June 17, 2009
Chinese authorities recently proposed the end to the dollar’s time as a reserve currency. While this might indeed come true, observers should notice that it’s neither SDRs nor the yuan, it is the euro to gain importance for now and the coming decade.
The US dollar has served as the world’s major reserve currency ever since it took over that role from the pound sterling in the inter-war period almost a century ago. Never before in history has the accumulation of foreign exchange reserve holdings remotely been as strong as during the current decade, with them more than tripling to 6.5 trillion US dollar equivalents. Two thirds of these reserves are held in US dollars. And most of these US dollar holdings are found in Asian countries. These countries have learned their particular lesson from the Asian turmoil in 1997 and 1998, when low levels of foreign exchange reserves meant that these countries could not defend their currency pegs. China with its total of USD 2 trillion and Japan with its USD 1 trillion stand out for their holdings in particular. Hard on their heels come the group of energy-supplying countries. Statistics are, however, not representative for the Middle East countries. In quite a few of the reserve-rich countries, the US dollar additionally plays a role as peg for the currency.
In many countries the peg to the dollar caused inflation to accelerate substantially in 2007/2008, the final phase of the most recent economic boom. Inflation advanced well above the levels targeted in mature industrial countries as well as in developing and emerging economies. Owing to the higher weight of energy and food in the consumer basket inflation started to run in the double digits in some developing countries and thus became a force of social destabilisation. This invited second thoughts on the value of the dollar peg. As a result, China recalibrated its FX policy and instituted a staged and moderate policy of yuan appreciation. Oil-producing countries in the Persian Gulf resolutely adhered to their US dollar policy, thus keeping inflation high and causing the real estate bubble to gain gigantic dimensions.
The unwelcome side effects of the dollar’s role as a reserve currency have now led to debate in China’s elite (see article by Andreas Landwehr on page 6 in this issue). Considerations have been floated to give Special Drawing Rights (SDRs) – a virtual basket of world currencies with fixed weights supervised by the International Monetary Fund – a bigger role in international financial dealings, including use as a reserve currency. Are SDRs a way out of the dependency of some emerging countries on the US? What would such a move imply for the US dollar? Or is such debate just the start of a more fundamental reform of the world currency order in the direction of giving Asian nations – that gain in economic weight – an equivalent weight in the FX markets?
These Chinese deliberations are quite understandable. First, any change in the currency order has massive implications for the valuation of large portfolios of FX holdings – especially in Asia. Second, exchange rate shifts would dramatically influence the price competitiveness of countries that are as internationally integrated as China. However, it is obvious at the same time that the choice of a reserve currency is a matter of immense technical preconditions and, ultimately, of international trust. Any reserve currency has to provide deep liquidity and low transaction costs to achieve transparency and predictability. It must serve as a reliable unit of account, an efficient transaction medium and a stable store of value. Hardly ever is the “infant industry” argument more valid than it is in discussing the role of a reserve currency. This suggests that it will be tough going for any technically complicated instrument like SDRs in superseding the dollar. And as for the case of an Asian currency taking a bigger role as a reserve currency, the time is not ripe. The yuan is not yet (capital market-) convertible and therefore not appropriate for international use. In addition, Beijing’s intention to keep capital controls in place – so it can continue to govern the country’s exchange rate – will constrain deeper international use of the Chinese currency.
Thus, neither SDRs nor the yuan are going to be the solution for the world currency order for now. Against this background, the Chinese initiative is rather to be seen as a demonstration of political aspirations rather than a practical suggestion for the currency order for the next several years. But what can be done if the worries concerning the huge FX dollar holdings persist? For the time being, the only suitable alternative considering all the above-mentioned characteristics of a reserve currency is the euro. So if diversification is considered to be an option at present, it should lead out of the US dollar and into the euro. While this consequence sounds logical, the exchange rate implications for the euro would cause new difficulties for Europe rather than for China. A further appreciation of an already overvalued euro in a period of dramatic recession in Europe would certainly not be greeted with enthusiasm in Berlin or Paris. The ECB would have to push its interest rates down even further.
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