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Can the SDR become a Global Reserve Currency?

Global economic prospects are worsening rapidly. This has revived the debate on the evolving international monetary system and the international reserve currency that will underpin it. Since the 1940s, the US dollar remains the world's dominant reserve currency. Developments since 2008 have challenged the pre-eminence of the US dollar. The euro appeared to have provided an alternative during 2000-08, but has come under fire since early 2010. Prospects for internationalisation of emerging economy currencies are still limited. The global crisis of 2008-09 has resurrected interest in the special drawing right as an international reserve currency. In this paper, we argue that the SDR fails to meet the main attributes of an international reserve currency - deep and liquid markets, supported by currency convertibility; wide use internationally; macroeconomic and political stability in the issuing country. At this juncture, the critical mass of political will to invest the International Monetary Fund with these responsibilities simply does not exist and/or will take a long time to form. Despite shocks and sometimes acute differences in views on the US dollar, the current system has been resilient over decades, and is likely to remain so for some more years.

SPECIAL ARTICLE

Can the SDR become a Global Reserve Currency?

C Rangarajan, Michael Debabrata Patra

Global economic prospects are worsening rapidly. This has revived the debate on the evolving international monetary system and the international reserve currency that will underpin it. Since the 1940s, the US dollar remains the world’s dominant reserve currency. Developments since 2008 have challenged the pre-eminence of the US dollar. The euro appeared to have provided an alternative during 2000-08, but has come under fire since early 2010. Prospects for internationalisation of emerging economy currencies are still limited. The global crisis of 2008-09 has resurrected interest in the special drawing right as an international reserve currency. In this paper, we argue that the SDR fails to meet the main attributes of an international reserve currency – deep and liquid markets, supported by currency convertibility; wide use internationally; macroeconomic and political stability in the issuing country. At this juncture, the critical mass of political will to invest the International Monetary Fund with these responsibilities simply does not exist and/or will take a long time to form. Despite shocks and sometimes acute differences in views on the US dollar, the current system has been resilient over decades, and is likely to remain so for some more years.

C Rangarajan (c.rangarajan@nic.in) is chairman, Economic Advisory Council to the Prime Minister, and Michael Debabrata Patra (MPatra@ imf.org) is with the Reserve Bank of India and currently at the International Monetary Fund, Washington.

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1 Introduction

O
ver recent months and weeks, global economic prospects have worsened rapidly. A large loss of confi dence hangs over the outlook for advanced economies. This portends a high risk of the global economy slipping back into recession at a time when policymakers have demonstrated that they may be ill-equipped to fight it. Growth across close to half of the global economy comprising the European Union (EU), the US and Japan has stalled or turned down. A dangerous dynamic is taking hold – the debt crisis in Europe is creating new risks for the US economy; the possibility of another US recession worsening the European fiscal crisis even further. In the emerging and developing world, overheating pressures have necessitated countervailing policy action that is causing growth to slow.

In sharp contrast to previous crises, this time around it is sovereigns that are threatened with solvency questions. The euro area sovereign crisis has been the greatest shock in recent months with every attempt to close divisive ranks colliding with unconvinced markets. The senseless US debt crisis has resulted in a first-ever rating downgrade, and left permanent scars on investor psyche. All this has revived the debate on the evolving international monetary system and the international reserve currency(ies) that will underpin it.

The global crisis of 2008-09 had resurrected interest in the special drawing right (SDR) as an international reserve currency, after it being assigned to oblivion for nearly three decades since its creation in 1969. The general proposition is attributed to People’s Bank of China Governor Zhou Xiaochuan on the eve of the G-20 summit in London in April 2009. Support was expressed by the presidents of Russia and Brazil in the run-up to the Brazil-Russia-India-China (BRIC) summit in Yekatrinberg in June 2009. Broader advocacy emerged in the context of concerns about disorderly diversification out of dollars, with suggestions about asset allocation rules stipulating a gradual rebalancing of portfolios (Bergsten 2009).

The idea itself is not new. Similar plans were devised in the late 1970s, when fears about the US dollar’s value were running high. It involved the International Monetary Fund (IMF) setting up a so-called substitution account to allow central banks to swap dollar assets for SDRs. The proposal did not materialise due to disagreement among IMF member-countries about cost sharing. There was also an underlying faith in the intrinsic strength of the US dollar which was proved correct in subsequent years. It was also argued that the very basis of allocation of SDRs, i e, in proportion to member-countries’ IMF quotas is flawed, driven by expediency in facilitating its acceptance by advanced economies and their ratifi cation (Hawkins and Rangarajan 1970). The basis of quota distribution has always been loaded by factors, including political and other special ones, that ensure a higher proportion going to advanced economies. Accordingly, SDR allocation in proportion to quotas is inherently disadvantageous to developing countries. These arguments remain as valid today. The small correction in the bias that is expected out of the 14th general review of IMF quotas agreed upon in November 2010 remains to be tested. More recently, a series of papers emanating from the IMF have attempted to resurrect the SDR’s claim to reserve currency status (IMF 2009, 2010a). Taking the cue from the diversifi cation argument, these papers attempt to situate the advocacy for the SDR in the broader context of the IMF’s responsibility of oversight of the international monetary system.

In this paper, we argue that the SDR fails to make the grade as an international reserve currency on several counts. In fact, these are well-known preconditions or prerequisites that are associated with currencies that qualify in the real world today. In the case of the SDR, the onus to create these enabling conditions rests with the IMF and therein lies the problem. At this juncture, the critical mass of political will to invest the IMF with this responsibility simply does not exist and/or will take a long time to form.

The rest of this paper is divided into six sections. Section 2 sets out the main attributes of a reserve currency, drawing from historical precedent and practical usage. Section 3 discusses the experience with the US dollar as the dominant reserve currency since the second world war, its strengths and pitfalls, especially in the light of the recent experience. Section 4 presents some stylised facts, followed by Section 5 which evaluates some alternatives to the US dollar-centric system. Section 6 examines the arguments being made in support of the SDR as an international reserve currency, the practical issues surrounding the subject, and why the SDR could be a long way off from becoming the Holy Grail. The last section brings it all together and concludes on a pragmatic note on what could endure the test of time, at least in the foreseeable future.

2 Attributes of a Reserve Currency: Blending the Desirable and the Feasible

A reserve currency is quite simply a national currency that serves an international role. Its fulfils the domestic functions of money

– a numéraire for establishing prices, a means of payment, and a store of value, but on a cross-border plane (Cohen 1970; Kenen 1983). An international currency must garner demand beyond its national borders by invoicing imports and exports, by anchoring the exchange rate of currencies pegged to it, by effectuating cross-border payments, and by denominating international assets and liabilities. In addition, just as domestic money serves as an alternative to bartering, an international currency can serve as a “vehicle currency” for trading between pairs of currencies. Such uses are mutually reinforcing.

2.1 A Short Digression through History

The story of the international monetary system is synchronous with the rise and fall of reserve currencies.1 The silver

42 drachma, issued by ancient Athens in the fi fth century BC could have been the first reserve currency that circulated widely beyond Athens. It was followed by the gold aureus and silver denarius coins issued by Rome. Inflation led to a continuous devaluation of the Roman-issued currency from the fi rst century AD through the early fourth century, causing it to give ground to the Byzantine Empire’s heavy gold solidus coin by the sixth century. By the seventh century, the Arabian dinar had partially replaced the solidus. By the end of the 10th century, large fiscal costs also led to a gradual devaluation of the Arabian dinar. By the 13th century, the fiorino, issued by Florence, was widely used in the Mediterranean region for commercial transactions. It was supplanted by the ducato of Venice in the 15th century. In the 17th and 18th centuries, the dominant international currency was issued by the Netherlands, refl ecting that country’s role as a leading financial and commercial power at the time. At that point, paper bills began replacing coins as the international currency of circulation, even though they were not backed by the Dutch government or any other sovereign entity. Beginning in the 19th century, bills and interestbearing deposit claims that could be substituted for gold also began to be held as reserves. This development coincided with the rise of Great Britain as the world’s leading trading nation. Between the 1860s and the outbreak of the fi rst world war in 1914, about 60% of the world’s trade was invoiced in British pound sterling. As UK banks expanded their overseas business, propelled by innovations in communications technology such as the telegraph, the British pound sterling became the dominant international currency. This role for the pound sterling was further enhanced by London’s emergence as the world’s leading shipper and insurer of traded goods and as a centre for organised commodities markets. Growing British foreign investment largely took the form of long-term securities denominated in pound sterling.

At the beginning of the 20th century, however, the composition of foreign exchange holdings by the world’s monetary authorities began to shift – the sterling’s share declined and the shares of the French franc and the German mark increased. However, it is the first world war in 1914 that is widely viewed as signalling the end of Great Britain’s leading role in the international economy. The US dollar’s use internationally as a unit of account and means of payment increased during the interwar period. Following the second world war, under the Bretton Woods system of fi xed exchange rates, the dollar formally took on the mantle of dominant international reserve currency. As the following section will show, this role has been faced with testing challenges right up to the present.

2.2 The Main Attributes of a Reserve Currency

What are the desirable properties of an international reserve currency? International demand for a currency is related to its ability to satisfy the role of international money with low transaction costs, while maintaining the confi dence of private and official users in its value. A key property of fi nancial markets is that the more the currency is used, the lower the transaction

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costs and the greater the liquidity associated with that currency. Thus, there is a positive externality that tends to produce equilibria with only one or a few currencies in widespread international use (Hartmann 1998). Moreover, as illustrated in the foregoing, this externality can produce multiple equilibria due to its interaction with the circumstances of history. Generally, it has been observed that currency use is reinforced by economies of scale or “network externalities” (Kiyotaki and Wright 1989). Once a currency is widely used, it retains incumbency advantages that make it hard to displace.

The supply of international currencies is influenced by the actions of governments to allow international use. This is closely linked to the provision of institutional and policy underpinnings that encourage the development of fi nancial markets and produce macroeconomic stability (Tavlas 1991). Without the existence of markets in various fi nancial instruments and a reasonable amount of investor confi dence in accessing them, the currency’s usefulness in the international realm is limited. If those underpinnings exist, the supply of international currencies can be considered to be close to perfectly elastic: demand can be satisfied through facilities offered by banks and by issuance of domestic and foreign securities denominated in the currency. Conversely, attempts to stimulate international use of a particular currency will be unsuccessful in the absence of demand.

Thus, drawing from history and practical usage in fi nancial markets, the key characteristics of a reserve currency, can be summarised as the following:

  • Deep and liquid financial and foreign exchange markets, facilitating the conduct of foreign exchange policies, managing foreign exchange reserves, managing currency risks effectively, as also supporting financial asset transactions denominated in the reserve currency.
  • Prerequisites: currency convertibility and a credible commitment to an open capital account to facilitate fi nancial flows with minimal transactions costs (Galbis 1996); liquidity (narrow bid offer spreads in normal and stress times); a full yield curve (to be able to manage duration and curve positioning); depth – offering a range of products across different credit qualities (to achieve the desired level of credit risk).
  • Wide use in private sector transactions: a currency with a large share in world GDP, trade, and finance attracts more users and establishes network externalities – by being a large exporter and importer, the country issuing the reserve currency could have a bargaining power to impose use of its currency; the more trading partners such a country has, the more familiar its currency becomes (Iwami 1994). Also, such an economy typically enhances the breadth and depth of domestic fi nancial markets.
  • Caveat: A number of convertible currencies (e g, Swiss franc, or the Swedish krona) are eligible reserve assets, but are not used globally, partly reflecting the constraints for their governments to support transactions at a systemic scale (Eichengreen 2009a).
  • Macroeconomic and political stability: Policymaking institutions with credibility and a track record of maintaining price
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    stability are a critical ingredient to sustain confidence in the currency’s long-term purchasing power.

    Corollary: To the extent that a flexible exchange rate regime can help maintain macroeconomic stability by facilitating domestic price adjustment, this may also be crucial.

    The attractiveness of a currency on an international plane depends on both its ability to retain its value in terms of other currencies and its purchasing power. In addition, it must be usable with low transaction costs. Thus, the various characteristics of a truly international reserve currency are interdependent and reinforcing. Wider political considerations (including military alliances and security) also play a role.

    3 The Rise and Fall (?) of the US Dollar’s Role as Reserve Currency

    Since the 1940s, the US dollar remains the world’s dominant reserve currency (see Section 4). In fact, the share of the US dollar in global reserve assets far exceeds the share of the US in the global economy.

    3.1 The Road to International Currency Status

    It is useful to trace and evaluate the performance of the US dollar as an international reserve currency to draw lessons for assessing the case for internationalisation of the SDR. At the end of the second world war, the US was the only strong economy left in the world. Europe and the UK, in particular, had lost its economic and financial power which ended its role as a global hegemon. The US accounted for 60% of global output, owned 60% of the world’s gold reserves, had modest import requirements and was able to produce much of what the rest of the world needed to resume economic growth (D’Arista 2009). It is, therefore, no surprise that the Bretton Woods system recognised the US dollar as the international reserve currency in 1944-45. Thus, the gold exchange standard that came into being was in practice “a solar system in which the US dollar was the sun” (Dam 1982).

    The ability to issue a currency that is used internationally confers obvious benefits to the issuing country. First, the acquisition of US dollars in currency form is, in effect, an interestfree loan to the US government. In addition, because foreign governments acquire interest-earning US dollar assets in the form of reserves, they lower the interest rate faced by US borrowers. In recent years, the seigniorage revenue of the US from having an international currency has totalled roughly $90 billion per year (World Bank 2011). Second, it is easier for American companies to engage in international activities because it reduces their forex risk. The growth of international trade automatically boosts demand for dollars. Foreign investors and central banks asking for more dollars can help compensate the US current account deficit. By the same token, attracting capital from abroad at low interest rates can compensate capital account deficits. Third, a potential advantage, though much more difficult to quantify, is the ability of the US to avoid the painful adjustment of macroeconomic policies – in fact, to run structural current account deficits without the US dollar depreciating. Yet, as time would tell, this advantage also carries costs. It required the US to subordinate fi scal and monetary policy to the objective of exchange rate stability, an objective that no country could meet over time (Gisselquist 1981). Allowing financial imbalances to build up sows the seeds of a more serious crisis down the road.

    Turning back to the evolution of the US dollar as the dominant reserve currency, the first dollar crisis erupted in 1960 with speculative sales of US dollars for other currencies and some official demand for gold in expectation of devaluation. The US authorities attempted to counter pressure on the dollar through “Operation Twist” (buying long-term securities to depress their yields and raising the yields on short-term securities so as to shift the slope of the yield curve) in 1961. This was followed by a series of capital controls (such as the interest equalisation tax on as US residents’ holdings of foreign securities issued in the US) as the decade progressed.

    The second run on the US dollar occurred in 1967, prompting the Fed to raise interest rates to attract foreign funds and dampen the economy. As rates declined, US banks ignored the voluntary restraint programme and moved funds back to the Euromarket – a move that prompted the next dollar crisis in 1969

    – a “monetary jolt” as the French franc devalued by 10% and speculative flows pushed up the value of the deutschmark by 10%. The countries of the European Economic Community (EEC) responded to the renewed turmoil by imposing capital controls and recommending a revival of the credit system for settling balances under the 1950s Payments Union (Kindleberger 1984). As the unsustainability of the US dollar/gold exchange rate system became increasingly obvious in the 1960s, the credibility of the US dollar as the key reserve currency was increasingly called into question (Triffi n 1960).2 Strident calls for a post-Bretton Woods system led to the Rio Agreement in 1967, authorising the IMF to create and issue SDRs.

    In 1971, the US dollar came under pressure from actions by Germany and France and the Bank of England to convert US dollar balances into gold to alleviate pressure on their currencies. Foreseeing a run on the dollar, President Nixon closed the gold window in August. This effectively ended US dollar convertibility and potentially undermined its role as the global reserve currency since it was technically tantamount to a default by the US. At a meeting of the G-10 nations at the Smithsonian Institution in December, the US announced a devaluation of the dollar to $38 to an ounce of gold, imposed a 10% tariff surcharge on Japanese imports and negotiated upward revaluations of the deutschmark, the yen and the Swiss franc. It also negotiated smaller revaluations of the Belgian franc and the Dutch guilder and even smaller revaluations of the pound, the Italian lira and the Swedish krone. The Smithsonian Agreement was short-lived. Another, much larger run against the dollar took place in February 1973, prompting $10 billion of intervention by central banks in an attempt to stabilise foreign exchange markets. Exchange markets were closed in March and the US took unilateral action, devaluing the dollar to $42.50 for an ounce of gold, letting its currency float and, in 1974, ended capital controls. Those who had argued that the market should set the price of the dollar had prevailed (Dam 1982).

    The 1970s also saw the advent of a number of so-called reserve currencies which formed the SDR basket, based on the criterion of “free usability” defined by the IMF.3 The US dollar’s hegemony as reserve currency was being tested.

    3.2 The Tumultuous Decades: 1980-2000

    The next two decades would witness a roller coaster ride for the US dollar and numerous other currencies. After falling precipitously through the 1970s, the US dollar regained strength in the 1980s following the election of the Reagan administration. This phase ended in 1985 with the Plaza Accord as the strong US dollar was causing structural imbalances with the growing US twin deficits – fiscal and current account. In less than two years thereafter, the US dollar lost half its value. The 1990s was the decade of currency crises – the UK pound sterling (1992); the Mexican peso (1994); the Asian crisis (1997-98); the collapse of the Russian ruble and Long-Term Capital Management (1998); and to a lesser degree, the Turkish lira crisis (2000-01), the Brazilian real (2002) and Argentina. By 1994, the world was mired in a global recession with Japan almost in an outright depression. From 1995-2000 the stated goal of the Clinton administration was a strong dollar. During each and every currency crisis, the Federal Reserve stepped in and either cut interest rates and/or provided massive doses of liquidity to the banking system, including and particularly during Y2K (1999) and 11 September 2001. With liquidity growing faster than the rate of economic growth coupled with a debt boom, the excess liquidity found its way into the stock market, eventually leading up to the dotcom bubble and bust (1995-2000).

    In the interregnum, a challenger to the throne was being born. European economists issued a manifesto on 1 November 1975, calling for monetary union in Europe. An EEC study group report issued in 1977 supported the commitment to resolving monetary instability by the leaders of Germany (Helmut Schmidt) and France (Giscard d’Estaing).4 The next step was the formation of the European Monetary System (EMS) in December 1978 and the introduction of a new unit of account

    – the European Currency Unit (ECU) – based on a basket of currencies. Twenty years elapsed between the introduction of the EMS and the full monetary integration – with the ERM crisis5 in between – that occurred at the end of the millennium with the adoption of a single currency by a majority of the states in the EU. The single currency appeared to have provided stability within the euro area during 2000-08. However, by no means did it shelter it from effects of monetary developments outside the eurozone, or as the recent sovereign debt crisis has shown, from the lack of unifi ed fiscal policy within.

    3.3 The Euro under Fire

    Since early 2010, when the modern tragedy of Greece started to unfold, financial markets have battered the edifice on which the euro came into existence. The ability of the eurozone economies to mount a credible rescue is being severely tested even as we write. A long shadow now clouds the future of the Euro as an international reserve currency. At one time or

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    another, every country in the eurozone has broken fi scal rules intended to ensure that no country takes advantage of monetary union for national purposes. Indeed, they were enabled to do so because the founding agreement of monetary union included no enforceable mechanism for harmonising fi scal policy. Yet, the lack of fiscal union is not a mere question of governance or institutional design. It is a basic problem of legitimacy. It reflects very real differences of culture, language and history across Europe, as well as citizens’ real, if loosely articulated, concerns about surrendering control over their pocketbooks to a distant bureaucracy.

    Even if Europe overcomes the political obstacles, the costs, economic and political, are steep – higher taxes and interest rates in rich nations such as Germany; seemingly endless austerity in less-rich nations such as Greece. A new sense of realism about the goals of European unity is needed along with the means of achieving them. So far, the only widely discussed approach, especially by non-Europeans, has been to launch a far bigger bailout – the only way to stop a fi nancial crisis is to overwhelm it. However, there is a fear that the measures announced by euro leaders recently may prove inadequate and underfunded. Investor concerns have also now turned to Italy, the euro area’s third largest (the world’s seventh largest) economy. The fire power of the European Financial Stability Fund is very much in question. All of these have implications for euro as a currency. There is already a talk of some member-countries leaving euro.

    3.4 Back to the US Dollar?

    While the emergence of the euro has resulted in a small decline in the role of the US dollar over the past decade, the latter has maintained its dominance. Over time, the ease and security involved with investing in US markets has led the rest of the world to take on massive levels of fi nancial exposure to the US. The value of foreign residents’ investments in US companies, real estate, capital markets, and government debt was nearly half of non-US global GDP as of end-2008. Changes in US monetary policy and financial conditions have had a direct wealth impact on foreign residents, infl uencing their expenditures, and posing a difficult dilemma for foreign investors. Individually, foreign investors have an incentive to diversify their portfolios as a matter of prudent risk management. Collectively, however, foreign investors have a strong incentive to maintain their holdings of dollar assets to avoid the risk of dollar depreciation that could undermine their investments.

    Developments since 2008 have challenged the international financial architecture and the pre-eminence of the US dollar. In the aftermath of the global financial crisis of 2008-09, confidence in the US economy has been shaken by its persisting structural imbalances. The US current account has been negative for the past 20 years, reaching 5% of GDP before the global crisis before declining to 3.1% in 2010. The budget defi cit stands at more than 9% of GDP and will be difficult to reduce. These deficits are not offset by sufficient levels of domestic saving. On the contrary, the savings rate of private households

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    is a mere 4% of GDP. Capital inflows from the rest of the world have financed these deficits. Foreign investors account for more than 50% of new subscriptions to US government bonds. This makes the US by far the most highly indebted country in the world. Reducing these imbalances will take many years and will require a highly cautious political strategy if shocks are to be avoided. Any disruption of confidence in the sustainability of the US economy would make it impossible for the dollar to play its role as international reserve currency.

    The growing sense around much of the world is that we have lost both relative economic strength and more important, we have lost a coherent successful governing model to be emulated by the rest of the world. Instead, we’re faced with broken financial markets, underperformance of our economy and a fractious political climate..... The question is whether the exceptional role of the dollar can be maintained (Volcker 2010).

    Like in the 1970s, the Triffin dilemma is back to haunt us again. The world is in a sense hostage to the reserve issuer’s ability to preserve its currency’s value. Reserves concentration in the government debt of one country introduces idiosyncratic risks to the international monetary and fi nancial system stemming from conditions and policy in that country. Policies designed to meet domestic concerns typically do not consider effects on the wider world (e g, a loose monetary policy may be warranted for domestic stability purposes, and yet induce unwanted demand at the global level). Moreover, the system is left vulnerable to policy mistakes as the US debt ceiling gridlock showed.6 The run-up to the crisis showed that IMF surveillance is a very weak substitute, if at all. In fact, the lesson of the crisis is that the IMF like others failed to see it coming, as was evident in glowing Article IV staff reports for the US and the UK in 2007.

    Finally, the challenge of organising international reserve currencies does not stop with the dollar and the euro. There are new economic giants on the horizon. China’s impact on world markets is already one of the biggest political challenges facing the international community. China, India, Brazil and Russia together outstrip Europe in terms of share in global GDP in purchasing power parity terms. As their growth rates are at least double that of the US, together they will soon overtake the US in size. How likely is it that China, which is set to become the world’s biggest economy over the next few decades, will continue to accept the supremacy of the dollar or the euro as international reserve currencies? Financial markets are already anticipating this future event. Although the shares of emerging economy currencies in global currency markets are still limited relative to the US dollar and the euro, prospects for internationalisation of these currencies are being increasingly recognised. Currency internationalisation in respect of key emerging economy currencies has added a whole new dimension to the ongoing debate on the future of the world’s reserve currencies. This is, however, a nascent and evolving process currently, and outside the scope of this paper. Nevertheless, it may be noted that the claim of any emerging market currency to evolve as a reserve currency will require in the first place that the country dismantles all

    86 65 64 59 52 46 24

    End-March 2011 Currency Composition (%)# – an obvious response to the IMF’s failed re($ billion) $ £ Yen Swiss Franc Euro Other

    sponse to the Asian financial crisis of the late

    Global foreign exchange reserves 9,694.47 60.7 4.1 3.8 0.1 26.6 4.7

    1990s. Five top reserve holders are also major

    of which:

    oil exporters. An interesting fact that emerges

    Advanced economies 3,161.94 63.4 2.6 4.7 0.1 25.4 3.8

    Emerging and developing economies 6,532.53 57.8 5.7 2.9 0.1 27.8 5.8is that almost all of the top reserve holders

    End-March 2000 run current account surpluses, the only excep-Global foreign exchange reserves 1,808.71 71.5 2.9 6.3 0.3 17.5 1.5 tions being the euro area (this is set to change of which:as fiscal consolidation begins), India, the US Advanced economies 1,132.18 70.7 2.9 7.2 0.3 17.2 1.7

    and Mexico. Traditionally, reserves have been

    Emerging and developing economies 676.53 73.5 2.9 3.9 0.3 18.3 1.2

    held with a view to ensure financing of the

    # Relates to reserves that could be allocated by currency comprising 63% in 2011 and 90% in 2000 for advanced

    capital controls and allow the currency to be determined by market forces.

    4 Some Stylised Facts

    In recent years, international reserve accumulation has accelerated rapidly. At $9,695 billion at end-March 2011, the global level of reserves recorded a sixfold increase over 11 years measured from March 2000 (Table 1). By contrast, this level

    Table 1: International Reserves: Important Facts

    outstrip those of other reserve currencies such as the yen and euro. More widely, the depth of US capital markets, offering a large variety of products and high volumes of trading, can reduce diversification and portfolio management costs.

    By end-2010, the top reserve holders were mostly emerging and developing countries, the largest being China’s, larger than the next five reserve holders – Japan, Saudi Arabia, Russia, Taiwan and the euro area – taken together (see Charts 2a and 2b).

    Ten of the top 18 reserve holders are from Asia

    countries and 39% in 2011 and 56% in 2000 for emerging and developing countries. Source: COFER Database, IMF. 7

    rose only 1.7 times over the 1990s. Emerging and developing countries have driven this accumulation. Their reserve levels have gone up more than ninefold between March 2000 and 2011, as against less than threefold for advanced economies. The currency composition of reserves has remained concentrated in US dollars, although over the last decade, the share of the US dollar has actually declined by 10.8 percentage points, almost matched by a 9.1 percentage points gain in the share of the euro. The yen has lost ground by about 2.5 percentage points, while the pound sterling has gained 1.2 percentage points in share. Interestingly, the switch out of the US dollar is largely by the Emerging Markets and Developing Countries (EMDCs) with a 15.7 percentage points decline in the US dollar’s share in their reserves and a 9.5 percentage points gain in the share of the euro. For advanced economies, the shedding of US dollar is about 7.3 percentage points with a 8.2 percentage point gain in the euro’s share.

    Chart 1: The Dollar in International Finance (2010, % of World Totals)

    Foreign exchange transactions

    Bank notes held overseas

    International reserves

    Cross-border deposits

    Cross-border bank loans

    Debt securities

    US GDP

    0 20 40 60 80 100 Source: Adapted from IMF (2010a).

    The dollar’s continued preponderance reflects its central role as an international unit of account and medium of exchange for cross-border trade and financial transactions with extremely desirable characteristics of the dollar in terms of liquidity, safety and yield (Chart 1). The US Treasury market volumes far

    current account deficit or specifi cally, imports. Accordingly, the standard norm for adjudging adequacy of reserves was equivalent of three months of

    import cover. As countries globalised and progressively opened up their economies to international trade to smooth domestic consumption and investment, reserve adequacy became larger and a level equivalent to 12 months of imports was considered precautionary. Yet, the fact that the major reserve holders have current account surpluses suggests that these holdings could be nonprecautionary – the desire to boost public savings to ensure intergenerational equity in the context of eventual depletion of oil reserves for oil exporters, and the counterpart to an export-led growth strategy in the case of some Asian economies (Subramanian 2009). Alternatively, reserves are being held for other purposes – the most obvious being the cushion against sudden stops or reversals of the surges of capital flows that emerging and developing economies have been subject since the 1980s. Reserves also fulfil the need for accumulating liqui dity as

    Chart 2a: International Reserves in $ Billion (2010) 0 1000 2000 3000

    China Japan Saudi Arabia Russia Taiwan Euro area South Korea Brazil India Hong Kong Singapore Switzerland Thailand Algeria US Mexico Malaysia Indonesia

    Chart 2b: Current Account Balance/ GDP (2010)

    -5 0 5 10 15 20

    China Japan Eurozone Russia Taiwan Saudi Arabia India Korea Brazil Hong Kong Switzerland Singapore Thailand Algeria US Mexico Malaysia Iran

    Source: WEO Database IMF.

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    a backstop for a potential banking crisis, and also for boosting policy credibility. According to some estimates, such insurance motives account for about two-thirds of current reserve holdings, or over half of the increase over the past decade (Obstfeld, Shambaugh and Taylor 2008).

    The stocks of reserves are high relative to a variety of metrics such as GDP, imports, gross capital formation and short-term debt, especially for emerging economies (Table 2). These numbers exclude substantial foreign assets of the official sector invested in liquid, dollar denominated financial instruments but not recorded as reserves, including in sovereign wealth funds (SWFs), that have grown even more in recent years.

    Table 2: Reserves in Relation to Selected Metrics in 2010

    Global Emerging Economies

    Months of imports 7.6 13.6
    Per cent of GDP 14.7 28.6
    Per cent of gross capital formation 64.4 92.0
    Per cent of money supply 13.3 28.0
    Per cent of short-term debt 840.5

    Total reserves (gold at SDR 35/ounce as reported in the IMF’s IFS; short-term debt is available only for emerging and developing countries. Source: IFS, IMF, various issues; “World Development Indicators 2011”, World Bank.

    More recent data suggest that the pace of reserve accumulation is recovering after the global crisis of 2008-09.8 Some countries will inevitably draw from the crisis experience and build even more reserves. The IMF projects that even if global reserves growth falls steadily to 8.5% per year by 2035 from an average of 15.4% in 1999-2008, their level will reach 690% of US GDP. Shorter term extrapolations suggest reserve levels approaching 120% and 200% of US GDP in 2015 and 2020, respectively (IMF 2010a).

    5 Alternatives?

    Every crisis leads to a catharsis. In the context of the recent crisis, this appears to have taken the form of a search for alternatives. This time around, however, it is not just back to imagining what could be a substitute to the US dollar-based system. It has a broader form, going beyond self-insurance through reserves. Several have been put on the table: third-party insurance (the most infeasible); global or regional reserves pools; and, creating a truly global lender of last resort that is able to deploy its resources rapidly in a crisis – an obvious refl ection of what the IMF is still not perceived to be, due to concerns about governance and stigma – complete with large resources, precautionary and automatic/high access lending/swap lines (the IMF’s Flexible Credit Line (FCL) meets substantially these criteria but has qualification prerequisites that could render it of dubious value in being regarded as a true reserve substitute) and an open mind. At the height of the crisis, the IMF’s outstanding lending commitments were of the order of SDR 100 billion or $150 billion while the US Fed’s swaps amounted to US 600 billion! This suggests that a pure liquidity line should be a better prospect for a reserve substitute and also as a game changer for the way in which the emerging world views the IMF.

    A more recent alternative is a global financial safety net combining all these aspects and coordinated by the IMF. It is important that the IMF treats national reserves also as a part of

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    march 17, 2012 vol xlviI no 11

    this safety net if it has to succeed. In this context, it is also conceivable that several broadly substitutable reserve currencies could emerge over time without any one of them being clearly dominant. The euro, the yen, the Chinese RMB, the Brazilian real, the Russian rouble, the South African rand and even the Indian rupee may be candidates to this multiple currency pool of the future, but absent political will, as stated earlier, this will remain in the realm of imagination. Such a system would impose policy discipline on reserve issuers. Close policy coordination among key reserve issuers would be necessary to keep exchange rate volatility at bay as portfolio selection and management of reserves becomes more active.

    6 Renaissance of the SDR

    With most ideas about reserve substitutes up in the air, the SDR has drawn attention as a proximate alternative on the ground. The crisis has revived interest in a global off-market mechanism for reserve holders to convert their excess reserves into SDR-denominated assets. The principal argument of large reserve holding countries appears to be that it could alleviate concerns of a disorderly diversification out of dollars if the currency turns volatile under the impact of economic and financial repair. For the IMF, it would be a bonanza. Such a move would place it in the centre stage of the international architecture. It would arm it with teeth in the conduct of hitherto neglected multilateral surveillance – “oversight of the international monetary system in order to ensure its effective operation” (Article IV, Section 3 of its Articles of Agreement). In fact, Article VIII Section 7 specifically requires members to undertake to “collaborate with the Fund and with other members in order to ensure that the policies of the member with respect to reserve assets shall be consistent with the objectives of promoting better international surveillance of international liquidity and making the special drawing right the principal reserve asset in the international monetary system.”

    What are the specifi c benefits claimed by the IMF itself? The first one is stability that is associated with a multiple reserve currency system, since the SDR is a composite of currencies. It could thereby provide diversifi cation benefits as it pools together the main reserve currencies and could spread out currency and interest risks. As a sum, it is technically more stable than its individual parts. Second, it would make adjustments smoother. The weights of different currencies in the SDR basket are defined in “hard” terms and adjust automatically on the basis of exchange rate movements, providing a policy disciplining mechanism on reserve issuers. A country issuing too much of its currency would face exchange rate depreciation and loss of weight in the SDR basket. Third, it would spread seigniorage evenly and bring balance to the system. It would also reduce the need for capital receiving countries to export capital to reserve issuers. Balance would be helped by having in place reconstitution requirements that force a member to rebuild spent SDRs over a stipulated period of time. Fourth, it would provide the automatic basis for global policy coordination. Fifth, it would align global “monetary conditions” – the reference rates off which risky assets are priced – more with global

    developments than with conditions in any single economy, followed by SDR 12.1 billion in annual instalments in 1979-81,
    particularly if the SDR basket is broadened (IMF 2009, 2010a). and SDR 161.2 billion in 2009. A special one-time allocation of
    Before evaluating these “so-called” advantages, it may be SDR 21.5 billion took effect on 9 September 2009, bringing to
    useful to digress briefly to facts about the SDR so as to place tal cumulative allocations to about SDR 204 billion (equivalent
    these issues in an appropriate perspective. to about $318 billion).
    Quantitative depiction of the role of the SDR in the inter
    6.1 What Is the SDR? national monetary system is usually in terms of the ratio of
    The SDR is neither a currency, nor a claim on the IMF, its crea- SDR allocation to international reserves which is less than 4%.
    tor. It is actually a potential claim on the freely usable curren- In a more futuristic perspective, this can, however, be ex
    cies of IMF members. Holders of SDRs can obtain these curren panded to encompass potential international transactions
    cies in exchange for their SDRs in two ways: through the which employ the SDR as the unit of denomination at least of
    arrangement of voluntary exchanges between members; and, the first resort. This enlarged set could include lending facili
    by the IMF designating members with strong external posi ties of the IMF such as the workhorse Stand-By Arrangement
    tions to purchase SDRs from members with weak external posi (SBA) and the Extended Fund Facility (EFF) that are fi nanced
    tions. In addition to its role as a supplementary reserve asset, out of its general resources that include holdings of members’
    the SDR serves as the unit of account of the IMF and some other currencies, SDRs, gold, and other assets derived from quota
    international organisations. The value of the SDR is currently subscription payments plus any activated borrowings by the
    defined in terms of a basket of currencies – the euro, Japanese IMF from bilateral/market sources. Recently, the IMF estab
    yen, pound sterling, and US dollar. The US dollar equivalent of lished the FCL has been to allow members with very strong
    the SDR is calculated as the sum of specific amounts of the four track records to access IMF resources based on preset qualifi
    basket currencies valued in US dollars on the basis of exchange cation criteria to deal with all types of balance of payments
    rates quoted at noon each day in the London market and is problems. The FCL could be used both on a precautionary
    posted daily on the IMF’s website. The basket composition is (crisis prevention) and non-precautionary (crisis resolution)
    reviewed every five years to ensure that it reflects the relative basis. Arrangements are renewable and access is determined
    importance of currencies in the world’s trading and fi nancial on a case-by-case basis and is not subject to a preset cap. So
    systems. In the most recent review in November 2010, the far, all three arrangements are in place and all are precau
    weights of the currencies in the SDR basket were revised based tionary with no drawals, but they can be treated as commit
    on the value of the exports of goods and services and the ted resources. It could also include the IMF’s usable resources
    amount of reserves denominated in the respective currencies less the full amount of undrawn balances under existing ar
    that were held by other members of the IMF. These changes rangements. A measure of the resources available for new
    became effective on 1 January 2011 (Table 3). The next review financial commitments in the coming year is the IMF’s for
    will take place by 2015. ward commitment capacity (FCC) which is equal to uncom-
    Table 3: Valuation of the SDR on 1 January 2011 mitted usable resources plus repurchases one-year forward
    Currency Weights Exchange Rate # Dollar Equivalent less repayments of borrowing due one year forward and less
    Euro 0.423 1.2972 0.548716 the prudential balance.
    Japanese yen 12.1 83.56 0.144806 There are other IMF activities in SDRs that could qualify to
    Pound sterling 0.111 1.5444 0.171428 US dollar 0.66 1 0.66 $/SDR 1.52495 SDR/$ 0.655759205 #: dollar per currency; yen is number of yen per dollar. be included in the expanded set. In September 1999, the IMF established the Poverty Reduction and Growth Facility (PRGF) to make the objectives of poverty reduction and growth more central to lending operations. Concessional lending under the
    Source: IMF website: http://www.imf.org/external/index.htm PRGF is administered by the IMF through Trusts which borrow
    Under its Articles of Agreement, the IMF allocates SDRs to resources from central banks, governments, and offi cial insti
    members in proportion to their IMF quotas. Such an alloca tutions generally at market-related interest rates, and lends
    tion provides each member with an asset (SDR holdings) and them on a pass-through basis to PRGF-eligible countries. The
    an equivalent liability (SDR allocation). If a member’s SDR Heavily Indebted Poor Countries (HIPC) Initiative was launched
    holdings rise above its allocation, it earns interest on the in 1996 by the IMF and World Bank, with the aim of ensuring
    excess; conversely, if it holds fewer SDRs than allocated, it pays that no poor country faces a debt burden it cannot manage.
    interest on the shortfall. There are two kinds of allocations: About 45% of the funding comes from the IMF and other multi
    (a) general allocations of SDRs, based on a long-term global lateral institutions, and the remaining amount comes from
    need to supplement existing reserve assets; and (b) special bilateral creditors. The IMF’s share of the cost is fi nanced prima
    allocation which are typically one-time measures, intended rily by the investment income on the proceeds from off-market
    to enable all members to participate on an equitable basis as gold sales. The Multilateral Debt Relief Initiative (MDRI) provides
    in 1997 since some members who had joined the IMF after for 100% relief on eligible debt from three multilateral institu
    1981 had not received any allocation. SDR 9.3 billion was allo tions – the IMF, the World Bank and the African Development
    cated in yearly instalments in 1970-72. A general allocation of Fund – to a group of low-income countries to help them advance
    SDR 9.3 billion was made in annual instalments in 1970-72, towards the United Nations’ Millennium Development Goals
    48 march 17, 2012 vol xlviI no 11 Economic & Political Weekly
    EPW
    (MDGs). The use of the IMF’s resources is consistent with the This is essentially an obligation that is upon the membership
    principle of uniformity of treatment – all countries with per of the IMF. Undoubtedly, the IMF is empowered to conduct
    capita income of $380 a year or less receive MDRI debt relief fi surveillance of its members’ policies with a view to ensuring
    nanced by the IMF’s own resources through the MDRI-I Trust. the stability and smooth functioning of the international
    HIPCs with per capita income above that threshold receive monetary system; but this remains a responsibility of the
    MDRI relief from bilateral contributions administered by the members themselves. The recent experience of Europe shows
    IMF through the MDRI-II Trust. In June 2010, the IMF estab how diffi cult it is to manage a common currency when there
    lished a Post-Catastrophe Debt Relief (PCDR) Trust that allows is no adequate fiscal control over the members who form part
    it to join international debt relief efforts when poor countries of the union. The IMF’s ability to enforce it carries a question
    are hit by the most catastrophic of natural disasters, such as mark related to its governance structure, and the degree of
    the earthquake in Haiti in January 2010. traction it has been able to secure with policymakers. The re-
    This expanded total of resources in SDR terms inc ludes petitive visitations of systemic crises are a testimony to its
    undrawn facilities and future transactions which may not limitations in these spheres.
    even take place. For instance, if there are no further drawals In the current circumstances, an augmented role for the SDR
    on the IMF as the world returns to normal, its uncommitted may actually meet with potential resistance from reserve issu
    resources will not be used. Likewise, the FCL is a purely pre ers who have no direct use for it. The need to convert it into a
    cautionary facility and not likely to be drawn, going by the freely usable currency for most payments transactions means
    experience so far. Furthermore, while these transactions are that reserve issuing countries face a contingent charge on
    denominated in SDRs their ultimate usage may be in one or their currencies which may be undesirable if it coincides with
    more of the major reserve currencies. Nevertheless, in idea of a restrictive monetary policy. They may not be comfortable
    the practical usability of the SDR under current and near-term with demands on their currencies emanating from unpre
    circumstances emerges from this expanded set – its sum dicted sources as when large volumes of home currency are
    accounted for less than 8% of global foreign exchange reserves held overseas, similar to the situation facing the US in the
    at the end of September 2010 (Table 4). early 1970s. Furthermore, it is also necessary to evaluate the
    desirability of making the SDR an international reserve cur
    6.2 Why the SDR Falls Short rency before putting in place the governance reforms that are
    It is important to assess how the SDR performs against the key required to make the IMF more representative, legitimate,
    prerequisites of an international reserve currency that were accountable and even-handed. Another issue is that the large
    identified in Section II. First, the SDR’s global monetary role volumes of issuances that the SDR internationalisation will
    has thus far been very limited. There are virtually no deep entail could be undesirable for economic reasons – it could
    and liquid markets in which the SDR can be traded and hedged thwart genuine macroeconomic adjustment where needed, or
    with, or used in the settlements of transactions, either trade even encourage countries with fragile debt positions to spend
    and fi nancial. The SDR’s role as a store of value is also extre their way out of trouble.
    mely limited, i e, SDR holdings in the reserves of countries is To argue the counterfactual, what will it take to make the
    extremely low and mostly related to transactions related to SDR a truly international reserve currency? First, it must be a
    the IMF. The SDR’s usage has remained essentially rest ricted monetary liability of the IMF, just like the other reserve cur
    to the official sector – international fi nancial institutions, rency with its value guaranteed by the fiat of the membership
    national governments. Second, the SDR is not used as an in of the IMF. For the SDR to become a true international cur
    voicing currency or in other private sector transactions. Con rency, in other words, the IMF would have to become more like
    sequently, there are no network externalities associated with a global central bank and international lender of last resort
    the SDR, effectively circumscribing its wide use. There is also (Eichengreen 2009b). This warrants careful consideration.
    little or no evidence of any preference of holding assets Will it need to be backed by a globally unified monetary policy
    denominated in the SDR. Third, and mostly as a corollary, the and are members willing to subjugate national discretion to
    IMF is not required to pursue credible and prudent monetary supranational authority? Inflation and growth outcomes may
    and financial policies that underwrite the stability of the SDR. differ across countries for country-specific reasons. This clearly
    Table 4: Potential SDRs in Global Liquidity: End 2010 (SDR Billion) requires a critical mass of political will by its membership to
    Cumulative allocation of SDRs 204 vest the IMF with this power. It may be recalled that at the time
    Credit outstanding under IMF’s general resources account 55.6 of the establishment, Keynes’ bancor was a proposal for a
    Credit outstanding under poverty reduction and growth trust 4.8 global currency, but the world shied away from it and never
    Cumulative disbursements: heavily indebted poor countries initiative 2.5 returned it to the table.
    Cumulative disbursements: multilateral debt relief initiativePost-catastrophe debt reliefCommitments under flexible credit line IMF’s uncommitted usable resources 3.5 0.2 47.5 What else would be required? As a first step, increasing the role of the SDR in the global monetary system would require a significant increase in the stock of SDRs through substantial
    (includes repurchases one year forward and prudential balances) 201 and regular allocations of new SDRs of at least the size of the
    Total of above as a proportion to global reserves Source: IMF website: http://www.imf.org/external/index.htm 8.2 cumulative allocation currently available on an annual basis. It has also been proposed that targeted periodic allocations to
    Economic & Political Weekly march 17, 2012 vol xlviI no 11 49
    EPW

    a subset of members that are accumulating reserves could be considered (IMF 2010a). This will require fundamental reform of the IMF. Second, the IMF and its membership must engage in the development of deep and liquid markets for SDRs outside the confines of the official sector so that holdings of SDRs are encouraged across the world in view of easy transferability/ convertibility and exchange. To facilitate this development, the IMF, other financial institutions and national governments should be ready to issue instruments such as bond and notes denominated in SDRs which can be fluently traded. An SDR yield curve would need to emerge as a global public good to price other instruments off it. Subsequently, the private sector could be incentivised to issue its own instruments in SDRs. It has to be recognised that to the extent that demand for SDRdenominated assets remains less than for the component currencies, a liquidity premium would prevail. Is this price worth paying? Third, promoting invoicing of international trade and fi nance in SDRs could further enhance its role as a reserve asset. Invoicing commodities such as oil could be a useful and visible starting point. Fourth, developing clearance systems in SDR-denominated instruments would also facilitate private use, although settlement may eventually need to be in one of the constituent currencies. Easier said than done! How for instance, to overcome market participants’ inertia in using existing reserve currencies for invoicing and settlement? One incentive that has been proposed is to get countries to peg their exchange rates against the SDR (IMF 2009), and we are back to the days of Bretton Woods!

    Finally, it is necessary to ask: is all this really feasible? Currently, restrictive allocation rules and complicated usage rules laid out in the Articles of Agreement and Executive Board decisions of the IMF will render it extremely difficult if not impossible. The hurdles are very significant and require an extraordinary age of global cooperation to bring these changes in. The 85% majority of the total voting power of the Board of Governors sets a high threshold for both allocations and cancellation and, therefore, makes both more difficult to achieve.

    7 Conclusions

    In the final analysis, the SDR is not a currency; it was never intended to be one. It was created as an international unit of account and that is what it is best suited to be. It is diffi cult to conceive of an international monetary system based on a unit of account without an actual currency role.

    Why is the SDR being resurrected? The main reason can be correction of global imbalances by the IMF and de-concentration of reserve holding patterns by large reserve holders. The SDR is not the remedy. It might become a part of the problem. In the absence of a global adjustment mechanism, this role is best played by active, incisive and equitable surveillance by the IMF. The surveillance function has a critical pre-emptive role in the context of crises in contrast to its lending function which is a crisis mitigation tool. Early warnings that have traction with its membership, drilling down into the specific aspects of macroeconomic policies of members with special emphasis on inconsistencies that can have external effects, equal emphasis on multilateral and bilateral surveillance, and addressing of risks to global financial stability wherever they may lie are the hallmarks of the desired surveillance role of the IMF. If reserve accumulation is a by-product of exchange rate policy, the cause must be addressed unequivocally. If reserves are the counterpart of quantitative easing or of persistently high defi cits by a reserve issuing country, the IMF should call a spade by its name. The IMF was designed to be an institution that leverages its relatively small financial resources with its relatively large human resources. The IMF must decide what it wants to be – the global policeman that it has failed to be or honest and trusted policy advisor, a role it must explore and aspire for. It is said that no one can hold back an idea whose time has come. For the time being, the SDR must await its moment of reckoning.

    Despite shocks and sometimes acute differences in view on the US dollar, the current system has been resilient over decades. Arguments continue to be made that there is no necessary connection between US deficits and reserve accumulation, and that relatively favourable demographic trends in the US and the likely persistence of high savings in emerging markets are consistent with sustainable growth (Truman 2009, 2010; Cooper 2008). As global demand for reserve assets grows in relation to the US economy, a more acute trade-off between domestic priorities and international monetary stability is conceivable. Yet, in the near future, factors such as inertia in currency use, the large size and relative stability of the US economy, and the dollar pricing of oil and other commodities will help perpetuate the dollar’s role as the dominant medium for international transactions. The hard facts predicate this outcome. The US dollar is a major form of cash currency around the world. Roughly 75% of 100 dollar notes, 55% of 50 dollar notes, and 60% of 20 dollar notes are held abroad, while about 65% of all US banknotes are in circulation outside the country (Goldberg 2010). In 2010, eight countries used the US dollar as legal tender, nine countries has currency board using the US dollar, 15 had conventional pegs against the US dollar, 12 had exchange rate arrangements that stabilised their currencies against the US dollar, two had crawling pegs, two had crawl-like pegs and three other managed arrangements linked to the US dollar (IMF 2010b). A shift away from dollar assets, including Treasury securities, could be a concern for the US if divestiture triggers higher funding costs. However, such a drastic outcome appears unlikely.

    The future of the dollar in this context continues to be the subject of discussion and policy statements, but the currency’s status has been maintained and is likely to remain so for some more years. As the size and structure of the global economy change, international currency use may change as well, and the currency’s pre-eminence could diminish in the future. Indeed, historical precedent exists for the rise and fall of the international status of currencies. The question is not “if” but “when”. Accordingly, it seems important in the context of global stability to monitor the role of the US dollar in international economic activity and to understand the potential causes and consequences of the dollar’s changing international role.

    march 17, 2012 vol xlviI no 11

    Notes

    1 For a fuller exposition, see World Bank (2011).

    2 Testifying before the US Congress in 1960, Robert Triffin pointed out that if the US stopped running balance of payments defi cits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral. However, excessive US deficits (dollar glut) would erode confidence in the value of the US dollar. Without confidence in the dollar, it would no longer be accepted as the world’s reserve currency. The fixed exchange rate system could break down, leading to instability. Triffi n proposed the creation of new reserve units, not dependent on gold or the US dollar, to enable global economic expansion without chronic US deficits. “A fundamental reform of the international monetary system has long been overdue. Its necessity and urgency are further highlighted today by the imminent threat to the once mighty US dollar.”

    3 In addition to the US dollar, these currencies were Deutsche Mark (DM), Japanese Yen, French Franc, Pound Sterling, Canadian dollar, Italian Lire, Netherlands Guilder, Danish Krone, Belgian Franc, Swedish Kroner, Australian Dollar, Norwegian Krone, Spanish Peseta, Austrian Schilling, and South African Rand. The number 16 was chosen because it happened to be the cut-off point for countries accounting for at least 1% of world exports. In 1978, the IMF dropped the Danish krone and the South African rand from the SDR, added the Saudi Arabian riyal and the Iranian rial. Only nine currencies had well developed financial markets. In addition to the G-5 currencies, these included the Italian lira, the Netherlands guilder, the Canadian dollar, and the Belgian franc. Effective 1981, the SDR basket was reduced to the G-5 namely, the US dollar, the DM, the French Franc, the Pound Sterling and the Japanese Yen (de Vries, 1976). The IMF defines a freely usable currency as on the IMF determines is “(i) widely used to make payments for international transactions, and (ii) is widely traded in the principal exchange markets” (Article XXX, Section (f) of IMF Articles of Agreement).

    4 Economic and Monetary Union – Draft Communication to the Council, European Commission, 1977, October.

    5 The European Exchange Rate Mechanism, ERM, was introduced by the European Community in March 1979 to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for the introduction of a single currency, the euro, which took place on 1 January 1999. A grid of bilateral rates was calculated on the basis of the central rates expressed in ECUs, and currency fl uctuations had to be contained within a margin of 2.25% on either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6%). Shortly after the launch of the ERM, the pound sterling, which was not an ERM currency, appreciated against all ERM currencies. The UK entered the ERM in October 1990, but was forced to exit the programme within two years after it came under major pressure from currency speculators, including George Soros. The UK spent over £6bn trying to keep the currency within the narrow limits. The ensuing crash of 16 September 1992 was subsequently dubbed “Black Wednesday”. In 1993, the margin had to be expanded to 15% to accommodate speculation against the French franc and other currencies. On 31 December 1998, the European Currency Unit (ECU) exchange rates of the countries were frozen and the value of the euro, which then superseded the ECU at par, was thus established. In 1999,

    Economic & Political Weekly march 17, 2012

    EPW

    ERM II replaced the original ERM. EU countries that have not adopted the euro are expected to participate for at least two years in the ERM II before joining the eurozone.

    6 The world has found the dysfunctional political wrangling on raising the debt limit baffl ing, given that it is reported to have been raised 102 times by Congress since 1917. Doomsday scenarios of the aftermath of a US default that fl ooded the media do not inspire confidence in the US recovery or in the credibility of US public fi nances. US financial markets generate the maximum outward spillovers and the global consequences of a US default or even a downgrade would be disastrous. In terms of the US fi scal position alone, they would imply a question mark on the ability to fund future deficits however small they may be, even fuel flight to safety out of US paper, additional interest payments on Treasury debt hitherto considered riskless, and eventually threats to business investment, consumer spending, employment and confi dence.

    7 COFER is an IMF database that keeps end-ofperiod quarterly data on the currency composition of official foreign exchange reserves. Foreign exchange reserves in COFER do not include holdings of a currency by the issuing country. The definition of foreign exchange reserves in COFER is the same as that in the IMF’s International Financial Statistics (IFS). Currently, 139 countries report to COFER. The unallocated reserves in COFER refer to the difference between COFER reportings and the total reporting for the IFS which comprises all 187 member countries of the IMF.

    8 Data from the IMF’s International Financial Statistics indicate that between end-2008 and end-2010, global reserves increased by almost 30%. Reserve accretion by advanced economies during this period was of the order of 31.2%, faster than the global rate and that of emerging and developing countries (29.4%).

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