The Geopolitics of Currencies

The Geopolitics of Currencies

The 1944 Bretton Woods agreement jumpstarted the dollar into its reserve currency status. While economists proposed global trust and confidence in the US ability to pay its obligations, a more compelling justitification has its roots in United States’ political influence.

The Real Relation with Trade Deficits

For a long time, the fact the US had the largest trade deficit in the world suggested the idea such deficit was the main determinant of the dollar’s dominant status. For some reason, instead, the economies of the euro and the yen had substantial trade surpluses contradicting this hypothesis. Nonetheless, it remains true that the use of the dollar as a reserve and international funding currency enabled the policies that led to such a status and that, in turn, are facilitating the US in growing and funding its trade and fiscal deficits.

The Security Premium

Although mainly related to the role of reserve currencies, a country’s strategic, diplomatic, and military power can increase the willingness of foreign governments to use its currency for cross-border transactions (i.e., the geopolitics of currencies); additionally, a leading power like the United States can employ its political influence to encourage countries in adopting the dollar for reserve and trade purposes. Interesting conclusions are provided by studies correlating the imports for security and military alliances with the adoption of the dollar; indeed, Germany, Japan and Saudi Arabia (i.e., more reliant on security imports from US) had a greater share of reserves held in dollars than China, Russia, and France (i.e., less reliant). Other studies from VOX-EU quantified this difference in about 30% of a foreign exchange reserve portfolio. In other terms, it might exist a security premium for the dollar that explains its strength against other currencies.

Alternatives and Prospects

On one hand, the above studies suggest that US policies promoting disengagement from global geopolitics will reduce the security premium. In general , the impact of “America First” policies must include the impact of Covid-19 (neutral because affects other currencies as well), deflation (slightly negative, -1-2%), debt (negative, -2%), interest rates (neutral because zeroed on the mid-term), and macroeconomic reforms (positive, +5-8%).

Among the alternatives currencies, the international adoption of the Euro has been constrained by its perceived limited power in providing stability and safety in terms of AAA coverage of Euro denominated debt. Similarly, the fragmentation of its capital markets and missing unitary policies in international affairs are reducing its appeal. The yuan is another candidate although the restrictions on capital flows to mainland China substantially exclude the development of globally accessible capital markets; similarly, the offshore Hong Kong market is negatively affected by the new policies and political annexation. Instead China might opt for another alternative like Central Bank Digital Currency (CBDC) representing an extension of the fiat currency. Specifically, the digital yuan will improve its international status through the domestic adoption but also more prominently through its Belt and Road Initiative involving more than 65 countries; specifically, the speed and safety of digital transactions could improve the yuan’s international adoption.

Therefore, once all the factors are included, a reduction of the 10-15% might occur with a progressive devaluation of the 10%.


Caballero, R, E Farhi and P-O Gourinchas (2015), “Global Imbalances and Currency Wars at the ZLB,” NBER Working Paper, No 21670.

Cohen, B. (2015). Currency Power: Understanding Monetary Rivalry. Princeton, NJ: Princeton University Press.

Eichengreen, B., Mehl, A., and Chiţu, L. (2017). Mars or Mercury? The Geopolitics of International Currency Choice. NBER Working Paper.

Juncker, J. C. (2018). The Hour of European Sovereignty. State of the Union Address 2018.

Murray, R. (2020). Understanding the DIgital Yuan. Foreign Policy Research.

Sullivan, J. W. (2020). Don’t Discount the Dollar Yet. Foreign Policy.

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