The US dollar is the most common currency of choice for debt contracts. Dollar-denominated credit to non-banks outside the United States amounts to around $11.5 trillion. While the dominance of the dollar declined prior to 2008, the currency has strengthened its international role since then.
We develop a model to study how a dominant currency emerges. Guided by our results, we show empirically why it is the dollar, and why the dollar's dominance may have declined and recovered in the last two decades.
We propose a "debt view" to explain the dollar's dominant role internationally. The model has nominal debt as the main driver and assigns an important role to monetary policy. Expansionary monetary policy in downturns alleviates financial distress through its effects on inflation and exchange rates. We provide both modern and historical empirical support for our mechanism, analysing currency choices over time and across currencies, including evidence using granular bond issuance data.
Theoretically, the dominant currency is the one that depreciates in global downturns at the horizons of corporate debt maturity (around six years). Empirically, the dollar fits this description, despite being a safe haven currency over horizons up to a year. Monetary policy is a key determinant in the choice of the dominant currency. Expansionary monetary policy in global downturns lowers the real debt burdens of firms through its impact on inflation and exchange rates. Indeed, differences in inflation risk premia between the United States and the euro zone help explain the fall and the rise of the dollar's dominance.
We propose a "debt view" to explain the dominant international role of the dollar. We develop an international general equilibrium model in which firms optimally choose the currency composition of their nominal debt. Expansionary monetary policy in downturns prevents Fisherian debt deflation through its effects on inflation and exchange rates, and alleviates financial distress. Theoretically, the dominant currency is the one that depreciates in global downturns over horizons of corporate debt maturity. Empirically, the dollar fits this description, despite being a short-run safe-haven currency. We provide broad empirical support for the debt view. We also study the globally optimal monetary policy.
JEL classification: E44, E52, F33, F34, F41, F42, F44, G01, G15, G32
Keywords: dollar debt, dominant currency, exchange rates, inflation, debt deflation
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