The future of the dollar and the euro as the global reserve and transaction currencies

Christine Lagarde, President of the European Central Bank (ECB), analyses the consequences for the economy and central banks of the current environment, marked by an increase in geopolitical risks, leading to a fragmentation of the global economy, with a consequent rise in inflation, lower economic activity, a fall in international trade and to a potential threat to the hegemony of dollar and the euro currencies.

Main highlights of the speech:

The consequences from the global economy fragmentation could have far-reaching implications across many domains of policymaking. For central banks mainly in two areas:

• Instability and higher inflation derived from supply shocks and protectionist policies: 
  
  
  • During favorable geopolitical environment after cold war global supply became more elastic to changes in domestic demand, leading to a long period of relatively low and stable inflation. Central banks could focus on stabilizing inflation without having to pay too much attention to supply-side disruptions. From now on we could face the risk of repeated supply shocks: in Europe the energy crisis is one example but for example the United States is completely dependent on imports for at least 14 critical minerals. According to the ECB, if global value chains fragment along geopolitical lines, the increase in the global level of consumer prices could range between around 5% in the short run and roughly 1% in the long run.
    
    
  • The Inflation Reduction Act in the United States and the strategic autonomy agenda in Europe aim to increase supply security but they also accelerate fragmentation. According to ECB, the share of global firms planning to regionalize their supply chain almost doubled – to around 45% – compared with a year earlier.
    
    
• Current geopolitical fragmentation could threat the hegemony and leading position of the US dollar and the euro as the global reserve and transaction currencies. As new trade patterns may also lead to new alliances according to the ECB, that alliances can increase the share of a currency in the partner’s reserve holdings by roughly 30%. All this could create an opportunity for certain countries seeking to reduce their dependency on Western payment systems and currency frameworks.

According to Christine Lagarde the single most important factor influencing international currency usage remains strength of economic fundamentals, which also applies to the US and European currencies. Regarding Europe, according to her, is critical to complete the European capital markets union to determine whether the euro remains among the leading global currencies or others take its place.