Liquidity, Debt Denomination, and Currency Dominance-Chenzi Xu (Standford)

Department: Finance

Speaker: Chenzi Xu (Standford)

Room: T022

Abstract

The international monetary system of the last four centuries has experienced the rise,
persistence, and fall of specific currencies as the dominant unit of denomination in
global debt contracts. We provide a liquidity-based theory to explain this pattern.
Firms issue debt that can be extinguished by trading their revenues for financial assets
of the same denomination. When asset markets differ in their liquidity, as modeled
via endogenous search frictions, firms optimally choose to denominate their debt in
the unit of the asset that is most liquid. Equilibria with a single dominant currency
emerge from a positive feedback cycle whereby issuing in the more liquid denomination
endogenously raises the benefits of that denomination. This feedback mechanism has
historically been seeded by governments that created the largest pool of liquid assets in
the same denomination. Once dominance is established, a country’s costs of investing
in the ability to create liquid assets, such as by increasing fiscal capacity, are lower
while the incentives to do so are higher, thereby entrenching dominance. We explain
the historical experiences of the Dutch florin, the British pound sterling, the US dollar,
and the transitions between them. Our theory highlights normative features of liquidity
provision in the international monetary system through the lens of the Bretton Woods
arrangement, and we discuss the implications of modern policy tools such as central
bank swap lines. We rationalize the current dollar-dominant international financial
architecture and provide predictions about the potential rise of the Chinese renminbi