The optimists that have long assumed that the dollar will continue to reign supreme due to lack of alternatives have just have their sanguine views challenged as China threw down the gauntlet on coming up with an alternative, non-country-specific, reserve currency.
The US in fact had this option at the time of Bretton Woods and opted instead for a dollar fixed rate standard with the dollar backed by gold. You know how that movie ended. Being the reserve currency requires that the sponsoring nation run current account deficits to get enough currency in circulation for it to serve as a trade vehicle. That’s why China and the EU are not keen about the idea of someday having the reserve currency. Both are wedded to being exporters, or at least not being importers.
But the Bretton Woods system came apart due to gaping fiscal deficits in the 1960s: substantial military commitments, made worse by Vietnam, a big uptick in social spending, plus the space program. It was evident that we had issued more dollars than we had gold to back it up. So Nixon ended convertibility and floated the dollar, a defacto devaluation. Other countries, which faced a big drop in exports engaged in compensatory government spending. That plus the oil shock, and the result was inflation in most advanced economies in the 1970s.
Many had assumed that the China talk on moving to a special drawing rights regime, or a similar approach was just that, talk to serve as a bargaining chip in negotiations. Surely the Chinese would not jeopardize the value of their dollar holdings!
Well, that simply isn’t a rational view of things. The proper way is to construct a decision tree and look at the attractiveness of various moves going forward. The FX reserves are a sunk cost. Continuing to support the greenback long term is a losing strategy, It just digs the Chinese into a bigger hole. The Chinese want their cake of a continued trade surplus without the attendant costs of supporting the dollar, and more important, continued US hegemony (yes I hate that word, but it fits here), Even if they face FX losses in an SDR regime if they insist on continued large trade surpluses, they’d have much more influence over IMF than they do over the US policies.
The practical impediments to an SDR regime is the lack of deep trading markets for investments, But the transition from sterling as reserve currency to the dollar was a protracted, messy, and disorganized affair. The Chinese prefer order and particularly want a fixed rate (or at least narrow float as they have now) regime. They see floating rates as destabilizing and as bad for trade. They increase uncertainty which deters investment.
Again, this may simply be more insistent posturing. The Chinese tend to be frontal. But if nothing else, the Chinese are signaling that they are not happy with the status quo and expect change. The US simply has not been with that program. And we don’t seem to have other ready ways to placate the Chinese. We’ve nixed deals we considered politically sensitive, to their outrage, and will continue to guard our advanced military technology. It isn’t clear what China wants in the way of gives and gets here. Again, this may be playing to a domestic audience, but negotiators can get locked into what was initially mere playing to the gallery.
This salvo coming now is also going to be perceived to constrain US fiscal deficits if we need a second stimulus package (likely). I tend to buy the analysis that the spending shortfall is large enough that this isn’t the inflationary monster that it is perceived to be. However, the fly in the ointment is first, that we have already thrown so much firepower into the sinkhole of the financial system with perilous little effect (restructuring debt, shorting up certain borrowers directly, reining in the banks, and smaller capital infusions would have been a much better course of action). In particular, the Fed efforts to create a zillion facilities to shore up TBTF markets that have become important channels for credit extension muddies the picture considerably. Monetary easing without fixing the financial system was unproductive in Japan. We would have been better off with less desperate monetary measures (dropping Fed funds to ZIRP land) and more fiscal stimulus, but that horse is out the gate and in the next county (before credit vigilantes protest, the object in my policy fantasy would NOT have been to offset teh demand fall, I see deleveraging as necessary, but to keep it from being violent and disruptive. We have achieved the latter end, or at least it looks that way now, but at an unduly high cost and with a difficult exit).
China’s central bank renewed its call for a new global currency and said the International Monetary Fund should manage more of members’ foreign-exchange reserves, triggering a decline in the U.S. dollar.
“To avoid the inherent deficiencies of using sovereign currencies for reserves, there’s a need to create an international reserve currency that’s delinked from sovereign nations,” the People’s Bank of China said in its 2008 review released today. The IMF should expand the functions of its unit of account, Special Drawing Rights, the report said.
The restatement of Governor Zhou Xiaochuan’s proposal in March added to speculation that China will diversify its currency reserves, the world’s largest at more than $1.95 trillion. Chinese investors, the biggest foreign owners of U.S. Treasuries, reduced holdings in April after Premier Wen Jiabao expressed concern about the value of dollar assets….
“It’s extremely unlikely the dollar will be replaced as the reserve currency,” said Glenn Maguire, chief Asia-Pacific economist at Societe Generale SA in Hong Kong. “A currency needs to be internationalized and that requires a fully convertible capital account, which China doesn’t have. The second is that it needs to be adopted.”…
On June 13, Russian Finance Minister Alexei Kudrin reassured investors of the country’s confidence in the greenback by saying it was “still early to speak of other reserve currencies.” Brazilian Finance Minister Guido Mantega said on June 10 the government’s decision to switch some reserves into IMF bonds wasn’t aimed at weakening the dollar.
Federal Reserve holdings of Treasuries on behalf of central banks and institutions rose by $68.8 billion, or 3.3 percent, in May, the third most on record, Bloomberg data show.
China has started to pare its holdings, trimming them by $4.4 billion to $763.5 billion in April, the first monthly reduction since February 2008, according to U.S. Treasury Department data. Figures for May have yet to be released.
“There may be signs here of tensions mounting between the PBOC’s economic concerns over China’s holdings of dollars and the Chinese government’s diplomatic reasons for doing so,” Stephen Gallo, head of market analysis at Schneider Foreign Exchange in London, wrote in an e-mail…
IMF First Deputy Managing Director John Lipsky said on June 6 it’s possible to take the “revolutionary” step of making SDRs a reserve currency over time.
SDRs were created by the IMF in 1969 to support the Bretton Woods exchange-rate system that collapsed in 1971. They act as a unit of account rather than a currency. The cash is disbursed in proportion to the money each member nation pays into the fund.
The value of SDRs are based on a basket of currencies, shielding them from swings in a single currency. One SDR is valued at $1.54. China is proposing the basket be broadened. The current weighting is: 44 percent for the dollar, 34 percent for the euro and 11 percent each for the yen and the pound. It doesn’t include the yuan.
The dollar’s dominance of global finance buffeted developing nations last year. Investors abandoned emerging markets after the September bankruptcy of Lehman Brothers Holdings Inc. eliminated demand for all but the safest, most easily traded assets, such as Treasuries and the dollar. A shortage of the U.S. currency forced central banks to pump reserves into their economies.
“The excessive reliance on the credit of several sovereign currencies have added to the extent of risks and crises,” the central bank report said. “A currency with stable value in the long term is required.”
Originally published at Naked Capitalism and reproduced here with the author’s permission.