Wednesday, April 15, 2009

a claim, or even simply an IOU. The current composition is USD 44%, EUR 34%, JPY 11% and GBP 11%

TO BE NOTED: From Shadow Bankers:

"Michele Bachmann and SDRs

By Ranjan X. Roy

Michele Bachmann (R-MN), best known for her views on “re-education camps” and McCarthyism, recently introduced a “resolution that would bar the dollar from being replaced by any foreign currency,” in response to Chinese comments regarding the potential use of SDR’s as a global reserve currency. When I paused to evaluate the resolution, visions of Freedom Fries danced through my head.

Rather than addressing the vital impact currency reserves and related policy have had on the current crisis and our future prosperity, Bachmann’s “legislation” was an absurd digression rooted in paranoia. Bachmann articulated her fears on the Glenn Beck show:

What that means is that all of the countries of the world would have a single currency. We would give up the dollar as our currency and we would just go with a one world currency. And now for the first time, we’re seeing major countries like China, India, Russia, countries like that, calling for a one world currency and they want this discussion to occur at the G20… Once you lose your economic freedom, you lose your political freedom. And then we are no more, as an exceptional nation, as we always have been. So this is imperative.

Central banks and monetary authorities globally have accumulated more than $6 trillion of currency reserves as of 2007, with 63.9% being held in USD. While the mechanics and history of reserve currencies are complicated, what is certain is the massive increase in USD reserves held by nations like China is a vital issue of economic policy that must be addressed to bring longer-term global prosperity into balance.

To be clear, no one, including Geithner, Zhou Xiaochuan (the Governor of the People’s Bank of China), or Obama, has ever suggested replacing the currency of individual nations with a single global currency akin to the Euro for the EMU. What is being addressed is the critical issue of how to manage the risk involved with USD volatility and its effect on FX reserves. Governor Zhou, prior to the G20 meeting, simply indicated that:

The role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system.

It is crucial to note the non-committal nature of the statement, which does not even regarding SDR’s as the light at a proverbial “end” of the tunnel in monetary policy reform. What Zhou is addressing are the risks involved with a global reliance on USD as a reserve. China, after a decade of keeping an artificially weak Yuan to promote export growth, has suddenly found itself in the position of being tremendously “long” on the USD via currency intervention (they bought USD assets to artificially keep the CNY weak, thus keeping their exports to the US cheaper). Monetary growth in the US, inflationary by its nature, could have a negative impact on their assets, and China has naturally begun to address the issue.

Zhou’s reference to SDR’s as a potential replacement was the key that turned on the paranoid Bachmann engine. SDRs, or Special Drawing Rights, are a tool traditionally utilized by the IMF. It is crucial to understand that SDRs are a specific and logical tool used by the IMF to create a better system of debt issuance when they step in to help countries. IMF loans are denominated in SDRs to control for major currency volatility (i.e. the EUR/USD exchange rate) for loans to emerging nations. Rather than having the loan denominated in one specific currency, the loan is denominated against a basket of currencies. This prevents situations such as Argentina receiving a loan from the IMF in USD, the USD depreciating against the EUR, and Argentina now finding itself impaired from purchasing goods from Europe, through no actions of its own.

A SDR, as defined by the IMF’s website, is not actually currency, but rather a claim, or even simply an IOU. The current composition is USD 44%, EUR 34%, JPY 11% and GBP 11%. The mechanics from the IMF website indicate that the borrowing nation would be able to use the SDR to claim any currency issued via “voluntary exchanges” or IMF designation of partners. The SDR certificate that the borrower holds would now have limited currency volatility, but could be used if the borrower requires hard reserve currency by arranging a swap with a participating central bank:

[T]he SDR has only limited use as a reserve asset, and its main function is to serve as the unit of account of the IMF and some other international organizations. The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.

SDRs are a specialized, but useful tool in creating a more stable borrowing environment for troubled economies. However, the Bachmann Paranoia Meter should remain on low alert for now, as the logistics and political implications of a sudden switch from the USD as the world’s reserve currency make it very unlikely in the short term. First, China cannot afford a sudden flight from the USD as it would tremendously impact their own assets. Second, a SDR is simply a tool Governor Zhou provided as an example of international cooperation resulting in a more stabilized market environment, not China’s master tool to end US power. Third, as the SDR is not a traded currency, we are light years away from a system that could easily trade goods like oil or gold via an international reserve unit. The system in place is extremely limited and requires explicit exchanges between “voluntary” IMF partners. The logistics involved in setting up a system that could manage these transactions, considering the trillions of dollars of currency exchanged daily, is somewhat inconceivable. Finally, the US is still a dominant force behind both the IMF and global monetary policy, and is in no danger of being shut out of any decisions made related to monetary reform.

The issues that have arisen from the global dependence on the USD as a reserve unit have made clear this is an issue that will continue to be addressed in the coming decade. Rather than “world government” ranting, this is an opportune time where competing governments have a shared interest in a lack of volatility or any sharp market adjustments and should work towards creating a more stable global monetary system.

(Note: The G20 meeting held post the initial SDR hoopla saw important developments related to the issue that will be addressed in a follow-up post.)"

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