If
time lags matter, news of the dollar's demise as the
world's principal reserve currency is grossly exaggerated.
That prediction has been periodically heard at least
since the early 1970s when the United States brought
the Bretton Woods arrangement to an end by breaking
the link between dollar and gold. As is obvious, whatever
else may be said of the role of the US in the world
system, this expectation of the dollar's displacement
as the currency that is as good as gold has not materialised.
This, however, is not to say that the dollar fulfils
its role adequately or even satisfactorily. Not surprisingly,
with the strength of the US economy once again in question,
the dollar has begun to slide. Between the low of 1.2932
to the dollar it touched on 21 April 2009 and its value
at the end of September 2009 the euro had appreciated
by 13 per cent vis-a-vis the dollar. This (and other
similar tendencies) has triggered predictions of the
demise of the dollar as lead currency. Should and will
a new currency replace the dollar as the paper that
is treated as good as gold?
There is a noteworthy feature of the debate sparked
by the revival of interest in the question of the dollar's
worthiness as a reserve currency. Most participants
in the debate who argue that it is time for the dollar
to go, are not basing their argument on the greater
strength of an alternative currency (like the euro,
the yen or the Chinese RMB) which should take the dollar's
place. Rather, the most popular alternative is the IMF's
Special Drawing Right (SDR) which is more a unit of
account than a currency and whose value is itself linked
to that of a weighted basket of four major currencies.
There are three implications here. First, even when
the weakness of the US and the dollar is accepted, the
case is not that the dollar should be completely displaced,
since even in the basket that constitutes the SDR the
dollar commands an influential role. Second, there is
no other country or currency that is at present seen
as being capable of taking the place of the US and its
dollar at least in the near future. And third, the search
is not for a currency that can be used with confidence
as a medium for international exchange, but for a derivative
asset that investors can hold without fear of a substantial
fall in its value when exchange rates fluctuate, because
its value is defined in terms of and is stable relative
to a basket of currencies.
It should be clear that in the absence of another currency
that can play a similar role in the world economy, rhetoric
alone will not end dollar hegemony. The question, therefore,
is whether the SDR can serve as an actual currency or
focus on the SDR is diverting attention from alternative
‘real' currencies. It must be noted that early expectations
of the displacement of the dollar came with the birth
of the euro in January 1, 1999 and the irrevocable fixing
of the exchange rates between the then member countries
of the European Union. The idea that the euro was an
alternative to the dollar came from the evidence that
after a brief period of stability and then depreciation
of the euro relative to the dollar, from the end of
2000 that currency appreciated from close to $0.8 to
the euro to $1.6 to the euro in April 2008. And then,
after a further period of depreciation to around $1.25
to the euro in November 2008, the euro has been on average
appreciating once again to reach $1.5 in September 2009.
There are two ways in which to view this relative decline
in the dollar's value. The first is to see it as a gradual
depreciation of the dollar as part of an effort to correct
for the loss of export competitiveness of the US. The
second is to see it as a challenge posed to the dollar's
supremacy by the new currency.
The supporting evidence to back the second of these
propositions is difficult to come by. Consider for example
the euro's role in international transactions. By September
2006, 30 per cent of outstanding international securities
were denominated in euros as compared with around 20
per cent in 1999. But this was not because of any significant
decline of the dollar's role in this area, since its
share had fallen from just around one half to 46 per
cent. In foreign exchange markets, the euro's share
had remained stable at around 20 per cent of all transactions,
compared with the dollar's 44 per cent. And, finally,
the euro accounted for a stable 25 per cent of the holding
of foreign exchange reserves by countries that reported
the composition of their foreign exchange reserves.
All in all, therefore, it appears that the euro was
not being displaced by the dollar as the major reserve
currency.
This is not surprising given the fact that the euro
is not the currency of a single national political formation
with the backing of a single powerful state. Though
monetary policy in these countries is harmonised through
the European Central Bank, which sets interest rates
for all, there is considerable fiscal policy independence
(despite the Growth and Stability Pact) of countries
characterised by very different levels of development.
This does not inspire confidence in the ability of the
EU as a formation to be able to influence as desired
the value of the euro. And no single state in this formation
has the military strength or activism to assert power
and stabilise the value of the currency when required.
Put simply, while there are some European nations like
Germany that are economically strong, though less so
than before unification, if we look at the conditions
which helped sustain the dollar's role as the reserve
currency, this united formation of still legally independent
sovereign states falls short of what seems to be the
prerequisites for the euro to displace the dollar as
reserve currency.
The SDR as reserve
Besides the euro the other contender to taking on the
role of the world's reserve currency is the SDR or Special
Drawing Right created by the IMF. The debate over the
SDR as an alternative currency gathered momentum when
in the aftermath of the 2008 global crisis the governor
of the People's Bank of China, Zhou Xiaochuan issued
a call for replacing the dollar with the SDR as reserve
currency. There are, however, many hurdles between this
stated desire and the actual transformation of the SDR
into the world's reserve.
Created in 1969, the SDR was initially seen as a supplemental
reserve which could help meet shortages of the two then
prevailing reserve assets: gold and the dollar. The
IMF issues credits of SDRs to its member nations, which
can be exchanged for freely usable currencies when required.
The value of the SDR was initially set to be equivalent
to an amount in weight of gold (0.888671 grams) that
was then also equivalent to one U.S. dollar. After the
collapse of the Bretton Woods system in 1973, however,
the value of the SDR was reset relative to a weighted
basket of currencies, which today consist of the euro,
Japanese yen, pound sterling, and U.S. dollar, and quoted
in dollars calculated at the existing exchange rates.
The liquidity of the SDR is ensured through voluntary
trading arrangements under which members and one prescribed
holder have volunteered to buy or sell SDRs within limits.
Further, when required the Fund can activate its ''designation
mechanism'', under which members with strong external
positions and reserves of freely usable currencies are
requested to buy SDRs with those currencies from members
facing balance of payments difficulties. This arrangement
helps ensure the liquidity and the reserve asset character
of the SDR. So long as a country's holdings of SDRs
equal its allocation, they are a costless and barren
asset. However, whenever a member's SDR holdings exceeds
its allocation, it earns interest on the excess. On
the other hand, if a country holds fewer SDRs than allocated
to it, it pays interest on the shortfall. The SDR interest
rate is also based on a weighted average of specified
interest rates in the money markets of the SDR basket
currencies.
The volume of SDRs available in the system is the result
of mutually agreed allocations (determined by the need
for supplementary reserves) to members in proportion
to their quotas. Till recently the volume of SDRs available
was small. SDRs have been allocated on four occasions.
The first tanche, to the tune of SDR 9.3 billion, was
issued in annual installments during 1970-72, immediately
after the creation of this asset in 1969. The second,
for SDR 12.1 billion, occurred during 1979-81, after
the second oil shock. The third, for an amount of SDR
161.2 billion, was issued on August 28, 2009. And the
fourth for SDR 21.4 billion took place on September
9, 2009. As a result the total volume of SDRs in circulation
has reached SDR 204.1 billion or about $317 billion.
As can be noted an overwhelming proportion of the allocation
has occurred in the aftermath of the 2008 financial
crisis. But even now the quantum of these special reserves
is well short of volumes demanded by developing countries.
Does the recent substantial increase in the amount of
SDR's allocated herald its emergence as an alternative
to the dollar? There are two roles that the SDR can
play, which favour its acceptance as a reserve. First,
it can help reduce the exposure of countries to the
dollar, the value of which has been declining in recent
months because of the huge current account deficit of
the US, its legacy of indebtedness and the large volume
of dollars it is pumping into the system to finance
its post-crisis stimulus package. Second, since its
value is determined by a weighted basket of four major
currencies, the command over goods and resources that
its holder would have would be stable and even advantageous.
There are, however, five immediate and obvious obstacles
to the SDR serving as the sole or even principal reserve.
First, the $317 billion worth of SDRs currently available
are distributed across countries and is a small proportion
of the global reserve holdings estimated at $6.7 trillion
at the end of 2008 and of the reserve holding of even
a single country like China. Since all countries would
if possible like to hold a part of their reserves in
SDRs, the fraction of this $317 billion that would be
available for trade against actual currencies would
be small, implying that even with recent increases in
allocations the SDR can only be a supplementary reserve.
Second, expansion of the volume of SDRs in circulation
requires agreement among countries that hold at least
85 per cent of IMF quotas. With the US alone having
a 16.77 per cent vote share, as of now it has a veto
on any such decision. Whether it will go along with
the decision to deprive it of the benefits of being
the home of the reserve currency is unclear. And even
if it does, there could be others with a combined vote
share of 15 per cent-plus who may not be willing to
go along.
Third, since SDR issues are linked to quotas at the
IMF and those quotas do not any more reflect the economic
strength of members, the base distribution of SDRs is
not in proportion to the distribution of reserve holdings
across countries. Reaching SDRs to those who would like
to hold them depends on the willingness of now ''weaker''
countries to sell. Fourth, since the value of the SDR
is linked to the value of four actual currencies, the
reason why a country seeking to diversify its reserve
should not hold those four currencies (in proportion
to their weights in the SDR's value) rather than the
SDR itself is unclear. This would also give countries
flexibility in terms of the proportion in which they
hold these four currencies (which is an advantage in
a world of fluctuating exchange rates, since weights
of currencies constituting the SDR are reviewed only
with a considerable lag, currently of five years). Finally,
as of now SDRs can only be exchanged in transactions
between central banks and not in transactions between
the government and the private sector and therefore
in purely private sector transactions. This depletes
its currency-like nature in the real world. It also
reduces the likelihood that a significant number of
economic transactions would be denominated in SDRs.
While this could be corrected, such a correction can
throw up a host of additional problems. But this has
not prevented suggestions from some like of John Lipsky,
the IMF's First Deputy Managing Director, that the SDR
can be used as the foundation to build a new currency
that would be ''be delinked from other currencies and
issued by an international organization with equivalent
authority to a central bank in order to become liquid
enough to be used as a reserve.''
This presumes we have or can think of a single global
state, which as of now is not a possibility. In fact,
to the many difficulties associated with treating the
SDR as a normal currency must be added the fact that,
not being the national currency of any country, the
confidence in its ability to serve as a viable reserve
currency for the world and in the stability of its cannot
be generated by either the economic or the military
strength of a state that governs that nation. Put all
of these together and while the SDR may be good as a
supplementary reserve that aids diversification of the
composition of reserves of individual countries, it
as yet falls short of the requirements that a true reserve
currency must meet.
If despite this the SDR is the focus of attention in
the search for an alternative to the dollar, that can
only be because there is as yet no national currency
that can displace the dollar. While the dollar lacks
the legitimacy to serve as the world's reserve, it dominates
because the time for its substitute is yet to come.
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