Towards a new reserve currency system?
On 7 September 2009, a report from the United Nations conference on Trade and Development (UNCTAD) blamed the "dominance of the dollar" for playing an important role in the recent build-up of global imbalances, particularly in trade and the current account, which helped lead to today's global economic crisis.
Is UNCTAD right and if so, what can be done to reduce the dollar's global dominance? The answers lie in the question of reserve currencies, how these evolve and why they exist in the first place.
Governments and institutions build up reserves for various reasons. They use reserves to help them trade and operate in global product and financial markets, or they may use them as anchors to protect their economies against turbulence on financial markets.
The US dollar has been the dominant reserve currency for several decades, accounting for about two-thirds of global reserves and 88% of daily foreign exchange trades. And though the euro now accounts for more than a quarter of reserves, the international pricing currency for oil, gold and other raw materials still tends to be in dollars.
Ever since the Second World War, which saw sterling dethroned, the United States has enjoyed the privileges that its reserve currency status conveys to a host country, from purchasing commodities at slightly lower rates than other countries by saving on currency exchange costs to borrowing at cheaper rates. At the same time, the US dollar has conveyed major benefits to the world economy, both officially as a reserve and anchor currency, and in trade and investment for private businesses.
Global trade is facilitated by the use of just one currency, while liquid debt markets allow central banks to intervene in foreign exchange markets to smooth currency fluctuations. Savers can escape inflationary governments by depositing in dollars. Commodities can be priced homogenously wherever traded. In short, the US dollar provides network advantages to firms and countries that use it.
Meanwhile, by enlarging the scope of issuers and investors, the dollar has lowered borrowing costs and facilitated balance of payments financing--the US may have outspent its national income by an accumulated 47.3% of GDP in current account deficits since 2000, but as the world (mostly Asia and the Gulf region) reinvested the corresponding surpluses mostly in US treasury bills, US treasury rates were depressed by as many as 130 basis points up to 2005.
The additional demand for dollars has generated "seigniorage" revenues: in 2008 the US Fed made a net interest income of $43 billion from issuing the currency, which as The Economist newspaper once put it, effectively makes US dollars in global circulation an interest-free loan by the public to the nation's central bank.
For many people, it is hard to imagine the global currency system any other way. They liken the dollar to English, a sort of natural language of the global economy. The trouble is, while the US dollar's dominance was all very well when OECD countries led the world economy, times have changed. New powerful markets have emerged, such as China, India and Brazil, stimulating global growth, and with it, demand for reserve currencies.
A rapidly rising world economy creates problems for a single-currency reserve system. These are clearly explained by the Triffin Dilemma, named after a Belgian economist, Robert Triffin, who famously warned Congress in 1960 that as the main supplier of the world's reserve currency the US had no choice but to run persistent current account deficits. Triffin's logic was straightforward. As the global economy expanded, demand for reserve assets-dollars-from economies around the world would increase. These could only be supplied if America ran a current account deficit and issued dollar-denominated obligations to fund it. Indeed, if the US stopped running balance of payments deficits and supplying reserves, liquidity would dry up and pull the global economy into a downward spiral.
How did these imbalances fuel the crisis? US deficits and saving surpluses in emerging East Asian economies, especially China, and oil-exporting countries have been growing since the early 2000s. Emerging market savings helped to bring down world interest rates, leading investors to search for higher-yielding but relatively low-risk assets, including real estate. Low interest rates in turn contributed to the financial excesses that finally culminated in the crisis.
UNCTAD has not been alone in criticising the dollar's dominance, which has been behind other unsustainable distortions, too. For years, poorer developing countries have complained that the current system forces them to transfer resources-their own currencies-back to wealthier countries in what has become a form of "reverse aid". To be sure, some emerging markets have accumulated dollars not just to pay for trade or to insure themselves against panic attacks by investors, but to bolster their export competitiveness too.
Clearly, a stronger and fairer post-crisis global economy would be helped by a less distorting reserve currency system. In fact, emerging market governments are particularly keen on replacing the US dollar as the international reserve currency because as net creditors to the rest of the world and with substantial holdings of US government debt, they fear big valuation losses on these holdings. The question is: which system to adopt?
The approach attracting most attention is a new global reserve system based on an extended version of the International Monetary Fund's Special Drawing Rights (SDR), an international reserve asset set up in 1969 to supplement member countries' official reserves (see Williamson in the references). Building on the SDR, the main global reserve currency would be represented by an extended basket of significant currencies and commodities. The UN-appointed Stiglitz Commission on reforming the international monetary and financial system has suggested a gradual move from the US dollar to the SDR. Moreover, following the G20 Summit in London earlier in the year, the IMF plans to distribute to its members $250 billion in SDRs. But as this will increase the share of SDRs in total international reserves to no more than 4%, some extra steps will be needed.
To make the SDR the principal reserve asset via allocation, close to $3 trillion in SDRs would have to be created. One expert, Onno Wijnholds, has suggested a so-called SDR substitution account. This would permit countries who feel their official dollar holdings are uncomfortably large to convert dollars into SDRs. Because conversion would occur outside the market, it would not put downward pressure on the dollar. This suggestion, however, carries exchange risks because the SDR substitution account is likely to hold mostly dollars.
Another step to enhance the SDR would be to make its currency composition more neutral to global cycles and more representative of the shift in economic power witnessed over the last two decades. This implies an increase in the commodity content and the inclusion of major emerging-market currencies. Today, the SDR is constituted as a basket of four currencies: the dollar, the euro, sterling and the yen. The convertible Australian, Canadian, Chilean, Norwegian and South African currencies could be included to give the SDR a link to the raw material cycles, as these currencies reflect price developments of copper, iron ore, gold, and oil. Major emerging-country currencies would be included in the SDR mix as soon as they reach a predefined level of convertibility.
But even with such changes to the SDR, the key question is whether major economies will really buy into it. Some doubt it, saying that if the current dollar dominated system is the currency equivalent of the English language, then the alternative SDR basket of currencies would be like Esperanto: logical and clear to those that use it, but not easy for most people to adopt. If demand for the SDR approach proved insufficient, would that mean the dollar-dominated system was here to stay?
Not necessarily. As global financial expert Avinash Persaud put it in a 2004 lecture, currency empires rise and fall. International currencies in the past have included the Chinese Liang and Greek drachma, the Roman denari, the Byzantine solidus, the ducato of the Renaissance, the Dutch guilder and sterling.
In 1872, the UK was overtaken by the US as the world's largest economy, and in 1915 as the world's largest exporter. As the US dollar emerged as a convertible net creditor currency, its use flourished, dethroning the pound by 1945.
Today, the US is in net-debtor position similar to the Britain of the 1940s. China is the world's largest creditor, and is on the way to becoming the world largest exporter. Its economy in purchasing parity terms is also poised eventually to outstrip that of the US. If history is a guide to the future, then the Chinese renminbi could replace the US dollar as a reserve currency from about 2050.
The renminbi seems far from ready to make that leap. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, deepen domestic financial reforms and make its bond markets more liquid. However, a renminbi-based system would still be a single-currency system, with all the shortcomings already articulated by Triffin half a century ago.
Change on international financial markets is under way. China has already set up currency swaps with several countries, including Argentina, Belarus and Indonesia, and by letting institutions in Hong Kong, China issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency. Brazil and China are now working towards using their own currencies in trade transactions rather than the US dollar. Moreover, the IMF executive board has approved a framework to issue SDR-based bonds, while China has signaled its intention to invest up to $50 billion, and Brazil and Russia up to $10 billion each.
To avoid crisis-prone current-account imbalances and more "reverse" aid from poor to advanced countries, serious attention should be given to a multiple currency system, such as the SDR approach. For the Stiglitz commission, the new global reserve system is feasible and non-inflationary, and would contribute to global stability, economic strength, and global equity. With today's crisis and still fragile outlook, this is further good reason to prepare for a new global currency reserve system sooner rather than later.
Kenen, P. (1983), "The Role of the Dollar as an International Reserve Currency", Occasional Papers No13, Group of Thirty.
Persaud, A. (2004), "Why Currency Empires Fall", Grasham Lectures.
Maddison, A. (2007) Chinese Economic Performance in the Long Run, OECD Development Centre
Triffin, R. (1961), Gold and the Dollar Crisis, Yale University Press.
Wijnholds, O. (2009), The Dollar's Last Days?, http://www.project-syndicate.org/
The Economist (2009), "The Hedge Fund of Foggy Bottom", 30 April 2009.
UNCTAD (2009), Trade and Development Report, September.
Williamson, J. (2009), "The case for regular SDR issues: Fixing inconsistencies in balance-of-payments targets", Voxeu, 2 October.
©OECD Observer No 274, October 2009
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