Beware the UN's FX Views

A Reuters report out last week is still eliciting client queries. The report claims that a UN panel will recommend this week "that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies". A panel member, who's currency hedge fund blew up because of the irrationality of the market (he said), was the apparent source of the leak.

Despite the drama, the UN panel recommendation is likely to fall flat. First, central bankers have the freedom to chose their reserve asset. The IMF COFER data clearly shows that those central bank that report their reserve allocation favor the dollar by a little less than 2/3. The euro, which many thought would or could replace the dollar remains roughly the size of its constituent parts (ECU, Deutschemark and French franc). Moreover, given the dollar's decline since 2000, one might have expected that on valuation grounds alone the dollar's share would have fallen by more.

In the Reuters story, the panelist asserts that the US is concerned that holding the reserve currency made it impossible to run policy. This claim is surely an exaggeration. The US has recognized the significance of having the numeraire by, among other things, making dollars available in unlimited scale to world's most important central banks and to a handful of central banks in emerging markets. Clearly too the support given to AIG has also found its way to numerous European entities. We have maintained that the IMF assistance programs have filled an institutional vacuum in Europe as all but one of its assistance programs have been aimed at European countries. In this context, the support the US have provided to AIG helps avert a deeper European banking crisis.

The panelist then suggests that "the rest of the world was also unhappy with the generally declining dollar." This too seems exaggerated. The main problem over the last six months is not too weak of a dollar, but its opposite, too strong. The dollar's appreciation aggravated the currency mis-match problem of a number of countries. If the world was as unhappy as the panelist claims, wouldn't there have been a bigger exodus out of the dollar.

The Reuters story also indicates that the panelist has "long argued that the dollar would give way to the Chinese yuan as a global reserve currency within decades."

While a new special drawing right (SDR) allocation from the IMF is possible, there does not seem to be strong calls to do so. SDRs were first created in the late 1960s and has since been used to settle inter-government obligations and an accounting unit. The SDRs though have not increased with world trade or cross border movement of capital and therefore plays a minor role in most countries' reserves.

Perhaps what gives the UN story some play is that China is also seen calling for a new international reserve asset. The head of the PBOC Zhou Xiaochuan is taking the lead in the charge, but there are important but subtle differences. First, Zhou is talking about strengthening IMF supervision of developed countries as opposed to developing countries, where the focus is often. In particular China argues that the with power of seniorage that accrues to the reserve provider comes extra responsibility. In a joint statement with the Finance Ministry China argued that the supervision of the credit rating agencies and other financial institutions that have systemic influences should be strengthened.

Recall that US Treasury figures show that China increased its Treasury holdings by almost 40% in H2 08. It bought more in January. China officials recognizes the primacy of the US economy. It has not sought to undermine the dollar. It has arguably done as much as any country, if not more, for the strong dollar policy. China, like Russia, is beginning to encourage the some domestic firms to invoice in yuan (or rubles), but this is quite different than actively pursuing a reserve currency status.

Just as importantly is what China is not saying. It is not saying it will dump dollars. It is not saying it will buy more euros. The support for a new international reserve assets seems to be an attempt to get around the Triffin Paradox (the contradictory pressures on a national currency that is also a reserve asset). However, these are longer-term issues.

UN headlines can hit anytime over the next few days. Do not be surprised. Do not expect of a large response and if there is, it won't be sustained. The UN does not have the same clout on financial issues as the IMF. A small group of US critics could capture a platform for their own purposes. It has happened before. It could happen again.

Meanwhile, the dollar's role seems as secure as ever. There is no clear national alternative and a new international asset cannot simply be foisted on countries. The dollar remains numeraire, imperfections and all.

Comments

[Dave Wrixon:]

Aren't most of these reserves held in T-Bills? Isn't it really about who has borrowed the most money?

Where the system is breaking down is that the borrower is borrowing in their own currency. That situation is really unsustainable when governments become so heavily indebted as the US. China should simply stop lending to the US in dollars and let Obama take the currency risk on his own shoulders. If they did that then he would not be so cavalier about inflating the US economy out of debt.

Actually, what China is suggesting is much less radical than what I would do if I were in their position. If I were the Chinese I would only lend in Yuan. Would the US for example ever lend money out in an African or South American Currency?

The idea makes sense, but in its current form the IMF is an inappropriate institution to administer such a reserve currency, which is why reform is desperately need.

I think the US should jump at China's offer on the basis that the alternative will almost certainly be less advantageous to the them.

Mar 24 10:19 AM

[Alex Filonov:]

Is UN equals to zero in economic matters? Or negative?

Mar 24 12:45 PM

[Socialism c...:]

"First, central bankers have the freedom to chose their reserve asset."

Do they? Are you SURE about that? Our central bank is the Fed...a quasi-private group of bankers...non-represen... government, since the Congress has ceded its Constitutionally-given MANDATE to govern the value of currency and coin in the U.S.

Time to ABOLISH THE FED!!! And...get the U.S. out of the U.N. -- enough giving away our sovereignty!!!

Mar 24 01:39 PM

[dtblount:]

Great article with some excellent views that cut through a lot of the rhetoric...very well done!

As for the UN, I respect and admire its goals (especially those regarding poverty reduction, etc.), but take issue with the attempts at executing many of these goals and the viability of the strategies used. It seems as if the UN has phased into more of a large think tank, capable of conjuring up interesting ideas and hosting elaborate summits with impressive attendees, but lacking in successful projects. I guess that's what happens when you crowd so many academics into a room...

The idea of China lending only in CNY, which is neither a reserve nor a free-floating currency, does not make any sense in this world right now. China needs USD (via USTs since hard currency yields 0%...while USTs are a bit better) almost as badly as the US needs to issue them.

As many issues as there are with USD being the world's reserve currency, it reminds me of the famous Churchill quote regarding Democracy...

"It has been said that Democracy is the worst form of government...except all the others that have been tried."

...change it around a bit...

It has been said that [the USD] is the worst [reserve currency]...except all the others that have been tried.

very true...

Mar 25 01:49 PM

[Gedankonomist:]

"Despite the drama, the UN panel recommendation is likely to fall flat. First, central bankers have the freedom to chose their reserve asset."

Actually, the UN is an instrument of the central bankers. If the UN recommendation "falls flat," it will be because the "recommendation" was a ruse, i.e. a distraction from something else the "central bankers" plan to do.

Mar 25 02:23 PM