| By: |
Dong He (Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research);
Xiangrong Yu (Hong Kong Institute for Monetary Research) |
| Abstract: |
The dominance of the US dollar in foreign exchange (FX) markets appears to
reflect very strong network effects in the use of international currencies.
What we observe today is the result of a slow-moving process that has
witnessed a switch from the dominance of the pound sterling to the US dollar,
perhaps during the interwar period in the early part of the 20th century. This
paper presents a discrete choice model of FX trading that explicitly allows
for this type of critical transitions in order to understand the dynamics of
currency turnover in FX markets. We estimate the model using the Bank for
International Settlements' data from triennial surveys of FX markets and also
examine the factors that could potentially shift the dynamic path and lead to
an earlier critical transition. We then discuss the implications for the
renminbi, a budding international currency. If the renminbi were to become a
dominant international currency, it would require China to attain a much
higher level of financial development and openness. It is important to note
that our model does not address the possibility of a gradual weakening of the
network effects in FX markets due to, for example, the advancement of trading
technologies, which would allow the co-existence of a few equally dominant
major currencies. |
| Keywords: |
Foreign Exchange, International Currency, Network Effects, Financial Development, Renminbi, Critical Transition |
| JEL: |
F31 F33 G12 O53 |
| Date: |
2014–09 |
| URL: |
http://d.repec.org/n?u=RePEc:hkm:wpaper:242014&r=ifn |