Reserve currencies must provide an anchor in a sea of uncertainty

Since the Renaissance there have been several currencies which have enjoyed the status of reserve currencies. Yet often overlooked is that becoming a reserve currency is the end result of the assumption of material responsibilities by the issuing country. These responsibilities are not only important to maintaining the role of the reserve currency but the preservation of the system which requires such a currency. To fulfil these roles effectively requires the efficient utilisation of global networks and alliances aimed at achieving a common goal. History shows that failure to maintain such networks and thereby provide an effective anchor is generally associated with a decline in a reserve currency.

What is a Reserve Currency?

Often a reserve currency is defined in terms of modern financial structures namely the existence of central banks. For the purposes of this discussion a more general definition is adopted namely that a reserve currency is a foreign currency held by governments, government agencies and individuals/businesses to facilitate global trade and other international transactions and, more importantly, as a store of value. Effectively a reserve currency acts as the anchor to the interrelated system of global trading and financial relationships (referred to as simply the ‘network’).

Development of a Reserve Currency

Since the Renaissance in the 14th century the increasing complexity of global economic and financial relationships has meant that the demand for a reserve currency to act as an anchor to the network has grown. But reserve currencies don’t just spring up. Rather the development of a reserve currency is a decades-long process where the currency’s status evolves through a series of mutually reinforcing phases. The first two phases are :

• Economic and Trade Leadership: The nation becomes the world's dominant trading power making it highly desirable for other nations to denominate international transactions in its domestic currency. Often the ability to dominate trade will be determined by geographic location, access to key markets and trade routes and technology such as shipbuilding capabilities etc.

• Financial Market Depth : As the nation establishes and builds upon its economic and trade leadership the resulting increase in wealth in turn supports the development of relatively deep financial markets.

The result of this is that the first two characteristics needed for a reserve currency to develop are put in place; namely :

• Liquidity: A currency is highly liquid, meaning it can be easily converted into other currencies or used for large transactions without significantly impacting its value.

• Global Acceptance/International Use: A currency is widely accepted and used in international trade and finance. This acceptance reduces transaction costs and simplifies trade agreements between countries.

With these two characteristics in place what the issuing nation has is a ‘desirable’ currency but not necessarily a ‘reserve' currency.

To make the transition to a ‘reserve’ currency one additional economic characteristic is required and that is :

• Stability/Store of Value: The perceived stability of the desirable currency starts to see it increasingly serve, not only as a means of facilitating transactions, but as a store of value. The shift to a store of value transitions the currency from being ‘desirable’ to becoming a ‘reserve’ currency which is now seen as a source of stability to the network especially during times of uncertainty and instability; i.e. becomes the financial anchor to the network.

Once a currency is seen as a store of value it increasingly benefits from inertia and network effects. Put another way the more participants that see the currency as a store of value the stronger the network. In turn the stronger the network the greater the inertia which assists to preserve the reserve currencies dominance over time even in the face of the issuing countries economic decline. What develops is a self reinforcing loop strengthening the position of the issuing country as the anchor to the network.

Networking and inertia are important for the issuing country to maximise the benefits from possessing a reserve currency namely ‘exorbitant privilege’. The ‘exorbitant privilege’ for the issuing nation comprises (a) materially lower borrowing costs and (b) greater stability in capital flows given its status as a safe haven during periods of crisis. Indeed, maintaining the ‘exorbitant privilege’ often becomes more important over time as the resulting lowering in borrowing costs has historically tended to result in the issuing nation over leveraging; i.e. borrowing in excess of longer term sustainable levels. What eventually develops is a complex socio economic network built around the issuing nation which serves as the ‘anchor’ for the entire system. Within this structure all participating nations benefit from the network and accordingly have a vested interest in maintaining the ‘status quo’.

The Missing Piece

This is where the discussion often ends but in doing so risks overlooking a key piece of the dynamic which goes beyond simple economics. Specifically :

• Political and Economic Stability: The reserve currency needs to be backed by a strong economy and a stable political environment. This stability reassures investors that their holdings in the reserve currency will retain their value over time; i.e. reserve currencies are generally stable and reliable in value. Stability is accordingly necessary to maintain confidence in the reserve currency thereby reinforcing its position as the preferred choice for holding wealth.

Importantly reserve currencies do not exist within a vacuum. Political and economic stability are the result of the interaction of not only those participating within the network but also the interaction of the network with parties outside of it. What occurs is an important geopolitical change as the issuing nation needs to effectively shift from being a ‘price taker’ to being a ‘price maker’ to ensure the level of geopolitical stability required to protect its position as a store of value. This requires that the issuing country maintain either control, or at least a very material say, in the ongoing stability of their currency and hence the associated geopolitical and trade environment.

To do this the issuing nation must not only develop a vested interest in preserving the conditions which made its currency desirable in the first place but also demonstrate over time that it can translate those desires into effective outcomes. In practice this means that the issuing country will have a bias to maintain the ‘status quo’. Yet this may often be ‘easier to say than do’ given that the issuing nation’s position is built upon the generation of outsized levels of wealth. The success of the issuing nation and the ‘exorbitant privilege’ it enjoys will not go unnoticed by other nations who may covet a larger share of the benefits generated by the network. These other nations may be termed ‘revisionist’ nations; i.e. those nations dissatisfied with the current world order and are thereby seeking to change it. For the purposes of the discussion it is assumed that revisionist nations are moderate (want to alter the anchor but not the network) as opposed to extreme (want to overturn the entire network).

What results is a network in which all parties simultaneously possess a vested interest in the status quo but at at the same time there is an ongoing tension between members to get a greater share of the benefits flowing to the issuing nation. Put another way all nations within the network have a vested interest in maintaining the network but may still compete for the position of being the anchor to the network. This tension will increase the greater the wealth generated by the network and the greater the exorbitant privilege being earned by the issuing nation. As the anchor to the entire network it now falls upon the shoulders of the issuing nation to navigate these tensions to maintain the status quo with itself at the centre.

The Importance of Alliances

In effect the issuing nation becomes the de facto ‘global policemen’ ensuring the stability of the very economic and political conditions which created the existing network in the first place. Only by demonstrating its ongoing effective role as the anchor to the network can the issuing nation resist the manoeuvring of revisionist nations seeking to assume the role of anchor.

To proactively resist the actions of revisionist nations the issuing nation is faced with two options. The first is to go it alone and become the ‘global policeman’ through its ‘stand alone’ determination or might. Unfortunately, from a resource perspective this is unlikely to be practical which is why it is nearly impossible for a nation to make a bid for international, as opposed to regional, primacy on its own. In practice all systems for the maintenance of the status quo, or even revisionist power, in history have operated via formal alliances or deeply structured systems with the issuing country at the centre acting as the stabiliser. For this reason alliances become even more important for the issuing nation given their objective is preservation of more broadly based network stability rather than territorial acquisitions per sae.

In this context alliances can be viewed more generally as organised strategic relations, such as strategic partnerships, alignments or compacts. In a relatively stable order, nations tend to seek strategic relations primarily with economic and developmental goals in mind, and often offered for no substantive reason other than fostering ‘good relations’ or aligning with wider trends in the network. But in periods of greater international volatility nations often look to forge explicit alliances which have a natural geo-strategic function. Accordingly, the role of the issuing nation as global policemen may often be unofficial or simply taken for granted with it only becoming exercised explicitly during periods of uncertainty.

As a tool for ensuring the ongoing stability of the network alliances offer several key advantages to the issuing nation :

Defray the cost of being a ‘global policeman’ : The key strategic advantage for the issuing country is that effective alliances defray the cost of being the ‘global policeman’ by catalysing national strategy and acting as force multipliers. By doing so effective alliances (a) enhance military power and reach, (b) drive economic benefits and (c) enhance political-strategic postures via mutual political commitments. In particular, a network of allies or partners can act as a backstop and support mechanism at times when a nation enters a crisis or comes under political, economic or some other kind of pressure from a revisionist nation. From not only the issuing nations perspective but also that of the other nations with a vested interest in maintaining the status quo, effective alliances serve an important role as a means of defraying the costs associated with preserving the existing socio economic system.

Offer Operational Fluidity : Broadly based alliance systems provide greater flexibility as the emphasis and focus within the system can be shifted as needed. This flexibility is important as both the cost and risk profile of alliances changes over time with the evolution of the world system – which is why these constructs require not just constant re-evaluation but also re-calibration. It is for this very reason that alliances with issuing nations will tend to be more broadly based and fluid as the purpose is to provide the flexibility to maintain the status quo.

The Importance of 'Credibility'

One of the crucial determinants underpinning the ability of the issuing nation to maintain the status quo is not only its own credibility but also the ongoing credibility/sustainability of its alliance system. The credibility/sustainability of the alliance system to maintain the status quo around the issuing nation is important not just in the calculations of its adversaries but also of those of its own members – especially the weaker ones – and its wider ‘friends’. Hence while the nature of alliances may be fluid the reliability and credibility of the anchor country to its objective of ensuring stability of the network or maintaining the status quo needs to remain largely consistent. Intrinsic to this ongoing credibility/sustainability is that there is a :

• Consistency of Behaviour : An initial requirement is that there is a consistency in behaviour from the issuing nation. Consistency is necessary so that other nations within the network can accurately assess the shared outcome of any conflict before entering an alliance with the issuing nation. Often this consistency in behaviour may simply be the anchor nation seeking to maintain a balance of power within the network.
• Convergence of Interests : There is a convergence between the interests of the issuing nation and both the alliance members and the wider network. This is not to suggest that there is a general loyalty between members of an alliance but rather there is a convergence in the shared interest in the outcome of a conflict.
• Capacity to Impact Outcomes : The alliance which the anchor nation can form needs to have the ability or capacity to have a material impact on outcomes. This is important as the anchor nation is not necessarily the most powerful nation within the network. Accordingly, the formation of appropriate alliances becomes more important to project the capacity to impact outcomes.
• Desire to Impact Outcomes : The alliance has not only the capability but also the determination to pro actively act in maintenance of the status quo. This is important not only should action be needed but can also serve to defuse a potential crisis simply via the thread of action.

Critically, failure for the issuing nation to maintain credibility may not only impact on the effectiveness of any alliances formed but may also hinder its ability to form alliances in the first place. Either of these has the potential to undermine its ability to act as the stabilising anchor at the centre of the network. Once this occurs the seeds are in place for a revisionist nation to step in and position itself, again via alliances, as the new anchor and ultimately issuer of the new reserve currency.  The dynamic driving the shift in anchor is not some dramatic collapse in the current issuing nation but simply results from the new issuing nation being in a better position to pro actively manage the stability of the network. Intrinsic to this is the effectiveness of the alliances which the respective rivals can form as defenders of the network. Ironically with such changes what is initially seen as the revisionist nation ultimately becomes the new defender of the status quo; i.e. the aim of the revisionist nation is not to destroy the network but rather to place themselves in the centre of it to extract the ‘exorbitant privilege’.

While the issuer of a reserve currency may decline the need for a reserve currency does not. Since the internationalisation of trade and finance there has been the desire for a currency to act as the anchor to the global economic and financial network. For this reason the ‘exorbitant privilege’ enjoyed by issuers of reserve currencies simply shifts over time among those that are best able to act as the anchor to the network. To effectively maintain its role the anchor country needs to maintain friends and be able to effectively operate via alliances to ensure the ongoing stability of the system. Conceptually the inability of an issuing country to effectively leverage an alliance system to ensure it can control the stability of the network should signal the decline of its position as the reserve currency. This is supported by history (see appendix article : "A brief history of reserve currencies - their rise and decline" for more colour) which highlights that it is ‘nigh impossible’ to maintain ones role as an issuing nation if one doesn’t cultivate friends and form effective alliances within the network. Ultimately the issuing nation of a reserve currency without any friends is going to find itself replaced by a more effective anchor.