Forward to the past: The international monetary system

Eleventh Asia-Pacific Forum on the Economy and Finance, Dealing with New Challenges of Global Financial Governance: Rethinking at the 80th Anniversary of the Bretton Woods Conference, Session 2: The Future of International Monetary System

School of Finance, Central University of Finance and Economics; Center for International Finance Studies; Hongru Financial Education Foundation; Institute of World Economics and Politics, Chinese Academy of Social Sciences

Prepared remarks, Beijing, 18 December 2024

Dear Conference Participants,

I'm delighted to be back in Beijing after several years. I'm most grateful to the organisers for the invitation. The conference is most timely amid a seemingly increasingly complex and difficult international monetary and financial environment. While the title of the session is the future of the international monetary system, I would like to go back to the past for guidance how the system should evolve. I will focus on the structure of the foreign exchange market as an obstacle for change and emphasise the role digital monies can play as a foundation of a future system.

The international monetary system as a formal arrangement can be traced back to the origins of the International Monetary Fund (IMF). This year, as we have been commemorating the 80th anniversary of the Bretton Woods conference of July 1944 that led to the establishment of the IMF, it is a good time to assess what had been achieved but also to what extent the objectives set at the time still remain relevant today.

With the threat of increasing fragmentation of the international economy, it is worth reminding that participants at the Bretton Woods conference felt that the push for multilateral cooperation was in their own best interest. U.S. Finance Secretary Henry Morgenthau stated at the closing of the conference: “Today the only enlightened form of national self-interest lies in international accord.”1

A central purpose of the IMF, as set out in the Articles of Agreement, is to establish a multilateral payment system. This has largely not been achieved and remains its biggest short coming and source of persistent vulnerabilities in the international economy. It means some countries have to use other countries’ currencies to conduct international transactions and if those are not readily available or accessible significantly constrain their abilities to meet external obligations. This shall be the starting point of my remarks.

Delegates at Bretton Woods wanted all currencies to be used in international transactions: “[…] If imports from countries other than the United States and the United Kingdom must be paid for in dollars and sterling, […] other currencies [will be] of limited usefulness in settling international payments.”2

The concern about currency dependence has accompanied the IMF for decades. In fact, the IMF was of course established because of the scarcity of currencies that can be used in international payments (gold-convertible currencies). This had also been reflected in the scarce currency provisions of the Articles. Its most significant reform attempt came with the adoption of the IMF Special Drawing Right (SDR) and with the second amendment of the Articles that installed the SDR as the principal reserve assets to reduce dependence on national currencies. However, those changes never had any material impact.

Today, the central feature of the international monetary system remains the very high level of concentration by market actors and currencies in particular the dependence on a single currency, the U.S. dollar. This dependence has brought many advantages amid the positive network effects of using the same currency and in serving as a policy coordination mechanism. At the same time, naturally it requires all parties to have access to dollars.

The foreign exchange market serves as the critical gateway for accessing dollars. With a daily average turnover of US$7.5 trillion, it is by far the largest financial market. The dollar represents either the sold or the bought leg in about 9 out of 10 currency pairs traded. Nowhere does the role of the dollar matter more.

The currencies of China and major emerging markets play an increasing though still very small role in foreign exchange (Figure 1). This contrasts with the growing and absolute importance of China and major emerging markets in the real economy (Figure 2). The asymmetry between the monetary and real sides of the international economy has been a source of persistent tension and instability for a long time.

Figure 1. Currency dominance

Figure 2. Economic dominance

Banks are subject to important prudential requirements to settle foreign exchange transactions. To mitigate risks, banks typically rely on netting to offset their exposures and hold large amounts of regulatory capital. Yet netting greatly favours market concentration and the need for capital imposes high barriers of entry. The fewer counterparties and the fewer the currencies being traded, the more opportunities for netting exist. In 1990, a BIS report on netting concluded, that “trading with preferred counterparties is an important incentive to adopt netting.” 3

I shall argue here that the structure of the foreign exchange market provides important disincentives for greater diversification. To change the system therefore, the market structure of the foreign exchange market needs to change.

Digital monies offer new possibilities out-of-the-box that may significantly alter existing settlement arrangements. They shall denote here, monies issued in a digital token format on blockchain. They are typically exchanged instantly and atomically, that is, both legs of the transaction need to succeed or none does. Instant implies that the duration exposure is nil. This allows to mitigate most settlement-related risks. It is also assumed to require less liquidity to perform efficient settlement.

The central bank digital currencies (CBDC) projects Jura and mBridge, I worked on both, had adopted instant and atomic settlement for foreign exchange. They have shown how it works offering an entirely new architecture for foreign exchange settlement and the basis for significant efficiency gains and as such provides a strong basis for adopting smaller currencies.

The international monetary system needs to become more diversified. It will naturally rest on the attractiveness of alternative currencies in terms of stability. But it will also depend on settlement arrangements that require less capital and less liquidity. It may be the micro-foundations of the foreign exchange market that offer the key for establishing a multilateral payment system.

Thank you.