Size of Major Currency Zones and Their Determinants

Author Name ITO Hiroyuki (Visiting Fellow, RIETI) / KAWAI Masahiro (University of Tokyo)
Creation Date/NO. May 2024 24-E-059
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The US dollar has long been the most dominant international currency used for international trade, investment, financial settlements, foreign exchange market trading, foreign reserve holding, and exchange rate anchoring. This paper develops a new method to estimate the size of major currency zones, i.e., those for the US dollar (USD), euro (EUR), Japanese yen (JPY), British pound sterling (GBP), and Chinese yuan (RMB), and identify their determinants. The paper employs the simple Frankel-Wei (1994) and Kawai-Pontines (2016) estimation models to identify major anchor currencies and the degree of exchange rate stability (ERS) for each economy. The paper uses the estimated currency weights to construct the size of major currency zones globally and regionally over time and econometrically identify the determinants of these currency weights. In this analysis, the paper considers the degree of ERS, defined by the Root Mean Squared Error (RMSE) of the estimation model, which allows for the possibility that a part of each economy or region or part of the world is under a floating exchange rate regime. This method avoids overestimating the size of a particular major currency zone such as the RMB zone, when economies do not rigidly stabilize their currencies to such a major currency, and thus presents a better picture that is more consistent with the current state of the international monetary system.

The paper yields several interesting results. First, the global economic share of the USD zone, still the largest in the world, has declined over time due to the emergence of the EUR zone and the recent rapid rise of the RMB zone. The size of the EUR zone is larger than that of the RMB zone if the degree of ERS is taken into account. Additionally, the share of the world economy under floating exchange rates has expanded in size over time. Second, the USD zone is the largest in the Middle East & Central Asia, followed by emerging & developing Asian and Sub-Saharan African economies, while the EUR zone is dominant in emerging & developing economies in Europe. The USD zone share has been declining rapidly in Latin America & the Caribbean. The size of the RMB zone has been increasing in most regions. Third, the USD weight is positively affected by the share of trade with the United States and the US dollar shares in export invoicing and cross-border bank liabilities. Similarly, the EUR weight is positively affected by economies’ shares of trade with the Euro Area as well as the euro shares in export invoicing, inward FDI stock, and cross-border bank liabilities. The RMB weight is not significantly affected by economies’ shares of trade with, or inward FDI stock or borrowing from China. The paper provides some policy implications.