Privilege Lost? The Rise and Fall of a Dominant Global Currency

How does a country obtain the status of a safe haven with a dominant global currency? This paper argues that size matters: as a country becomes larger, the underlying shock process of the economy becomes less variable. Shocks that can drive a government to default become less likely, implying lower default probability, lower interest rates and higher debt-to-GDP. Conversely, if the dominant currency country grows less than the rest of the world, its status as a safe haven erodes and interest rate differentials should decline. This could explain the recent long-term evidence of shrinking US differentials on its cross-border bond portfolios