More thoughts on the switch from dollars as reserve currency

This comes from Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman (bolding in original).  Chandler does NOT see an imminent switch to  Euros in the offing, despite the recent musings by Chinese officials  (Neither do I.  However, I do believe the US dollar is a weak currency.  At a minimum, gold and oil should gain as the Fed monetizes debt):

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.

  1. smoody says

    First, the US is not exaggerating when it asserts that foreign central bank purchases of US Treasuries interfered with (if not defeated) the Fed’s monetary policy in 2004. See Roubini and Setser, Federal Reserve Papers 2005. See Greenspan’s reference to the event in his inaptly named book. Between 2000 and 2007 (inclusive), foreign central bank reserves increased by USD 4.4 trillion while marketable US Treasuries increased by (only) 1.5 trillion. (China, at the time, happened to be buying longer dated maturities, of which readers will recall there were relative few.)

    Second, the euro is not a candidate to become the world’s next reserve currency. Were it, it would have done so by 2004. As a reserve currency, the euro has shortcomings–most notably the lack of unified euro-denominated debt in which foreign central banks can invest accumulated reserves. Who wants to own Portuguese, Italian, Greek or Spanish paper? Apparently not China.

    Last, the Chinese proposal deserves serious consideration if the world is still bent on globalization. Keep in mind that since 1998 the ‘free world financial system’ has added at least 25 convertible currencies, each with its own exchange rates and interest rates together servicing a total of some 2.7 billion citizens of various lands. The ‘free world financial system’ was designed in 1944 to service the trade and international finance needs of the post-war non-communist financial community. The last major modification to the system occurred in 1971 when Nixon slammed the gold window shut.

    None of the foregoing makes an argument–bullish or otherwise–about the dollar or the euro. Those arguments are short term sentiment issues. The Chinese proposal is grist for the long term mill. One would want to hear it thoroughly discussed by the G-20.

  2. aitrader says

    Although the suggestion for a new reserve came from the head of the Chinese Central Bank, it hasn’t received any backing from Chairman Wen. Until he mentions it the suggestion for a new reserve is just posturing on the part of an official rather than a serious shift in policy.

    What I find more interesting is that this essay was published after the G20 meeting where the Russians presented a paper pushing for a new reserve currency. The Chinese initially rejected the idea but obviously it did gain some traction.

    A Russian paper submitted at the recent G20 meeting along with Kazakhstan’s recent proclamation that the US dollar reserve is illegal preceded Zhou’s essay. There seems to be something afoot here. Western Europe will not likely go along but at the very least this could lead to a splintering of trading blocks with some following into a new potential reserve currency alternative. I would suggest we focus on energy as the leverage to force a new reserve into play.

    Russia’s moves to create a natural gas cartel are the tell that I believe will be the first serious step to a new reserve alternative.

    Once we have multiple fiat reserve currencies the lynchpin holding the current floating fiat currency system together will be gone. This is uncharted territory. The actors will inevitably succumb to the temptation to manipulate their favored reserve to primacy over the others. This could critically destabilize the whole system – and will in my opinion.

    Dollar as world’s only reserve currency is illegal, Kazakhstan president says

    Russia wants to start debate on new reserve

    Gazprom producing 25% less gas

  3. Glen says

    Ed, don’t believe there’s an immediate ‘threat’ to change the US$ reserve currency though there is growing debate over how the rest of the world sees the participation and use of the US$ in the global environment given the actions of the Fed and banking system – read: worried. Given that the Fed actions are of a self centred nature, China has every right to express concern over the value of the US$ given their extensive holdings. No one single nations currency should dominate the world given the now that one nations currency is essentially worthless.

    1. Edward Harrison says

      Good comments here all around. I agree with the general view that we are NOT going to see the dollar replaced any time soon. This is posturing on the part of a senior official that has not even been echoed by Premier Wen. Over time, I do think the dollar’s role as the only reserve currency will diminish and that is dollar bearish, but this is a longer-term view.

      As to how the posturing plays out is anybody’s guess. Because I expect a cyclical rebound here, I imagine the worst-case scenarios of threats and protectionism may be off the table. But, if we relapse in the summer/fall due to massive writedowns (which I foresee) on bank credit card and CRE exposure, we should expect populist sentiment to incite protectionist responses from both sides.

  4. aitrader says

    L’argent papier finit toujours par retourner à sa valeur intrinsèque, c’est a dire zéro.
    (“Paper money always ends up returning to its intrinsic value; that is, zero.”)

    — Voltaire

    The fuse was lit in 1971 when Nixon removed the intrinsic value of gold to back the dollar, hence backing of all global currencies. And it’s about to explode.

    The global financial community is punch-drunk with the 38 year success of a pure fiat currency. It would behoove those that seek to replace it with yet another fiat alternative to tease apart the reasons for that historically amazing longevity. Centralized government control of the dollar and an economy that dwarfed its rivals by an order of magnitude are a couple reasons that come to mind. Historically cheap food and energy are a couple of others.

    The French experience under John Law, whose monetary system based on derivatives resembles the current one to a marked degree, will be viewed in retrospect as an obvious example of the eventual outcome of the current fiat money experiment. In this case history not only rhymes, it is repeating itself.

    The existence of multiple fiat “reserve” currencies will result in nothing other than the collapse of the system as a whole. In the midst of a downturn looking more and more like a global depression and with cheap energy on a plateau and possibly a decline, a worse time for an yet another fiat experiment is hard to imagine.

  5. smoody says

    A multi-currency reserve system is not a reserve system at all. Mssrs Putin and Nazarbayev should probably stick with politics and leave central banking to, well, others. The Chinese proposal, however, deserves discussion and elaboration along the lines of Paul Davidson’s paper. (You might want to re-post Davidson’s piece, Ed.)

  6. Edward Harrison says

    Smoody, that’s a good idea. I will do that. Cheers.


Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More