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IdeasClash 2.0 Entry#1: A currency that can replace dollar as reserve currency
A few months back, some businessmen
launched world’s first gold ATM in London. You put in your credit card and the
machine will give you the real gold.
The current global economic scenario has
become increasingly interesting with the gold rising and the euro and the
dollar falling apart. The point here to be noted is, the dollar is in long term
decline. This can be seen from certain recent events happening across the
globe. IMF released a report that says that the Dollar holdings by central
banks in their reserves in declining for last few years. UBS recently conducted
a survey of investment institutions with more than USD 8 trillion under their
management and most of them think that the dollar will lose its reserve
currency status in 25 years from now.
For more than 50 years, the dollar has
dominated the global trade. It was the most dominant unit used for cross-border
transactions and formed major part of the reserves of central banks and
governments. This bright and shiny currency has now started losing its luster.
It has lost its share in the global trade, a change from 70% to just over 60%
in last decade. The reason is so clear, US economy no longer dominates the
world economy to the extent it dominated in the past. Also, it makes more sense
for the global monetary system should direct the global economy in becoming
multipolar. The stage, which belonged solely to USA, must now be shared with
other economies and the dollar must create some room for other currencies. The
US debt- ceiling fiasco has created concerns for the central bankers for
holding dollars. Europe has failed to resolve its sovereign-debt crisis and
there is a doubt on the existence of euro. Thus, the central bankers are now
looking for alternatives other than these two falling currencies.
Everybody seems to admit the fact that
sometime in future the dollar will lose its position of the global currency but
there is no agreement on what will replace the dollar as world’s reserve
currency.
There are many contenders to take this
crown like Gold, Yuan, SDRs, Euro, Commodities, etc.Now let us explore each of these options
one by one.
Gold
The gold has been on a rise as the dollar
continues to fall in the international market. The gold has been riding on the
increasing concerns over dollar as reserve currency and the risk of dollar
falling further. The long term graph for gold shows that it has adjusted for
inflation over a long period of time
Central banks in Asia are increasing their
exposure to gold so as to protect the value of their reserves. They have bought
about 151 tonnes of gold so far this year (2011-12) according to the World Gold
Council. They are further going to make more purchases which will be the
largest annual purchases of gold since the collapse of the Bretton Woods system
in 1971, that pegged the value of the dollar to gold.
Gold cannot be controlled by any government
and cannot be debased unlike fiat currencies. Furthermore, sovereign defaults
is considered as the biggest risk for the next year and reserve managers across
the globe have predicted that gold will be the best performing asset class in
coming years.
The steps required will be as follows:
-Stop printing the paper currency
-Remove custom duties on gold and any other
restrictions on its import/export
-Removing restrictions on possessing,
owning, buying and selling gold
-Removing restrictions against possession of
currencies and making them competition free
But, this is just not enough to make gold
as the world’s new reserve currency.
The supply of gold is inadequate. Thus,
implementing gold standard might result into deflation. The supply of gold is
highly imbalanced across regions of the world and maintaining reserves of gold
will be very challenging. The demand supply gap will eventually result into
inflation in some regions. Gold standard will create greater price instability
in short term. The prices are highly volatile as gold is a commodity. The gold
standard is inelastic and it will create a mismatch in the quantity of money in
relation to volume of economic activity.
Again, the governments cannot be trusted to
maintain the gold standard. In 1960s, the US was accused of breaching the
agreement and printed money more than gold reserves. In the past, it was
constantly re-valued as countries were finding it difficult to stay within the
disciplines. It was highly affected by wars.
With increased complexity of the global
economy and constantly changing environment, it will not be a wise decision to
again go back to gold standard.
Standard Drawing Right (SDR)
The SDR will be similar to a hybrid
currency. It consists of following four currencies by weights as given
below.
U.S. Dollar: 41.9%
Euro: 37.4%
Yen: 9.4%
British Pound: 11.3%
It can be seen that around 80% weight is
given for dollar and euro combined. Thus, using SDR in the current form will
not be really different than using dollar. Some other countries have also
demanded for inclusion of their currencies in SDR. In that case, SDR can be
said to have potential of becoming a true global currency. A more diversified
SDR will reduce currency based risks, stabilize the global economy and make the
rest of the world less reliant on the events happening in the United States.
The IMF has issued only 21.4 billion SDRs
since 1970 and they are valued at $32 billion at today’s exchange rate. There
is a proposed issue of $250 billion. But, it still looks smaller when compared
with trillions of dollars of reserves held globally. Also, SDRs are issued in
proportion to the country’s quota in IMF. Thus, two-third of them will go to
developed countries and countries like India and China will get 2% and 3.7%
respectively. This is definitely not serving the purpose of a truly global
currency. Also, the process of issuing SDRs is cumbersome. SDRs cannot be
traded in private markets.
Thus, it will take time for SDR to evolve
as a truly global reserve currency.
Yuan
The Chinese government has kept its
currency pegged to dollar to make Chinese goods less expensive for American
consumers. To maintain the artificial exchange rate, the central bank in China
keeps on purchasing dollars. Now, the “money-printing policy” of USA has made
dollar lose its value steadily. Thus, China has to increase its dollar
purchases to maintain the exchange rate and prevent yuan from rising against
dollar. Eventually, the Chinese will have to depeg the currency from dollar and
allow it to appreciate against dollar.
Now, China is promoting use of its currency
for cross border transactions to reduce reliance on dollar. Japan and China
have agreed to promote direct trade of yen and yuan between the two countries.
China has also arranged currency swaps with some of its trading partners. It
allows China to receive yuan and not dollars for their exports. Thus, China
will be able to perform direct trade without putting the currency in the open
market.
It can be seen from the past that the
currency of the world’s biggest economy has been the reserve currency. It was
true for pound as well as dollar. China is likely to replace the US as the
world’s largest economy sometime during 2020s. It is already the world’s
largest exporter (On contrary, the US is world’s largest debtor!).
The current situation can be considered
similar to the transition from pound to dollar except that yuan is not fully
convertible and china is not politically stable. China does not have open
capital market. The domestic bond market is small and illiquid. The access to
these markets is highly restricted.
Thus, before heading towards becoming a
global reserve currency, China must address these issues. Even if China overcomes
all these issues, what it will still need to overcome is network externalities
that are favouring dollar and euro currently. Still, yuan seems to be the
strongest contender today that can replace dollar as global reserve currency.
Euro
The GDP of the euro area is 76% of the GDP
of the United States. Euro is the second most traded currency. Also,
euro-dollar currency pair is the most heavily transacted. Euro has its basic
attribute as stability which is given priority over strength. Stability is one
of the most important requirements of a global currency which will in turn
impart credibility to the currency. Even is SDR, euro is a major contributor.
But, the sovereign debt crisis has raised
doubts on existence of euro. The objective of euro was to challenge the role of
dollar. But, euro is not in a better position than dollar today. The central
banks are losing faith in dollar and euro as well and are in search of a new
currency to hold their reserves in. Thus, euro is not in a position to become
global reserve currency.
Commodities
A possibility is to use a currency based on
a basket of commodities. Raw materials are the things that every country has to
have access to. A currency unit that is formed of commodities like gold, oil,
iron ore and rice will be something that will hold its value for a long period
of time.
The currency will be linked to something
real. Also, it will be more diversified unlike gold standard. It will also
overcome the issues with gold standard regarding the adequacy. Basket of commodities
will make more sense than basket of currencies (SDR).
GDP Linked Bonds
One innovative alternative will be to
create a global reserve asset. The ideal would be a global GDP linked bond. The
returns on it will vary with global growth rates. Thus, the central banks will
be holding instruments that will behave like a widely diversified global equity
portfolio. It would compensate for inflation and currency fluctuations as the
payout will depend upon the nominal GSP and not real GDP. IMF can purchase
GDP-indexed bonds from governments and provide new global reserve assets and
capacity to generate interests.
According to IMF, governments should issue
GDP-linked bonds, but convincing them to do so has been difficult so far for
the IMF. So, convincing them for a global GDP indexed bond would be harder. Thus,
this alternative is also not very close to be implementable in near future.
A Final Word
As the dollar is the reserve currency, the
US can run trade deficits indefinitely. But, if some other currency replaces
dollar as the reserve currency it will lose this advantage. But, in near future,
this does not seem to happen. There is no indication from Gulf countries that
they are intending to move away from dollar for their oil trades. The US shares
a very high degree of political and strategic relationship with some key Gulf
countries. Euro seemed to be the only currency with the ability to displace
dollar from its position but with the Eurozone crisis, euro itself is in deep
trouble. Yuan is still miles away from being a potential global reserve
currency. There is no doubt that the world will witness a shift of power from
US and Europe to Asia. But, the dollar has a long way to go before stepping it
down as the global reserve currency.
Bibliography
Books and articles
1.Will the euro eventually surpass
the dollar as leading international reserve currency?, by Menzie
Chinn and Jeffrey A. Frankel, 2007
2.The rise and fall of the Dollar, or
when did the Dollar replace Sterling as the leading international
currency?, by B Eichengreen, 2008
3.Why SDRs could rival the dollar, by J
Williamson, 2009
4.Explorations in the gold standard
and related policies for stabilizing the dollar by RE Hall, 1982
5.The end of dollar hegemony, by R.
Paul, 2006
Websites
http://www.dbresearch.eu
http://www.cnbc.com
http://www.telegraph.co.uk
http://arabnews.com
http://online.wsj.com
http://the-diplomat.com
http://www.bis.org/
[The article has been written by Ajinkya Patil. He completed his B.Tech in Computer Engineering from VJTI,Mumbai and is presently pursuing his MBA at JBIMS,Mumbai. He can be reached on twitter @ajinkya89 ]
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