The topic of a reserve currency to replace the dollar never gets old, and the logic behind it is a bit fuzzy. First and foremost, why is the dollar the reserve currency of choice? Does America threaten to bombard any country that chooses to keep its reserves in euros, yen, Swiss francs, or gold, instead of adorable Benjamin Franklins? Let’s look at the landscape first.
The Financial Times published the article “The best alternative to a new global currency,” authored by Joseph Stiglitz, a recipient of the Nobel Prize in Economics in 2001. Mr. Stiglitz points out some issues, as follows:
Further, when crises occur in many countries simultaneously, as happened, for instance, during the 1998 east Asian crisis, IMF lending could be totally financed by new SDR issues in unlimited amounts. If and when the world economy recovered or boomed, SDR issues could then cease, or even be reabsorbed. Thus the IMF would have a greater role in creating official liquidity, in a way that curbed both recessionary and inflationary trends at different times.
Wait a second! New SDR issues in unlimited amounts? But isn’t the SDR designed to be a reserve quasi-currency that is created from members’ “existing” cash reserves? Or could the IMF become the official global money-printing machine that would save the globe from its missteps?
As SDRs would be created at will to provide “official liquidity,” countries would be forced to print money if their vaults were a bit empty. In simpler words, the proposed IMF process would be called “indirect simultaneous currency devaluation” and, once again, nobody talks about unpopular political and social reform, but rather on how to create a bigger “nanny” system. Do I get a Nobel Prize now? I will settle for 1/10th of the cash and a plastic replica.
But exactly what is an SDR, or Special Drawing Right? The IMF has plenty of information on this; pay close attention to the following excerpt from the IMF’s website answering the very same question:
The SDR is based on a basket of international currencies comprising the U.S. dollar, Japanese yen, euro and pound sterling. It is not a currency, nor a claim on the IMF, but is potentially a claim on freely usable currencies of IMF members. The value of the SDR is not directly determined by supply and demand in the market, but is set daily by the IMF on the basis of market exchange rates between the currencies included in the SDR basket.
I understand that most people are trying their best to develop systems that contribute to global economic stability, but when the word “potentially” is included in the excerpt above, one can only wonder whether an SDR could “actually” be exchanged for “freely usable currencies” under extreme conditions. Let’s say Country X buys SDR 100 million and at some point wants to convert the SDRs into euros and yen. But if “potentially” the claim cannot be fulfilled, Country X is out cold. Here’s the answer on how the SDR market works.
- For more than two decades, the SDR market has functioned purely on a voluntary basis.
- Various Fund members and one prescribed SDR holder have agreed to stand ready to buy and sell SDRs on a voluntary basis.
- The Fund facilitates transactions between members seeking to sell or buy SDRs and these counterparties to the voluntary agreements that effectively make a market in SDRs.
- In the event that there are not enough voluntary buyers of SDRs, the IMF can designate members with strong balance of payments positions to provide freely usable currency in exchange for SDRs. This so-called "designation mechanism" ensures that a participant can use its SDRs to readily obtain an equivalent amount of currency if it has a need for such a currency because of its balance of payments, its reserve position, or developments in its reserves.
Once again, pay close attention to the key word “voluntary,” which in itself is not very inspiring. In addition, the IMF, or its members, cannot enforce anything on anybody.
But a complex issue is that with China now the second-largest economy in the world, the G20 wants the yuan to be part of the SDR’s basket of currencies. Reuters reported on March 30 that Xu Hongcai, a Chinese economist and department deputy director at the China Center for International Economic Exchanges, stated that, “Nations around the world have no way of restricting dollar issuance by the Federal Reserve. The current international monetary system lacks both stability and fairness."
The article also points out that “Beijing has repeatedly warned that loose U.S. monetary policy threatens the dollar, but it has continued to accumulate dollar assets at the same time, adding about $260 billion of Treasury securities last year, according to U.S. data.” Maybe they are implementing the “dollar cost averaging” strategy.
I don’t think that Mr. Hongcai is crazy, just frustrated that the game has changed. But I’m going to agree with him for a change, and propose that the Chinese government should start dumping the dollar tomorrow and start buying all other currencies and precious metals. Why does the Chinese government keep buying the greenback? If I don’t like something, I shop around for alternatives.
But here’s where the story gets tricky, because China needs to maintain the economically beneficial peg, and floating the yuan is the equivalent of taking a cyanide pill for back pain. At the risk of sounding like a 10-year-old, I yell at the top of my lungs: “Kill the peg, make the Arctic penguin the official reserve currency for all I care, and show us what you’ve got!”
On March 31, Reuters reported that the “G20 sets conditions for the yuan to join SDR,” a move to recognize China’s place in the global economy. The reaction? "The West is conspiring against us!" Just can’t please anybody these days, especially when the IMF had decided on November 15, 2010 that the Chinese yuan was not used widely enough be to included in the IMF Special Drawing Right.
China suspects that the West is looking for new levers to force Beijing to let the yuan, now tightly managed by the central bank, trade more freely and to dismantle its capital controls more quickly than it wants to.
In short, if the yuan floats freely, China will sink fast and freely as well. But the rhetoric that the dollar is a bad idea never dies, and when the SDR is pushed to play a bigger part as a reserve currency, China does not want to be part of it.
What gives? One cannot have one’s cake and eat it too. Let’s propose to make the yuan the main reserve currency and wait for China’s response.
Why not adopt the gold standard then? Because politicians everywhere on the planet like to print money at will, and it will never happen. Although it may be different in the distant future, exactly why is the dollar the reserve currency of choice? Confidence and consumption -- not to mention a number of other beneficial factors as perceived by foreign holders of the currency, not Americans. And I refer back to an earlier post and borrow a quote from Mr. Luo Ping, director-general at the China Banking Regulatory Commission, as reported by the Financial Times.
"Except for U.S. Treasuries, what can you hold?" he asked. "Gold? You don’t hold Japanese government bonds or UK bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option." Mr Luo, whose English tends toward the colloquial, added: "We hate you guys. Once you start issuing $1-$2 trillion [$1,000bn-2,000bn] ... we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."
A valid argument is that China, and the world, contributed to the financing of American excesses, and I accept that fact without having to squirm. But it’s a two-way street. The drunken sailor consumed what he borrowed, and now can’t pay it back. Yet the drunken sailor is the consumer of last resort and is the only one that keeps the bartender in business.
Is it called "contributory negligence," "Catch-22," or "checkmate?" Once again, this is not a biased opinion, but simply stating the dynamics of global economics, and all the grandiloquence emanating from international organizations and agenda driven individuals will stay alive till the milking cows come home. Got money?
Investing in currency ETFs – PowerShares DB US Dollar (UUP), Euro Shares (FXE), Japanese Yen Shares (FXY), and WisdomTree Dreyfus Chinese Yuan Fund (CYB) are some examples -- should be done in accordance with economic factors, not the very old and tiresome nonsense of reserve currency substitution. In the end, every country will allocate its reserves based on economic principles, not conspiracy theories or political rhetoric.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.