Why dollar rules

Print edition : November 06, 2009

John Lipsky (left), First Deputy Managing Director, and Dominique Strauss-Kahn, Managing Director, of the IMF in Istanbul on October 2. Lipsky has suggested that the SDR can be used as the foundation to build a new currency that would be delinked from other currencies and issued by an international organisation with equivalent authority to a central bank in order to become liquid enough to be used as a reserve.-DANIEL ACKER/BLOOMBERG

IF time lag matters, news of the dollars demise as the worlds principal reserve currency is grossly exaggerated. That prediction has been heard periodically at least since the early 1970s when the United States brought to an end the Bretton Woods arrangement by breaking the link between the dollar and gold. As is obvious, whatever else may be said of the U.S. role in the world system, this expectation of the dollars displacement as the currency that is as good as gold has not materialised.

This, however, is not to say that the dollar fulfils its role adequately or even satisfactorily. Not surprisingly, with the strength of the U.S. economy once again in question, the dollar has begun to slide. The euro, between its low of 1.2932 to the dollar on April 21, 2009, and its value at the end of September 2009, has appreciated by 13 per cent vis-a-vis the dollar. This (and other similar tendencies) has triggered predictions of the demise of the dollar as the lead currency. Should and will a new currency replace the dollar as the paper that is treated as good as gold?

A noteworthy feature of the debate on the dollars worthiness as a reserve currency is that most people who say it is time for the dollar to go, do not base their argument on the greater strength of an alternative currency (such as the euro, the yen or the Chinese renminbi) that should take the dollars place. Rather, their alternative is the International Monetary Funds (IMF) Special Drawing Right (SDR), which is more a unit of account than a currency and which derives its value from a weighted basket of four major currencies.

There are three implications here. First, even when the weakness of the U.S. and the dollar is accepted, the case is not that the dollar should be completely displaced; even in the basket that constitutes the SDR the dollar commands an influential role. Second, there is no other country or currency that is capable of taking the place of the U.S. and its dollar at least in the near future. And third, the search is not for a currency that can be used with confidence as a medium of international exchange but for a derivative asset that investors can hold without fear of a substantial fall in its value when exchange rates fluctuate, because its value is defined in terms of, and is stable relative to, a basket of currencies.

It should be clear that in the absence of another currency that can play a similar role in the world economy, rhetoric alone will not end dollar hegemony. The question, therefore, is whether the SDR can serve as an actual currency, or is the focus on the SDR diverting attention from alternative real currencies?

Early expectations of the displacement of the dollar came with the birth of the euro on January 1, 1999, and the irrevocable fixing of the exchange rates between the then member-countries of the European Union (E.U.). The idea of the euro as an alternative to the dollar came when, after a brief period of stability and then depreciation relative to the dollar, it appreciated from close to $0.80 in end-April 2000 to $1.60 in April 2008. Since then, after a period of depreciation to around $1.25 in November 2008, the euro has on average appreciated to reach $1.50 in September 2009.

There are two ways in which to view this relative decline in the dollars value. The first is to see it as a gradual depreciation of the dollar as part of an effort to correct for the loss of export competitiveness of the U.S. The second is to see it as a challenge posed to the dollars supremacy by the new currency.

The supporting evidence to back the second proposition is difficult to come by. Consider, for instance, the euros role in international transactions. By September 2006, 30 per cent of outstanding international securities were denominated in euros compared with around 20 per cent in 1999. But this was not because of any significant decline of the dollars role in this area, since its share had fallen from just around one half to 46 per cent. In foreign exchange markets, the euros share remained stable at around 20 per cent of all transactions, compared with the dollars 44 per cent. And, finally, among countries that reported the composition of their foreign exchange reserves, the euro accounted for a stable 25 per cent of the holding. All in all, the euro did not appear to be displacing the dollar as the major reserve currency.

This is not surprising given the fact that the euro is not the currency of a single national political formation backed by a single powerful state. Though monetary policy in these countries is harmonised through the European Central Bank, which sets interest rates for all, these countries, which are characterised by very different levels of development, have considerable fiscal policy independence (despite the Growth and Stability Pact).

This does not inspire confidence in the ability of the E.U. as a formation to influence the value of the euro as desired. Besides, no single state in this formation has the military strength or activism to assert power and stabilise the value of the currency when required. Put simply, while some of the European nations are economically strong, such as Germany, though less so than before unification, a look at the conditions that helped sustain the dollar as the reserve currency makes it clear that this united formation of legally independent sovereign states falls short in terms of the prerequisites for the euro to displace the dollar as reserve currency.

The debate over the SDR as an alternative currency gathered momentum when in the aftermath of the 2008 global crisis the governor of the Peoples Bank of China, Zhou Xiaochuan, called for replacing the dollar with the SDR as reserve currency. There are, however, many hurdles between this stated desire and the actual transformation of the SDR into the worlds reserve.

Created in 1969, the SDR was initially seen as a supplemental reserve that could help meet shortages of the then prevailing reserve assets: gold and the dollar. The IMF issues credits of SDRs to its member-nations, which can be exchanged for freely usable currencies when required. The value of the SDR was initially set to be equivalent to an amount in weight of gold (0.888671 grams), which was then equivalent to one dollar. After the collapse of the Bretton Woods system in 1973, however, the value of the SDR was reset relative to a weighted basket of currencies and quoted in dollars calculated at the existing exchange rates. The basket of currencies today consists of the euro, the Japanese yen, the pound sterling, and the U.S. dollar. The liquidity of the SDR is ensured through voluntary trading arrangements under which members and one prescribed holder have volunteered to buy or sell SDRs within limits.

Further, when required, the IMF can activate its designation mechanism, under which members with strong external positions and reserves of freely usable currencies are requested to buy SDRs with those currencies from members facing balance-of-payments difficulties. This arrangement helps ensure the liquidity and the reserve-asset character of the SDR. So long as a countrys holdings of SDRs equal its allocation, they are a costless and barren asset. However, whenever a members SDR holdings exceed the allocation, it earns interest on the excess. On the other hand, if a country holds fewer SDRs than that allocated to it, it pays interest on the shortfall. The SDR interest rate is also based on a weighted average of specified interest rates in the money markets of the SDR basket currencies.

The volume of SDRs available in the system is the result of mutually agreed allocations (determined by the need for supplementary reserves) to members in proportion to their quotas. Until recently, the volume of SDRs available was small. They have been allocated on four occasions. The first tranche, to the tune of SDR 9.3 billion, was issued in annual instalments during 1970-72, immediately after the SDRs creation. The second, of SDR 12.1 billion, occurred during 1979-81, after the second oil shock. The third, of SDR 161.2 billion, was issued on August 28, 2009. And the fourth, of SDR 21.4 billion, took place on September 9, 2009.

As a result, the total volume of SDRs in circulation has reached SDR 204.1 billion, or about $317 billion. As can be noted, an overwhelming proportion of the allocation has occurred in the aftermath of the 2008 financial crisis. But even now the quantum of these special reserves is well short of volumes demanded by developing countries.

Does the recent substantial increase in the amount of SDRs allocated herald its emergence as an alternative to the dollar? There are two roles that the SDR can play, which favour its acceptance as a reserve. First, it can help reduce the exposure of countries to the dollar, the value of which has been declining in recent months because of the huge current account deficit of the U.S., its legacy of indebtedness, and the large volume of dollars it is pumping into the system to finance its post-crisis stimulus package. Second, since the value of the SDR is determined by a weighted basket of four major currencies, the command over goods and resources that its holder would have would be stable and even advantageous.

There are, however, five immediate and obvious obstacles to the SDR serving as the sole or even principal reserve. First, the $317 billion worth of SDRs currently available are distributed across countries and constitute a small proportion of the global reserve holdings, estimated at $6.7 trillion at the end of 2008, and of the reserve holding of even a single country such as China. Since all countries would, if possible, like to hold a part of their reserves in SDRs, the fraction of this $317 billion that would be available for trade against actual currencies would be small, implying that even with recent increases in allocations the SDR can only be a supplementary reserve.

Second, expansion of the volume of SDRs in circulation requires agreement among countries that hold at least 85 per cent of IMF quotas. With the U.S. alone having a 16.77 per cent vote share, as of now it has a veto on any such decision. Whether it will go along with the decision to deprive it of the benefits of being the home of the reserve currency is unclear. And even if it does, there could be others with a combined vote share of 15 per cent-plus who may not be willing to go along.

Third, since SDR issues are linked to quotas at the IMF and those quotas do not reflect the economic strength of members anymore, the base distribution of SDRs is not in proportion to the distribution of reserve holdings across countries. Reaching SDRs to those who would like to hold them depends on the willingness of now weaker countries to sell. Fourth, since the value of the SDR is linked to the value of four actual currencies, the reason why a country seeking to diversify its reserve should not hold those four currencies (in proportion to their weights in the SDRs value) rather than the SDR itself is unclear. This would also give countries flexibility in terms of the proportion in which they hold these four currencies, which is an advantage in a world of fluctuating exchange rates, since weights of currencies constituting the SDR are reviewed only with a considerable lag, currently of five years.

Finally, as of now, SDRs can only be exchanged in transactions between central banks and not in transactions between the government and the private sector and, therefore, in purely private sector transactions. This depletes its currency-like nature in the real world. It also reduces the likelihood that a significant number of economic transactions would be denominated in SDRs.

While this can be corrected, such a correction can throw up a host of additional problems. But this has not prevented suggestions from some like John Lipsky, the IMFs First Deputy Managing Director, that the SDR can be used as the foundation to build a new currency that would be delinked from other currencies and issued by an international organisation with equivalent authority to a central bank in order to become liquid enough to be used as a reserve.

This presumes that we have, or can think of, a single global state, which as of now is not a possibility. To the many difficulties associated with treating the SDR as a normal currency must be added the lack of confidence in its ability, not being the national currency of any country, to serve as a viable reserve currency for the world. While the SDR may be good as a supplementary reserve that aids diversification of the composition of reserves of individual countries, it as yet falls short of the requirements that a true reserve currency must meet. If despite this, the SDR is the focus of attention in the search for an alternative to the dollar, that can only be because there is as yet no national currency that can displace the dollar. While the dollar lacks the legitimacy to serve as the worlds reserve, it dominates because the time for its substitute is yet to come.

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