BERKELEY – Zhou Xiaochuan, the governor of the People’s Bank of China, made a splash prior to the recent G-20 summit by arguing that the International Monetary Fund’s Special Drawing Rights should replace the dollar as the world’s reserve currency. His reflections elicited nothing if not mixed reactions.
Sympathizers acknowledged the contradictions of a system in which a national unit is used internationally. Central banks understandably seek more reserves as their economies grow.
But if those reserves mainly take the form of dollars, then their rising demand allows the United States to finance its external deficit at an artificially low cost.
In turn, this allows unsustainable imbalances to build up, leading to an inevitable crash. Recent events have highlighted this problem – and Governor Zhou thus was right to call for a different system.
But skeptics question whether the SDR could ever replace the dollar as the world’s leading reserve currency, for the simple reason that the SDR is not a currency. It is a composite accounting unit in which the IMF issues credits to its members.
Those credits can be converted into dollars and other currencies at the Fund, and can be used in official transactions among IMF member countries.
But they cannot be used in the other transactions in which central banks and governments engage. They cannot be used to intervene in foreign-exchange markets, or in other transactions with market participants.
This means that the SDR is not an attractive unit for official reserves. This would not be easy to change. Despite the trials and tribulations of the American economy, dollar securities remain the dominant form of reserves because of the unparalleled depth and liquidity of US markets. Central banks can buy and sell dollar securities without moving those markets.
There is also the convenience factor: dollars are widely used in a variety of other transactions. As a result, not even the euro has seriously challenged the dollar as the dominant reserve currency. Doing so would be even more difficult for the SDR.
But difficult does not mean impossible. If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds.
Better still, it could encourage other G-20 countries to do likewise. They would pay a price, since investors in these bonds would initially demand a novelty premium. But nothing is free. That price would be an investment in a more stable international system.
Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims. Back in the 1970’s, there was some limited issuance of SDR-denominated liabilities by commercial banks and SDR-denominated bonds by corporations.
But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.
Overcoming that advantage now would require someone to act as market-maker for private as well as official transactions and subsidize the market in its start-up phase.
The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, private as well as official, at narrow bid/ask spreads competitive with those for dollars.
The dollar originally acquired international currency status in the 1920’s, when the newly established Federal Reserve started buying and selling dollar acceptances, backstopping the market and enhancing its liquidity.
If the international community is serious about the SDR as an international currency, it will have to empower the IMF to do likewise. Again, there would be a cost.
The IMF would be using real resources to subsidize the market until private market-makers saw it as attractive to provide those services at comparable cost.
The Fund’s shareholders would have to agree to incur those costs. But, again, what is this if not an investment in a more stable global monetary system?
Transforming the SDR into a true international currency would require surmounting other obstacles.
The IMF would have to be able to issue additional SDRs in periods of shortage, as when the Fed provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008.
At the moment, countries holding 85% of IMF voting power must agree before SDRs can be issued, which is no recipe for liquidity.
The IMF’s management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps.
For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.
Before the crisis, such ideas would have been dismissed out of hand. Even now they won’t materialize overnight. But they are the real implications of Governor Zhou’s remarks.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.
Copyright: Project Syndicate, 2009.