China’s latest thought experiment…

It is easy to take China’s recent call for the establishment of a new global reserve currency as a joke.

I mean, with all due respect Governor (Zhou), there is a difference between “reserve reserves”—i.e. the funds central banks should keep for contingencies; and excess reserves, which is the stuff they end up with because of their governments’ active policy decisions.

Clearly, China’s concerns are about the latter: It has massive (excess) dollar holdings, as a result of an active government decision, and it now fears that their purchasing power might be eroded due to inflation-prone policies by the U.S. government.

That’s unfortunate, but actually not a legitimate motivation for a discussion on a new (reserve) reserve currency. A more fitting motivation would be a case where existing alternatives fail to play the role well; and/or where a new currency would help fill any gaps in the current international monetary framework. But neither is the case and here is why…

1) Existing alternatives are really not that bad. First, a reserve currency has to be fully convertible, highly liquid, relatively stable and should be backed by deep and sophisticated financial markets. This is to ensure that reserves bear minimum liquidity, credit and market risk so that they can be made available whenever they are needed most.

In addition, reserve currency/ies tend to be widely used in international trade and financial transactions. This is because a central bank would be expected to broadly align the currency composition of reserves with that of a country’s external obligations, such as imports of goods and services, gross foreign debt obligations coming due, or demand from residents wishing to obtain foreign currency, etc. The currencies that dominate these types of transactions would therefore be expected to dominate in central banks’ reserve pools.

At this moment in time, two currencies fit the bill pretty well: the US dollar and the euro. Apart from being liquid, stable and backed by sophisticated financial markets, the two currencies dominated global transactions by far—with the US dollar accounting for 86% of total reported foreign exchange transactions in 2007 and the euro second at 37% (see BIS data),

2) Return, while desirable, is only a subordinate objective of (reserve) reserves. As I already suggested, the primary focus of reserve management is to minimize liquidity, credit and market risks. (This is not the case for excess reserves by the way). And what this means in turn is that a currency’s qualification for reserve currency does not hinge upon its yield but on all that other stuff.

Some have argued that the dollar’s recent volatility may undermine its usefulness as reserve currency by unduly exposing central banks to such volatility. But this is a gross exaggeration.

First of all, even during the height of the crisis, the dollar’s volatility was comparable to that of the sterling and the euro and lower than that of other advanced economy peers. Second, to the extent that a country’s external obligations remain largely denominated in US dollars, the dollar’s volatility does no undermine the ability to cover $-denominated obligations.

3) A new currency a la “Special Drawing Right” (SDR) would face serious challenges to its credibility and governance structure. In its strictest interpretation, China’s proposal would have the IMF as the international “supervisor” of countries’ macroeconomic policies and manager of global liquidity—a global central bank in effect. But barring an unrealistic surrendering of economic-policy sovereignty, that China itself would resist, the Fund would lack the enforcement authority to bestow the new currency with the due credibility.

One only has to remember the Fund’s multilateral consultation (MC) with the US, the eurozone, Japan, China and Saudi Arabia on global imbalances. As crucial as the topic was (we are now living through the consequences), the only outcome was an IMF staff report and participants noting “that the MC had been a useful initiative, which had contributed to an improved understanding of the issues and of each other’s positions”. Put differently, “participants noted that the MC had been a useful initiative, then took the staff report and flushed it down the toilet”.

A less strict interpretation of China’s proposal would have members surrender part of their reserves to the Fund in exchange for SDRs, effectively making the Fund a global vault. The benefit here would be simply one of diversification—the Fund would have no enforcement authority in the management of global liquidity beyond its current one.

But how would that help China in its current problem? If everyone expects the dollar to tank, reserve managers would only be willing to change their dollars for SDRs, not their euros. This would drive the dollar weaker in the same way it would if China went and sold dollars for euros outright in the FX market.

Importantly, it’s unclear whether the diversification benefit would be enough to make reserve managers willing to hold SDRs instead of dollars (or euros), unless the SDR takes a prominent role as unit of account or medium of exchange in global trade and financial transactions.

4) The use of an SDR in international trade and finance would be painfully slow. Geographical, historic and cultural ties create inertia in the currency/ies chosen as units of account in international trade and finance.

The euro is a case in point: It has yet to take off as the currency of choice for financial transactions at the global level. This limits its usefulness as a reserve currency for countries where private agents (or even governments) continue to prefer trading or raising finance in dollars—e.g. in Asia or Latin America.

5) And what would an SDR-denominated reserve asset be like? Conceivably, there would be a set of interest-bearing securities with different maturities backed by the underlying asset pool surrendered by the/(some?) IMF members. But these underlying assets are likely to have different risk characteristics, legal provisions, etc, making the asset pool a nightmare to “securitize”. There could also be “free-rider” problems—e.g. as some countries would be tempted to free-ride on the sounder policies the others.

Ultimately, barring the fully-fledged adoption of the SDR as the global currency, issued and managed by a credible global central bank, an SDR fund would not be an improvement to the status quo.

Still, this doesn’t mean that reserve diversification is not desirable—on the contrary. To this end, rather than calling for a distant utopia, China would serve the world best by deepening further its financial markets, increasing the robustness and sophistication of its financial sector, making its currency fully convertible for capital account purposes and, thus, offer a real alternative to the dollar and the euro as a global reserve currency.

I look forward to that!

Originally published at the Models & Agents blog and reproduced here with the author’s permission.