Fiscal capacity and the global competition for currency dominance
In this paper, Joseph Abadi, Jesús Fernández-Villaverde, and Daniel R. Sanche develop a tractable, micro-founded monetary model to analyze the competition between international currencies and the determinants of currency dominance in the global financial system. The authors’ methodology is based on building a monetary model where two countries issue sovereign bonds, which can be used either domestically (due to legal restrictions) or in international transactions. Agents in these countries interact as buyers and sellers in random decentralized markets and trade in centralized markets for consumption and labor. Governments set interest rates on their bonds and influence the international use of their currency through policy choices, especially by expanding debt issuance and offering attractive interest rates. Abadi et al. study different equilibrium outcomes—such as a single dominant currency or multiple currencies in circulation—and explore how fundamentals like country size, fiscal capacity, and global integration shape the patterns of international currency use.
Findings
- A single dominant currency is more likely to emerge from a large country with sufficient fiscal capacity to supply the global demand for liquid assets; smaller economies struggle to achieve this status because they cannot back enough outstanding sovereign debt.
- If the dominant country cannot meet global demand (for example, due to limited fiscal capacity), multiple currencies may coexist internationally (multipolar regime).
- Governments can try to internationalize their currency by offering more attractive interest rates on debt—higher real rates make national bonds more competitive outside their home country.
- Greater global economic integration favors internationalization and multipolarity, while a relative increase in one country’s size encourages that currency’s dominance.
- Policies promoting higher interest rates on government debt also lead to persistent trade imbalances, allowing the dominant currency issuer to run trade surpluses financed by seigniorage.
- Introducing financial market frictions or limited recognizability does not overturn the main results—dominance or coexistence emerges depending on country size, policy, and institutional settings.
The results capture a version of the Triffin dilemma: only countries with sufficient fiscal capacity can sustain a global currency role without risking unsustainable debt and loss of credibility.
International Currency Dominance
Authors: Joseph Abadi, Jesús Fernández-Villaverde, Daniel R. Sanche
From: Federal Reserve Bank of Philadelphia, University of Pennsylvania
Country reputation and currency competition
The paper by Christopher Clayton, Amanda Dos Santos, Matteo Maggiori, and Jesse Schreger, presents a theoretical and empirical analysis of how countries compete to become providers of international safe assets, such as reserve currencies. The authors model global competition in sovereign debt markets, where governments can build reputation by not imposing capital controls or expropriating investors ex post. Countries with stronger reputations face lower borrowing costs, but high competition reduces the incentive to build reputation. They estimate reputation using correlations in mutual fund and ETF portfolio holdings, comparing exposures to each country’s bonds with those of developed markets, based on Morningstar data and steady-state model solutions.
Findings
- Competition reduces reputation building: Increased competition among countries lowers the incentives for governments to build reputation as safe asset providers. This leads to a “low reputation trap,” where many countries remain stuck at low reputation levels and are unable to supply safe assets.
- Empirical reputation measure: The authors construct a time-series index of country reputation using portfolio correlation data. The U.S. and Eurozone show high, stable reputations, while countries like Brazil and South Africa have lower reputations. China’s reputation is intermediate, and it improved after the government refrained from imposing capital controls during a crisis.
- Incumbent strategy: An established safe asset provider (like the U.S.) can deter competitors by increasing its own debt issuance, which raises borrowing costs for others and makes it harder for new entrants to build reputation. This strategy can be valuable even if it reduces the incumbent’s own “exorbitant privilege.”
- Policy implications: The model suggests that the presence of a dominant incumbent can hinder the emergence of a multipolar international monetary system. Multilateral policy agreements may be needed to foster competition and diversification.
International Currency Competition
Authors: Christopher Clayton, Amanda Dos Santos, Matteo Maggiori, Jesse Schreger
From: Yale School of Management, Columbia University, Harvard University
Key distinctions between the two papers
- Clayton et al. (2024) focus on the dynamic reputation-building process in a competitive environment and show how high competition depresses the emergence of new safe asset providers through reduced incentives for reputation investment.
- Abadi et al. (2025) center on the structural determinants (size, fiscal space, policy) for the emergence and sustainability of currency dominance, with equilibrium regimes depending on countries’ ability to meet global demand for liquid, safe assets.
