Currency Realignments in a Fragmented World: How Geopolitics Shapes Global Payments

The paper explores how geopolitical proximity and economic factors like trade and financial linkages influence the use of global currencies, particularly the euro and renminbi, in cross-border transactions. It highlights how increasing geopolitical tensions may lead to a diversification away from U.S. dollar dominance.


CoE-EDP, VisionRICoE-EDP, VisionRI | Updated: 14-09-2024 20:58 IST | Created: 14-09-2024 20:58 IST
Currency Realignments in a Fragmented World: How Geopolitics Shapes Global Payments
Representative Image

A study by Jakree Koosakul, Longmei Zhang, and Maryam Zia from the International Monetary Fund, explores how geopolitical proximity influences the usage of major global currencies in cross-border transactions. This study, published in September 2024, comes in the context of rising global geopolitical tensions, such as Russia’s invasion of Ukraine and intensifying U.S.-China trade conflicts. These issues are reshaping global economic policies and the international monetary system, especially the use of currencies like the U.S. dollar, euro, Chinese renminbi (RMB), Japanese yen, and British pound, which are part of the Special Drawing Rights (SDR) basket. The paper examines the role that geopolitical proximity measured through voting patterns in the United Nations plays in driving currency preferences in international trade and financial transactions.

U.S. Dollar Dominance Faces New Challenges

Historically, the U.S. dollar has maintained its dominance in global finance, accounting for over 60% of cross-border payments since World War II. However, this landscape is evolving due to increasing geoeconomic fragmentation, which refers to the separation of economic policies between countries due to geopolitical tensions. The study uses SWIFT data on global financial transactions to assess how geopolitical alignment, along with trade and financial linkages, influences currency usage. The authors highlight that geopolitical proximity significantly boosts the use of the euro and renminbi, particularly among emerging market and developing economies (EMDEs). In these regions, political alignment with the eurozone or China has led to increased use of their respective currencies. For the RMB, the study found that geopolitical proximity had a more pronounced effect during times of heightened trade policy uncertainty, such as during the U.S.China trade war. In contrast, the U.S. dollar's usage shows an interesting trend—countries that are less geopolitically aligned with the U.S. often have higher dollar usage, a finding the authors suggest is linked to the dollar’s role as a global vehicle currency, particularly in countries with weaker domestic currencies.

Trade and Financial Linkages Drive Currency Usage

While geopolitical proximity plays a critical role, traditional economic factors like trade and financial linkages also significantly affect currency preferences. The paper underscores that trade relationships are a major driver of currency choice, especially for the euro and U.S. dollar. For example, in countries that trade heavily with the Eurozone, the euro is more likely to be used in cross-border transactions. This is also true for countries trading with the U.S., where the dollar dominates. In contrast, the renminbi has been slower to gain traction in global trade invoicing, which limits its internationalization. Financial linkages, particularly through foreign direct investment (FDI) and portfolio flows, also drive the use of major currencies. Portfolio investments, in particular, have a strong impact on the use of the RMB and U.S. dollar, as foreign investors seek to diversify their assets or take advantage of opportunities in these large markets. The paper points out that the increasing openness of China’s bond market has contributed to the rising use of the RMB in cross-border financial transactions.

Inertia in Currency Preferences Slows Change

One notable finding is the inertia in currency usage. Past transaction patterns heavily influence present choices, meaning that shifts in global currency preferences happen slowly. This inertia reinforces the dominance of currencies like the U.S. dollar, even in regions with weaker geopolitical alignment to the United States. The paper also discusses the role of legal tender status in promoting the use of specific currencies. For instance, when a currency like the U.S. dollar or euro is legal tender in a country, it is far more likely to be used in both domestic and international transactions. Legal tender status thus remains a critical factor in currency dominance.

Geopolitical Tensions Increase Currency Diversification

The authors also explore how geopolitical proximity’s influence on currency use becomes more significant during periods of elevated geopolitical tensions, such as international military conflicts or trade wars. During these times, countries may seek to diversify their currency holdings away from the dominant U.S. dollar to mitigate risks associated with geopolitical instability. The analysis shows that for the euro, geopolitical proximity’s impact increases by nearly 40% during periods of heightened global military conflicts, as countries look to reduce their reliance on the dollar. For the RMB, this effect is more tied to trade policy uncertainty, suggesting that China’s currency gains prominence when countries are uncertain about future trade relationships, particularly with the U.S.

The Slow Path to a Multipolar Currency System

The research highlights the complexity of the global currency landscape, where geopolitical, economic, legal, and historical factors intertwine. While the U.S. dollar remains dominant, particularly in advanced economies and among countries with weak domestic currencies, the euro and renminbi are steadily gaining ground, particularly in regions where political alignment with Europe or China is strong. However, the transition to a more multipolar currency system, where multiple currencies share global dominance, is likely to be slow and could bring financial volatility. The authors conclude that international coordination will be crucial in managing this transition to avoid destabilizing the international monetary system. As alternative currencies rise in prominence, their ability to maintain stability and liquidity in global markets will be essential in shaping the future of global finance.

  • FIRST PUBLISHED IN:
  • Devdiscourse
Give Feedback