The future of fiat currencies

Key takeaways

• Structurally higher inflation, if not tackled by credible monetary policies, could lead to a widespread loss of faith in fiat currencies.
• We are likely to see further erosion in the US dollar’s status as the world’s reserve currency. However, a lack of credible alternatives suggests the US dollar will remain the dominant global currency.
• Cryptocurrencies are unlikely to replace fiat currencies, but will pave the way for the emergence of central bank digital currencies (CBDCs).
  

The status quo may not last forever

The current floating exchange rate system is a direct consequence of US President Richard Nixon’s decision to “temporarily” end the gold standard in August 1971. More than 50 years later, it should not be taken for granted that fiat currencies will last forever. While it is assumed that paper money has value, even if it is no longer backed by precious metals, a lasting period of high inflation could dent that assumption.

While inflation could persist, a return to fixed exchange rates (which are known to keep inflation low) remains very unlikely in the next decade, in our view. But monetary authorities may be increasingly confronted to the unenviable choice between curbing inflation or managing the huge debt burdens. Should the authorities deem managing the pile of debt more important than tackling high inflation, there could eventually be a widespread loss of faith in currencies, which could result in a change in the exchange-rate regime.

The demise of the dollar?

For years, there have been questions about the dominance of the US dollar as the world’s reserve currency, with recent developments likely to fuel the debate further.

One of the reasons for the dollar’s dominance is its broad usage in global trade. However, the growing importance of China in the global economy is likely to lead to an increasing number of trades being conducted in renminbi, especially outside the Americas and Europe. Still, a significant obstacle for the renminbi is that capital flows entering and leaving China face significant restrictions. That said, China’s desire to reduce its reliance on the US dollar should see it increase its efforts to internationalise the renminbi, by promoting the currency’s broad usage and improving its convertibility.

The recent increase in US sanctions on other nations, most notably Russia and Iran, could also reduce the US dollar’s appeal as a reliable reserve currency. In a similar vein, increasing economic tensions between the US and other countries and the rise in populism around the world could lead to fragmentation of the global economy into regional trading blocs. This would probably also lead to a reduced international role for the US dollar and weigh on its value.

The impact of cryptocurrencies

The emergence of cryptocurrencies is also likely to have an impact on fiat currencies. We do not see cryptocurrencies as currencies in the traditional sense as they do not fulfil the three main functions of money (a means of payment, a unit of account and a store of value). As such, we do not expect them to replace fiat currencies.

But they could herald the rise of digital versions of existing fiat currencies called central bank digital currencies (CBDCs). In theory, CBDCs could result in commercial bank deposits becoming completely obsolete. However, we doubt that central banks are ready to take on the consumer-facing activities that commercial banks perform on top of their primary task of safeguarding price stability.

Ultimately, central banks will have to balance the chance of improving payment systems through CBDCs and the threat they pose to the stability of the existing commercial banking system. One solution would be for central banks to open CBDCs to retail investors, but only for a limited amount—for example, the equivalent of the maximum amount of notes and coins they might normally hold. CBDCs could thus replace cash, but not endanger the banking system.