Is it the right time to introduce new global reserve currency


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Is it the right time to introduce new global reserve currency

  1. 1. Abhyudaya-2012 Abhyutthan By Ratan Kumar “Kudos” IMI, New Delhi
  2. 2. IS IT THE RIGHT TIME NOW FOR A NEW RESERVE CURRENCY?As emphasized by economist Avinash Persaud: Reserve currencies come and go. Prior to 1944World reference currency was the Pound Sterling. However after World War II, Bretton WoodsSystem established US Dollar as international currency. US government guaranteed other centralbanks that they could sell their US dollar reserves at a fixed rate for gold. European countries andJapan saw this as an opportunity to boost their sale by deliberately devaluing their currenciesagainst the dollar. United States started facing Triffin dilemma. The amount of US dollar incirculation began to exceed the amount of gold backing them up. Thus the Nixon shock wasintroduced and dollar was delinked from gold.In the wake of the financial crisis 2007-08, the governor of the Peoples Bank of China explicitlynamed the Triffin Dilemma as the root cause of the economic disorder. In current scenario thecorrect question is not that whether it is the right time to introduce new reserve currency. Ratherthe question should be: Is there any suitable option available to replace “Dollar” as reservecurrency.As a prerequisite to replace dollar, substituting country should offer enough credibility to backits currency as globally acceptable reserve currency. Table below shows currency composition ofofficial foreign exchange reserves:- Currency 2011,QuarterIII US dollar 61.70% Euro 25.70% Pound sterling 3.90% Japanese yen 3.80% Others 4.90% Total 100.00%
  3. 3. As can be seen Euro is 2nd highest held foreign reserve, forming not even half of U.S. Dollarreserves. Also with the current prevailing scenario in European Union with majority of bignations on the verge of defaulting, Euro is not in a position to replace Dollar. After Euro allothers are mere show up. Japan is shaken abreast with tsunami last year and is still in the processof rehabilitation. Thus no single nation currently has enough credibility to replace dollar.China is slowing emerging as global economic power. China and Japan entered into anagreement and have announced plans to allow a "direct exchange" of their currencies tostrengthen financial ties and promote Yuan-Yen trade as a small, but notable, step toward a newglobal economy. The agreement will let a Japanese-backed institution sell Yuan bonds in China,helping to open China’s capital market. In return, Japan will convert some of its foreign-exchange reserves into Chinese bonds. However, the accord still lacks a timetable forimplementation. China is well versed with the fact that loosening up its currency control willlead it to “Trilema”. Thus, it still maintains capital control on the conversion of its currency. Thecurrency would not be attractive to central banks for holding unless China developed a strongopen bond market.
  4. 4. ARE SDRs A GOOD OPTION?The United Nations report was issued to abandon U.S. dollar as single major reserve currencyand suggested to emission of international liquidity to create a more stable global financialsystem. However this report came on the backdrop of global financial crisis (2010) that wasprevailing at that time. Credibility of US dollar was kept at stake and alternative solution was tobe found. U.S. Dollar was depreciating and SDRs appeared to be a lucrative option as itpromised to provide a stable global financial system.However SDR is of importance only when U.S. dollar is weak or otherwise unsuitable to be aforeign exchange reserve asset. For instance prior to 1970 there was shortfall of US Dollar due toconservative monetary policy. If the US had continued down this path, the dollar would havebecome a less attractive foreign exchange reserve asset. U.S. reversed its former policy andprovided sufficient liquidity. In the process a potential role for the SDR was removed.On the issue of can SDR be established as new global reserve currency, Paavo Vayrynen,Finlands Foreign Trade and Development Minister said: "It is based on the markets; I believethat the economic players in the market are going to have the decisive influence on that issue."SDR has its own benefits and shortcoming. Besides providing global financial stability, it can beused as cheap source of credit. However, currently SDRs are allocated only to member nations ofIMF. Other countries need to buy it from member nation or from IMF. Also in order to useSDRs, a country must find a willing party to buy them. Exchanging SDRs can take "severaldays". This removes the flexibility that Dollar provides on real time basis.Secondly, the way the value of SDR is determined is dubious in nature. The currency basket isre-evaluated every five years. This can be depressing for countries that will be holding theirreserve in SDR as they might need to revalue their reserve every five years.
  5. 5. Lastly, the current composition of SDR consists of: USD EUR JPY GBP 41.90% 37.40% 9.40% 11.30%As can be seen, US dollar and Euro form 79.3% of the basket. Again, the question is: can SDRbecome a stable reserve. Under the current scenario if European Union defaults or U.S.undergoes some crisis (sudden), there is huge risk still associated with SDR being stable globalreserve.Thus can SDR replace US dollar? I would say no. This is further boosted by the fact that duringthe past few months dollar has actually appreciated as investor are finding US dollar as substituteof Euro in the current scenario.Conclusion:After the great financial crisis (2007-08), voices have been raised to issues concerning U.S.Dollar as global reserve currency. There is urgent need to make a transition to a more stableglobal currency. However no single potential substitute exists currently. Chinese Yuan is one ofthe potential contestants to replace U.S. Dollar. However it is not going to take place in nearfuture and will take considerable amount of time. SDRs have its own shortcoming and cannot beconsidered as a suitable substitute.
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