Abhyudaya-2012Abhyutthan

By

Ratan Kumar

“Kudos”

IMI, New Delhi

IS IT THE RIGHT TIME NOW FOR A NEW RESERVE CURRENCY?

As emphasized by economist Avinash Persaud: Reserve currencies come and go. Prior to 1944

World reference currency was the Pound Sterling. However after World War II, Bretton Woods

System established US Dollar as international currency. US government guaranteed other central

banks that they could sell their US dollar reserves at a fixed rate for gold. European countries and

Japan saw this as an opportunity to boost their sale by deliberately devaluing their currencies

against the dollar. United States started facing Triffin dilemma. The amount of US dollar in

circulation began to exceed the amount of gold backing them up. Thus the Nixon shock was

introduced and dollar was delinked from gold.

In the wake of the financial crisis 2007-08, the governor of the People's Bank of China explicitly

named the Triffin Dilemma as the root cause of the economic disorder. In current scenario the

correct question is not that whether it is the right time to introduce new reserve currency. Rather

the question should be: Is there any suitable option available to replace “Dollar” as reserve

currency.

As a prerequisite to replace dollar, substituting country should offer enough credibility to back

its currency as globally acceptable reserve currency. Table below shows currency composition of

official foreign exchange reserves:-

Currency

2011,QuarterII

I

US dollar 61.70%

Euro 25.70%

Pound sterling 3.90%

Japanese yen 3.80%

Others 4.90%

Total 100.00%

As can be seen Euro is 2nd highest held foreign reserve, forming not even half of U.S. Dollar

reserves. Also with the current prevailing scenario in European Union with majority of big

nations on the verge of defaulting, Euro is not in a position to replace Dollar. After Euro all

others are mere show up. Japan is shaken abreast with tsunami last year and is still in the process

of rehabilitation. Thus no single nation currently has enough credibility to replace dollar.

China is slowing emerging as global economic power. China and Japan entered into an

agreement and have announced plans to allow a "direct exchange" of their

currencies to strengthen financial ties and promote Yuan-Yen trade as a small, but notable,

step toward a new global economy. The agreement will let a Japanese-backed institution sell

Yuan bonds in China, helping to open China’s capital market. In return, Japan will convert some

of its foreign-exchange reserves into Chinese bonds. However, the accord still lacks a timetable

for implementation. China is well versed with the fact that loosening up its currency control will

lead it to “Trilema”. Thus, it still maintains capital control on the conversion of its currency. The

currency would not be attractive to central banks for holding unless China developed a strong

open bond market.

ARE SDRs A GOOD OPTION?

The United Nations report was issued to abandon U.S. dollar as single major reserve currency

and suggested to emission of international liquidity to create a more stable global financial

system. However this report came on the backdrop of global financial crisis (2010) that was

prevailing at that time. Credibility of US dollar was kept at stake and alternative solution was to

be found. U.S. Dollar was depreciating and SDRs appeared to be a lucrative option as it

promised to provide a stable global financial system.

However SDR is of importance only when U.S. dollar is weak or otherwise unsuitable to be a

foreign exchange reserve asset. For instance prior to 1970 there was shortfall of US Dollar due to

conservative monetary policy.  If the US had continued down this path, the dollar would have

become a less attractive foreign exchange reserve asset. U.S. reversed its former policy and

provided sufficient liquidity.  In the process a potential role for the SDR was removed.

On the issue of can SDR be established as new global reserve currency, Paavo Vayrynen,

Finland's Foreign Trade and Development Minister said: "It is based on the markets; I believe

that the economic players in the market are going to have the decisive influence on that issue."

SDR has its own benefits and shortcoming. Besides providing global financial stability, it can be

used as cheap source of credit. However, currently SDRs are allocated only to member nations of

IMF. Other countries need to buy it from member nation or from IMF. Also in order to use

SDRs, a country must find a willing party to buy them. Exchanging SDRs can take "several

days". This removes the flexibility that Dollar provides on real time basis.

Secondly, the way the value of SDR is determined is dubious in nature. The currency basket is

re-evaluated every five years. This can be depressing for countries that will be holding their

reserve in SDR as they might need to revalue their reserve every five years.

Lastly, the current composition of SDR consists of:

USD EUR JPY GBP

41.90% 37.40% 9.40% 11.30%

As can be seen, US dollar and Euro form 79.3% of the basket. Again, the question is: can SDR

become a stable reserve. Under the current scenario if European Union defaults or U.S.

undergoes some crisis (sudden), there is huge risk still associated with SDR being stable global

reserve.

Thus can SDR replace US dollar? I would say no. This is further boosted by the fact that during

the past few months dollar has actually appreciated as investor are finding US dollar as substitute

of Euro in the current scenario.

Conclusion:

After the great financial crisis (2007-08), voices have been raised to issues concerning U.S.

Dollar as global reserve currency. There is urgent need to make a transition to a more stable

global currency. However no single potential substitute exists currently. Chinese Yuan is one of

the potential contestants to replace U.S. Dollar. However it is not going to take place in near

future and will take considerable amount of time. SDRs have its own shortcoming and cannot be

considered as a suitable substitute.

References:

http://www.reuters.com/article/2010/06/29/us-dollar-reserves-un-idUSTRE65S40620100629

http://en.wikipedia.org/wiki/Triffin_dilemma

http://en.wikipedia.org/wiki/Reserve_currency

http://en.wikipedia.org/wiki/Special_drawing_rights

http://www.bloomberg.com/news/2011-12-29/china-japan-currency-deal-points-way-to-a-new-world-

monetary-order-view.html