CBDC launches unlikely to condemn dollar dominance

Under Bretton Woods, the supremacy of the dollar was easily explained. America’s financial situation after World War II was impregnable. Changes in the price at which dollars could be converted to gold were unthinkable, first because of this financial strength, and then, as the country’s monetary position weakened, because of the possibility of a devaluation in creates expectations of another.

Many believed that Nixon’s move would diminish the dollar’s international role. With the fluctuation of the currency, it would be too risky for banks, businesses and governments to put all their eggs in the dollar basket. They would thus diversify by holding more reserves and carrying out more transactions in other currencies. Why this did not happen is now clear. The greenback had the advantage of seniority: the fact that its customers and suppliers also used dollars made it difficult to switch to alternatives. Moreover, the alternatives were not interesting.

As for the euro, there is a dearth of AAA-rated euro government bonds that central banks can hold in reserve. These authorities are therefore reluctant to allow those they regulate to do business in euros, because they are unable to lend change to banks and businesses in need. China’s capital controls complicate international use of the renminbi, amid legitimate fears that Chinese President Xi Jinping may abruptly change access rules. And the currencies of small economies do not have the scale for large volumes of global transactions.

Some say central bank digital currencies (CBDCs) will transform the status quo. In this brave new digital world, any national currency will be as easy to use as any for cross-border payments. This will not only erode the dollar’s dominance, the argument goes, but also dramatically reduce transaction costs.

In fact, this conclusion does not follow. Imagine South Korea issuing a “retail” CBDC that individuals can keep in digital wallets and use in transactions. A Colombian coffee exporter to South Korea can then be paid in digital won, assuming non-residents are allowed to download a Korean wallet. But this Colombian exporter will still need someone to convert those won into something more useful. If that person is a correspondent bank with offices or accounts in New York, and if that something is the dollar, then we’re back to where we started. Alternatively, the Colombian and South Korean central banks could issue “wholesale” CBDCs. Both would transfer the digital currency to domestic commercial banks, which would deposit it into customers’ accounts. Now the Colombian exporter would end up with a loan in a South Korean bank rather than in a South Korean wallet. But, again, the exporter would have to ask the South Korean bank to find a correspondent to convert this digital balance to dollars and then to pesos.

What would be a game changer would be if the CBDCs were interoperable. The South Korean payer would then ask their bank for a deposit receipt denominated in won, and a corresponding amount of CBDC in the payer’s account would be extinguished. This deposit receipt would be transferred to a dedicated international “corridor”, where it could be exchanged for a peso deposit receipt at the best rate offered by the dealers authorized to operate there. Finally, the Colombian beneficiary’s account would be credited with digital pesos, turning off the deposit receipt. The transaction would be completed in real time at a fraction of the current cost without involving the dollar or the correspondent banks.

But the conditions for doing this work are great. The two central banks should agree on an architecture for their digital corridor and jointly govern its operation. They should authorize and regulate dealers with stocks of currency and certificates of deposit to ensure that the exchange rate in the corridor does not diverge from that outside. And they should agree on who provides emergency liquidity, against what collateral, in the event of a severe imbalance in orders.

In a world of 200 currencies, that would require 200 factor-based bilateral agreements, which is impractical. And the corridors would require elaborate rules and governance arrangements much more elaborate than those of global institutions. The CBDCs are coming. But they will not change the face of international payments. And they won’t dethrone the dollar. © 2021 / Project union

Barry Eichengreen is professor of economics at the University of California at Berkeley and author of the forthcoming book “In Defense of Public Debt”