No Alternative Available For Now To Replace USD As Reserve Currency

Special Drawing Rights have captured the market's imagination in recent days. Behind the scenes, Chinese and Russian officials have harping on it, and the head of China's central bank posted a report suggesting that SDRs should have an expanded role in global finance, including as a super-reserve asset. In a presentation to the Council on Foreign Relations, beleaguered US Treasury Secretary Geithner appeared to some to initially be open to such proposals.

Governor Zhou Xiaochuan. In it Governor Zhou argues that the world needs a new and better reserve currency, one not dominated by a single country, and that it is in the best interest of the world that this reserve currency be created by a body like the IMF.

Many people are unfamiliar with SDRs. Special Drawing Rights were first issued by the IMF in 1969, as Bretton Woods was straining and fears there was not enough gold and dollars, the main reserve assets, were growing. SDRs are a basket of existing currencies. The basket gets reset every 5-years. The last reset was in November 2005. The US dollar accounts for 44% of the SDR basket. The euro's share is 34%, while the yen and sterling's shares are 11% each. The SDR is a basket of existing currencies not a single currency like the euro, but rather more like the old European Currency Unit. The value of the SDR is calculated and posted by the IMF daily. It is currently worth about $1.51.

There have been two allocations of SDRs. The first was in 1970-1972 for 9.3 billion SDRs and the second one was in 1979-1981 for another 12.1 billion SDRs. In 1997, there was a proposal to double the SDR issuance to 42.8 billion (roughly $64 billion). One hundred and thirty one members endorsed the proposal and they had a weighted vote of 77.7%.

Approval requires 85%. The US has a 16.75% vote share, and has not approved the proposal. If there was a signal in Geithner's remarks is was that the Obama Administration may reconsider the US stance. Here is why it is necessary: Roughly the fifth of the IMF members which have joined since 1981 have never received an SDR allocation. Of course that inhibits their ability to participate in the SDR system. Moreover, given the depth and magnitude of the financial crisis and economic downturn—anticipated to be the first time in more than half a century that the world economy will likely contract—an new allotment of SDRs may be compelling.

We have heard these kinds of arguments many times before over the course of the 20th century, and usually in response to a global balance of payments crisis. Is there anything new about this proposal? It looks likely to be a purely political move.

A number of people including Columbia University’s Joseph Stiglitz, are supportive of the idea, arguing that the status of the US dollar as the world’s reserve currency creates unnecessary problems for both the US and the rest of the world.

Most importantly for the US it means that it is very difficult for the Fed to manage domestic monetary policy because the US financial system must accommodate not only conditions in the US but also distortions introduced by the use of the US dollar as a reserve currency, and these distortions can be massive. The most obvious example is the way over the past decade systematic industrial policies mainly in China and East Asia aimed at running trade surpluses and the accumulation of reserves meant that the US economy and its financial and monetary systems were forced to adjust in ways that created large and serious imbalances, which only now are we resolving.

At least four months ago George Soros (and others) proposed an increase in SDRs to help provide sufficient liquidity to arrest the deflationary forces that were growing. Ironically, China and Russia, apparently inspired the by famous speculator, have gone even further.

For one thing liquidity is key, and I think not even the euro – and certainly not SDRs or alternatives to the SDR – can ever hope to achieve anything like the level of liquidity implicit in the US dollar market. For another thing, for a currency to achieve reserve status there must be some systematic way of delivering the currency to central banks and other players who want to acquire it, and the US does so by its ability and willingness to run persistent trade deficits. How will the IMF or whoever controls the SDR create and assign reserves?

A new issuance of SDRs is not the same thing as diluting the role of the dollar. The sums are a pittance, especially given the magnitudes of world trade, cross border movement of capital or the holdings of currency reserves. SDRs have been around for 40 years, but they are not really money. Money, as economists understand it, is a means of exchange, a store of value, and a unit of account. SDRs are not a means of exchange. As a basket of already existing currencies, it might appear more stable and hence a better store of value, but what is the metric? The purchasing power of fiat currencies individually and collectively has generally been eroded by inflation. The SDR is not a fiat currency, but a basket of fiat currencies. For the most part SDRs are relegated to a unit of account for the IMF and a few other international organizations.

Some observers suggest that SDRs are the IMF's money (sometimes referred as paper gold), but that reflects a misunderstanding. Issuing SDRs is not the same as the IMF printing money. The IMF doesn't do that. An increase in SDRs simply boosts each member’s claims on the composite currencies. The IMF is not a central bank.

More specifically, if the SDR is indeed a true reserve currency, and not simply an accounting entry that allows central banks to pretend that they are not holding dollars but whose value ultimately rests on its convertibility to the US dollar, who will determine the global money supply and how do we prevent this from becoming a horribly politicized process? After all the Fed has an interest in seeing stability in the value and use of the dollar, and so it can be counted on more or less to act in the best interest of the reserve currency, but why should anyone care about the value of the SDR over the long term and, more importantly, how can prudent behavior be enforced? More worryingly, if Europe has had so much trouble managing monetary policy among a group of neighboring countries with fairly similar social and economic conditions, how do we manage monetary policy on a global scale?

Perhaps the SDR is a covert way of getting back to something resembling the gold standard by creating a fiat currency with very strict rules about its expansion. If that is the case, the SDR almost certainly won’t last long.

Final thoughts:

a) the ramblings by China was interesting but its an airy-fairy idea at best, its motive is likely to "scare" the US officials to think harder about their macro and monetary policies going forward

b) the move will never happen unless IMF becomes more representative of the global financial system, that could take years of appointments to change the racial and country mix of IMF

c) there are a lot of countries that does not agree with IMF's policies

d) SDR needs to get liquidity to a substantial level before it can be an alternative, that is like asking Malaysia's economy to move into the global top 10 biggest economies in 5 years, possible but improbable

e) a saner proposal will be akin to the Euro currency - it can be started by getting ASEAN members to throw all their currencies into the hat together with HK, China, Japan and India... the rest can join later and the new currency can be called AZO... but even that proposal will be extremely difficult, in fact many times more difficult than for the the European Union/ Euro Currency to be formed because of the various differing political platforms each country has, and that each country basically have to give up on having their own monetary policies - if your country unemployment is very bad, but the rest are OK, there's nothing you can do to your monetary policies to loosen the purse, etc...

So, SDR, a pipe dream...

p/s photos: Lara Dutta