Over the past decade, the U.S. has begun to reconsider its role in the international order. Through tariffs on countries around the world, conflicts in the Middle East, and the weaponization of international payment systems (SWIFT), the U.S. has caused major tensions with allies using the U.S. dollar for trade and holding it as a reserve currency.
This begs the question: If the U.S. dollar takes a hit on the international stage, whose currency stands most to benefit?
Aside from the obvious ascendant world power that is China, our contention is that small, well-governed countries with open capital markets, and strong institutional rule of law stand to benefit most on the currency front as the U.S. harms its world reserve currency status and withdraws from the international stage.
This follows for three primary reasons. First, if the U.S. is no longer willing to supply a currency that is backed by a strong independent Federal Reserve, rule of law on the international stage, and rail networks that will not be weaponized, investors will demand a currency that offers these features. Smaller countries, with open capital markets, free-floating exchange rates, developed currency derivative markets, and all backed by strong institutions (well-managed central banks), stand to offer the same features that the U.S. dollar has offered over the past 100 years.
Second, technological changes in the form of stablecoins and CBDCs will make it even easier for international investors to bundle and diversify their small-country currency exposure (and with near-instant settlement). Large, institutional investors are obviously hesitant to use smaller currencies due to the lack of network effects (i.e. others using it in trade) and liquidity concerns. With the extension of blockchain-related products, end users will be able to group small currencies together and transfer them instantaneously, which mitigates any liquidity or settlement concerns in international trade.
Third, and possibly most importantly, small-country currencies’ greatest weakness is actually their greatest strength from the perspective of an international currency holder/seller. Because a small nation does not have the institutional power to kick users off their rail networks (as the U.S. has done with aggressors like Russia and the SWIFT system), the end user of a small nation’s currency does not have to worry about the political weaponization of the currency they are using. It is highly unlikely that when using a small nation’s currency (or a basket of small currencies), the international investor has to worry about a coordinated attempt to deny them access to monetary rail networks for international grievances.
With debt loads around the Western world reaching near all-time highs and the yield on 10-year bonds also skyrocketing, international investors are clearly worried about the fiscal standing of the United States and Western Europe. Yet the demand for a well-governed currency still remains high — investors demand an open currency, with deep/liquid markets, floating exchange rates, and backed by a strong rule of law. We are already seeing this demand-side story play out as the fraction of foreign reserves held in the Australian dollar and Canadian dollar has increased substantially over the past 10 years, as well as the fraction of international cross-border trade conducted in these currencies (yet still at a small overall fraction of total world transactions).
To be clear, we are not advocating a position that the U.S. dollar will lose its standing as the primary world reserve currency, but simply highlighting that a demand-side story persists for small, well-governed countries to gain a foothold in the international currency battle. If the U.S. is going to continue to make moves to fragment the international order, currencies from smaller nations with strong institutions and no credible threat of weaponizing their currencies stand to benefit most in this new world of international trade.
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