Dominant currency debt

Summary

Focus

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.

Contribution

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 and exchange rates. Expansionary monetary policy in downturns alleviates financial distress through its effects on inflation and exchange rates. We provide broad empirical support for our mechanism, analysing currency choices over time and across currencies, including evidence using granular bond issuance data.

Findings

Theoretically, the dominant currency is the one that: (i) depreciates in global downturns over horizons of typical debt maturity; and (ii) has the steepest nominal yield curve. We show empirically that the dollar fits this description better than other major currencies. 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. The debt view can explain dollar debt issuance patterns over the past two decades. It also offers insights into the future of the dollar's dominance in the aftermath of the Covid-19 crisis.

Abstract

We propose a "debt view" to explain the dominant international role of the dollar. Within a simple capital-structure model with debt-currency choice, we show that the "dominant currency'' is the one that (1) depreciates in global downturns over horizons of typical debt maturity and (2) has the steepest nominal yield curve. Empirically, we show the dollar fits this description better than other major currencies. The debt view can explain dollar-debt-issuance patterns over the past two decades. It also offers insights into the future of the dominance of the dollar in the aftermath of the COVID-19 crisis.

JEL classification: E44, E52, F33, F34, G15, G32.

Keywords: dollar debt, dominant currency, exchange rates, inflation, monetary policy.