-market dollar rate and the synthetic dollar rate implied by borrowing in foreign currency and swapping into dollars. The chapter documents a sharp pre- and post-crisis dichotomy – CIP “held remarkably well prior to the GFC,” with only fleeting deviations of 30 seconds to 40 minutes – and shows the post-crisis deviations survive replacing Libor with OIS or with government-collateralised repo rates, so they are not simply a credit spread. Three stylised facts follow. The basis is generally negative, with the Australian and New Zealand dollars the G10 exceptions; it correlates 90 percent in the cross-section with the level of nominal interest rates since 2008, which means the hedged CIP arbitrage runs opposite to the unhedged carry trade; and it has a strong factor structure, with the first principal component of quarterly changes in the five-year G10 bases explaining 51 percent of variation over 2008Q1-2020Q3 and correlating 96 percent with the average basis, so the basis widens in bad times alongside a strong broad dollar, high VIX, wide BBB-Treasury spreads and negative intermediary capital shocks. The explanatory framework is a supply-and-demand diagram for swapped dollars. Pre-crisis supply was perfectly elastic at a zero basis; post-crisis the leverage ratio requirement, which “mandate[s] banks to maintain capital against all assets, regardless of their risk characteristics,” makes even a riskless matched-book trade costly, tilting the supply curve upward so that demand shifts now move the equilibrium basis. On the demand side the chapter identifies three client types willing to pay the basis as an intermediation fee: non-top-tier non-US banks with local-currency insured deposits but dollar assets, non-US institutional investors with local-currency liabilities and dollar portfolios, and multi-currency corporate issuers exploiting currency-segmented bond markets. Central bank swap lines are the crisis backstop, priced at a fixed spread over OIS that fell from 100 basis points in the Global Financial Crisis to 50 in November 2011 and 25 in March 2020, with peak outstanding of about $580 billion in 2008-09, $110 billion in the European debt crisis and $450 billion during COVID. The chapter then separates government bond CIP deviations, which need not be arbitrage at all, since they can reflect sovereign default risk, capital controls and market segmentation, or cross-country differences in convenience yields. A final section surveys two views of what CIP deviations mean for exchange rates – one treating them as a signal of intermediaries’ risk-bearing capacity, the other as a determinant working through bond convenience yields – and the chapter closes with open questions about whether post-crisis regulation is calibrated correctly, about the growing role of non-banks, and about the macroeconomic consequences.

Dominant Currency Paradigm

Standard open-economy macro models assume that export prices are sticky either in the producer’s currency, in which case a depreciation improves the terms of trade and competitiveness, or in the destination’s currency, in which case it worsens them. Neither matches the invoicing evidence: the vast majority of world trade is priced in a small number of dominant currencies, with the dollar playing an outsized role. This paper builds an alternative “dominant currency paradigm” from three joint ingredients – infrequently adjusted prices set in a dominant currency, strategic complementarities in pricing that make desired markups variable, and roundabout production using imported inputs – and derives four sharp testable implications: the bilateral terms of trade should be insensitive to bilateral exchange rates; for non-US countries import price pass-through should be high but driven by the dollar rather than the bilateral exchange rate, and more so the higher the country’s dollar invoicing share; import quantities should likewise be driven by the dollar rate, with US import quantities much less responsive; and a uniform appreciation of the dollar should reduce trade among countries other than the United States. The tests use two new datasets: bilateral non-commodity price and volume indices built from UN Comtrade for more than 2,500 country pairs covering 91 percent of world trade, 1992-2015, and firm-10-digit-product-country-quarter customs records for Colombia, an economy that invoices 98 percent of its exports in dollars. All four implications hold. Regressing bilateral terms of trade growth on bilateral exchange rate growth gives a contemporaneous coefficient of 0.037 with a 95 percent confidence interval of [0.02, 0.05], against a predicted 1 under producer currency pricing and −1 under local currency pricing, and the coefficient shrinks further toward zero once relative producer prices are controlled for. A standard bilateral pass-through regression implies near-complete pass-through – a 10 percent depreciation of the importer’s currency against the exporter’s raises import prices about 8 percent within the year – but adding the dollar exchange rate and time fixed effects knocks the bilateral coefficient from 0.76 to 0.16, with the dollar coefficient at 0.78 absorbing almost all of it, and raising a country’s dollar invoicing share by 10 percentage points raises contemporaneous dollar pass-through by 3.5 to 7.6 percentage points. On volumes the contemporaneous dollar elasticity is roughly −0.19 to −0.13 while the bilateral elasticity is an order of magnitude smaller; the euro is far less important than the dollar in both sets of regressions. Consistent with 97 percent of US exports and 93 percent of US imports being dollar-invoiced, bilateral pass-through into US export prices is complete on impact and close to zero for US import prices, and US import volumes are essentially unresponsive to the bilateral exchange rate (an implied 0.003 percent contemporaneous response to a 1 percent dollar depreciation, against −0.12 percent for non-US importers), so US trade balance adjustment runs through exports rather than imports. Aggregating the bilateral panel, a 1 percent ceteris paribus dollar appreciation against all other currencies predicts a 0.6 percent contraction in rest-of-world trade volume within the year, persisting for at least two years, controlling for proxies for the global business and financial cycles; dollar pass-through into foreign CPI and PPI averages 11 and 28 percent within the year and rises with the dollar invoicing share. The Colombian microdata reproduce all of this and additionally let the authors estimate the model: the estimated invoicing shares are essentially DCP, the estimated model tracks the observed dynamics of pass-through while PCP and LCP counterfactuals do not, and removing strategic complementarities and imported inputs halves four-quarter export pass-through from 65 to 30 percent. The authors are explicit about interpretation: the volume regressions “do not capture structural demand elasticity parameters” and “conflate expenditure switching and shifts in aggregate import demand,” so they are predictive relationships rather than structural estimates; and the invoicing currency is taken as given, with the argument that the model’s own ingredients are the ones that would generate dominant-currency pricing endogenously.

Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens

Because global firms raise capital through subsidiaries incorporated in tax havens, official residency-based statistics attribute those securities to the haven rather than to the parent’s country; this paper matches the universe of traded securities to their ultimate parents and restates bilateral investment positions, finding developed-market financing of large emerging market firms to be dramatically larger than reported and China’s net creditor position to be roughly half its official size. The scale of the problem is set by two numbers: the corporate sector globally raises 7 percent of its equity and 9 percent of its bond financing through foreign subsidiaries located in tax havens, and CPIS records $3.9 trillion of foreign portfolio investment in the Cayman Islands in 2017 against a Cayman GDP of $5 billion. The method has three steps. First, combining seven commercial data sources, the authors map each issuer of the 26 million stocks and bonds in CUSIP Global Services’ master file to a single ultimate parent, reallocating more than 90 percent of the corporate bonds and equities issued in each of Bermuda, Curacao, the Cayman Islands, the Channel Islands, Luxembourg, Macau, Panama and the British Virgin Islands. Second, merging that mapping with Morningstar security-level holdings of 61,000 funds reporting over 11 million positions worth $32 trillion as of December 2017, they build “reallocation matrices” giving, for each investor country, asset class and year, the share of residency-based holdings in each country that belongs to each other country on a nationality basis. Third, they apply those matrices to two public residency-based datasets – the US Treasury’s TIC and the IMF’s CPIS – for nine developed investor economies with adequate fund coverage. Two patterns dominate the redrawn map. Bond positions in the BRICS are far larger: US corporate bond holdings in the BRICS rise from $19 billion to $126 billion, a 560 percent increase, and euro-area holdings from $152 billion to $389 billion, because emerging market corporates issue through haven affiliates partly to spare foreign bondholders withholding taxes that are 15 percent in Brazil and 20 percent in Russia but zero in the British Virgin Islands, the Cayman Islands, Luxembourg and the Netherlands. Equity exposure to China is far larger still: US holdings rise from about $150 billion to almost $700 billion, the euro area’s from under $100 billion to over $300 billion, overwhelmingly reflecting Variable Interest Entities listed in the Cayman Islands. Because foreign claims on VIEs enter China’s accounts as intercompany positions valued without reference to listed share prices, China’s reported net creditor position of $2.1 trillion at end-2018 is overstated by $1.1 trillion. The paper is careful about what it does and does not establish. Its central identifying assumption is that reallocation matrices built from fund holdings are representative of all security investment, which it tests against US insurance-company and Norwegian sovereign-wealth-fund holdings, obtaining best-fit slopes of 0.98 to 1.00 with R-squared of 0.95 to 0.98. On China’s accounts it states that it has “corresponded with China’s statisticians and have no reason to believe their treatment of these FDI positions is inconsistent with official guidelines” – the claim is one of mismeasurement relative to market value, not of misreporting. And it insists there is no single correct restatement: alongside the baseline it offers full-nationality, guarantor-based and sales-based alternatives, since “the most appropriate concept in accounting for these positions will depend on the question at hand.”

When inequality matters for macro and macro matters for inequality

This paper argues that two standard excuses for relying on representative-agent macro models – that heterogeneous-agent models with aggregate shocks are computationally intractable, and that realistic household heterogeneity does not matter much for aggregate dynamics anyway – are both weaker than commonly believed. To address the first, the authors extend Michael Reiter’s discrete-time linearization approach to continuous time: they solve a model’s stationary equilibrium fully nonlinearly using the finite-difference methods of Achdou et al. (2015), take a first-order Taylor expansion of the full discretized equilibrium system around that steady state using automatic differentiation, and solve the resulting large linear system of stochastic differential equations by standard techniques, exploiting continuous time’s tendency to generate sparse transition matrices; a companion model-free dimensionality-reduction method, adapted from the engineering “model reduction” literature, lets the computer – rather than the researcher – identify the low-dimensional information in the cross-sectional distribution needed to forecast prices accurately, generalizing the “approximate aggregation” logic of Krusell and Smith (1998) beyond cases where a hand-picked set of moments happens to work. On the standard Krusell-Smith (1998) business-cycle model, the method is roughly 1,500 times faster and about three times more accurate (by Den Haan’s 2010 error metric) than the best-performing algorithm in the JEDC comparison project, though its accuracy – being a local, linear approximation – degrades as the size of aggregate shocks grows. To address the second excuse, the authors apply their (open-sourced) toolbox to a two-asset incomplete-markets model, calibrated to match the U.S. joint distribution of income, wealth, and marginal propensities to consume, in which “wealthy hand-to-mouth” households arise endogenously from a costly-to-access illiquid asset. This richer model jointly reproduces two features of aggregate consumption dynamics – sensitivity to predictable income changes and relative smoothness – that have long challenged representative-agent and simple spender-saver benchmarks, and, in an extension with capital-skill complementarity, shows that aggregate productivity shocks can generate substantial, shock-specific swings in income and consumption inequality, providing what the authors call “a striking counterexample to the main result of Krusell and Smith (1998).”