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Editors' note: This column is part of the Vox debate on the economic consequences of war.
Sanctions imposed by the US on Russia have generated a lively debate about the ability of the dollar to maintain its position as the dominant reserve currency.1 The surprisingly strong sanctions limiting the use of Russian dollar reserves suggests that, at least for some countries, accumulation of dollar assets for a rainy day will be less attractive. But the consensus view seems to be that the dollar will remain dominant if only because there is no good alternative (Brunnermeier et al. 2022).
The current debate is driven by the assumption that governments hold reserves to smooth international payments in the face of trade or capital account disturbances. We have no quarrel with this line of thought, but have argued since 2003 that it provides a seriously incomplete framework for understanding the modern role of the dollar and the US in the international monetary system (Dooley et al. 2008).2 Empirical research suggests that the traditional story is incomplete in the face of very large reserve accumulations by China and other emerging markets since 2002 (Levy Yeyati 2010, Calvo et al. 2012). Rather than stretching the traditional story to fit the facts, we propose an additional reason for holding reserves. In our framework, optimal reserve holdings for poor countries seriously pursuing economic development should be much larger than amounts suggested by the conventional model. Moreover, there are good reasons for the US and the dollar to continue to play the dominant role in the system, notwithstanding a record of previous freezes or even expropriations of reserves.
In our framework, the willingness and ability to engage in comprehensive financial asset seizures is part of the job description for a modern reserve currency. Such potential seizures were the collateral foundation of the massive expansion of net and gross capital flows between rich and poor countries for at least the past 25 years. Moreover, for good reasons, the US was and is the country most trusted and most likely to fulfil this responsibility. It has had a long track record of seizing foreign assets while suffering no diminution of its role as the key reserve currency.3 It follows that the demonstration that the US and its allies are willing to impose sanctions even against a militarily powerful country reinforces the dollar’s dominance going forward.
The most important historical example of demand for reserves to reassure private foreign investors is that of China after 2002. China had to convince foreign industrial capital that the Chinese government, hitherto a fervent enemy of private capital, would not ultimately expropriate their investments. China’s policy employed to manage the exchange rate, i.e. sterilised foreign exchange intervention, also provided the reserve accumulation commitment necessary to support the inflow of private foreign capital. The accumulation of collateral may have been inadvertent, but this made it no less effective.
This net export of Chinese capital for collateral has been so large and permanent that long-term real interest rates in industrial centre countries have been reduced for the last 20 years. An influential academic theory for persistently depressed real interest rates in the centre is that the US supplies ‘safe assets’ to the rest of the world (Caballero et al. 2017). This is only part of the story. The US also produces assets that are unsafe to those who misbehave, and these also are in high demand. The centre country must provide safety for good behaviour and punishment for bad behaviour.
A key difference between a transaction demand for reserves and the collateral demand for reserves is that collateral demand is much larger. The collateral that was provided by reserve accumulation was comparable in China to what would have been required between private investors with comparably different credit risks. We calculated the collateral requirement for a hypothetical total return swap of reserves against direct investment. To our surprise, direct investors in China were getting about what a commercial swap would require. Over the years, updates in our calculations reconfirmed our findings (Dooley et al. 2014)...
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