Big conversions by China or another large holder, or even market fears thereof, could trigger a massive run on the dollar.

TO BE NOTED: From the FT:

"We should listen to Beijing’s currency idea

By Fred Bergsten

Published: April 8 2009 20:12 | Last updated: April 8 2009 20:12

Zhou Xiaochuan, governor of China’s central bank, has suggested creating a “super-sovereign reserve currency” to replace the dollar over the long run. He would sharply enhance the global role of special drawing rights, the inter­national asset created by the Inter­national Monetary Fund in the late 1960s and just given an enormous boost by the decision of the Group of 20 to expand its issuance by $250bn (€189bn, £171bn). These are the first big proposals for international monetary reform from China or indeed any emerging market economy and deserve to be taken seriously for that reason alone.

Several other Asian countries, Brazil and Russia have expressed support for Mr Zhou’s ideas. The US and several other governments, however, have been quick to reject them, reaffirming their confidence in the central global role of the dollar. They apparently fear that serious discussion of this issue could shake confidence in the dollar, driving down its value and prompting a sharp rise in the euro and other currencies. Such instability and consequent rise in global interest rates would severely complicate US, European and global recovery from the crisis.

But there is a more immediate threat to financial stability from the global role of the dollar that could be significantly reduced by pursuing a more limited proposal made by Mr Zhou. The risk is that China and perhaps other monetary authorities, together holding more than $5,000bn in dollar reserves, will lose confidence in the dollar owing to the prospects for huge and sustained budget deficits in the US. Premier Wen Jiabao recently expressed such concerns in a highly unusual public statement, asking for “guarantees” of China’s dollar holdings that recall the British demand for a guarantee in 1971 that triggered the US decision to break the dollar’s link to gold.

These worried dollar holders have refrained from dumping Treasury securities only because the dollar has strengthened over the past year – which is almost certainly a temporary phenomenon – and because of the adverse global repercussions. We ignore at our peril the prospect that they may feel compelled to do so, especially if the US were to provoke the Chinese by taking aggressive trade policy actions against them. Big conversions by China or another large holder, or even market fears thereof, could trigger a massive run on the dollar.

Mr Zhou proposes to alleviate this problem by creating “an open-ended SDR-denominated fund” at the IMF into which dollar balances could be exchanged for SDRs. This is essentially the substitution account idea negotiated in the IMF in the late 1970s and for which detailed blueprints were developed. Similar anxieties about the dollar at that time prompted its sharpest plunge in the postwar period, intensifying the double-digit inflation and soaring interest rates that brought on the deepest US slowdown since the 1930s, until now.

I set out how the idea would work in an article on these pages in December 2007, in which Chinese officials displayed considerable interest. Instead of converting unwanted dollars through the market, official holders would deposit them in a separate IMF account for SDR. Their new asset would be liquid and pay a market rate of return. It would offer the desired diversification as the SDR is denominated in a basket of currencies – 44 per cent dollars, 34 per cent euro and 11 per cent each of yen and sterling.

The substitution account would be a winning proposition for all concerned. The dollar holders would obtain instant diversification. The US would avoid the risk of a free fall of the dollar. Europe would prevent a sharp rise in the euro. The global system would eliminate a potential source of great instability. These benefits call for the use of a global asset to make up any losses to the account from future falls in the dollar, such as creation of additional SDR or the IMF’s gold holdings (including the sizeable US share of them).

The main argument against such an account is that China has accumulated its dollar hoard of more than $1,000bn by keeping its currency substantially undervalued, through massive intervention in the foreign exchange markets, and thus deserves no sympathy if it takes losses on those dollars. One might even suspect that the Chinese have mentally booked such losses as the implicit cost of the subsidy to exports and jobs achieved through their currency manipulation. But there is no sign that China will stop intervening, or that its surpluses will abate, even though the US external deficit has declined sharply, and its reserve build-up is thus likely to become even more threatening.

Moreover, this is an ideal issue for China and the US to develop the informal “G2” partnership that is needed to provide global economic leadership to pass needed reforms at the existing multilateral institutions. Since China advocates currency consolidation, the US could insist that it contribute substantially to the IMF’s new lending facilities as a quid pro quo. The Europeans would have to concur, since the agreement would include a large increase in China’s voting rights at the IMF, where Europe is so heavily over-represented, but China-US agreement would go far to seal the deal.

The writer is director of the Peterson Institute for International Economics. He was assistant secretary of the Treasury for international affairs in 1977-1981 and led the substitution account negotiations for the US in 1980"

Chinese policy makers increasingly seem to view China’s large reserves as a burden, not as an opportunity.

TO BE NOTED: From Follow The Money:

"The PBoC’s call for a new global currency, the SDR, the US and the IMF

Posted on Sunday, March 29th, 2009

By bsetser

A $200 billion shared pool of reserves ($250 billion counting the IMF’s supplementary credit line) is tiny relative to the world’s $7000 billion in national reserves, or — more importantly — relative to the emerging world’s short-term external debt. The IMF currently lacks enough funds to be a lender of last resort for Eastern Europe, let alone the world. George Soros:

“capital is fleeing the periphery and it is difficult to rollover maturing loans. …. To stem the tide, the international financial institutions (IFIs) must be reinforced … the fact is that the IMF simply doesn’t have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and potential needs are much greater.”

A bigger IMF implies a somewhat larger role for the IMF’s unit of account: the Special Drawing Right (SDR), itself a basket of dollars, euros, pound and yen. When the IMF lends, its loans are denominated in SDR – not dollars, euros or yuan. China may argue that SDR-denominated lending is the first step toward creating a new “supranational” reserve currency. But that is a stretch. No one made such an argument back when the IMF was making a lot of SDR-denominated loans to Asia in the 1990s.

The IMF pools contributions from many countries, so denominating its accounts in a composite of the world’s main currencies make sense. Using the SDR inside the IMF isn’t a threat to the US dollar either. Last I checked, the dollar has somehow managed to maintain its position as the world’s leading reserve currency even though United States’ contribution to the IMF (its quota) is measured in SDR.

Indeed, the SDR – as the IMF explicitly recognizes on its website – isn’t actually a currency.

“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.”

Countries intervene in the foreign exchange market with dollars and euros not SDR. An IMF loan is just denominated in SDR – so the amount a country has to repay doesn’t change all that dramatically when the dollar moves v the euro. In practice countries actually want to borrow “freely usable currencies” not SDR. In other words, they generally want dollars and euros.

As Dan Drezner observed, many traders presumably hadn’t read Governor Zhou’s white paper or spent much time brushing up on the mechanics of the SDR . They consequently read a bit too much into the headline that was slapped onto Geithner’s comments at the Council. Macroman is right:

“Geithner said that …. he was certainly open to expanding the pool of IMF SDRs. This was an innocuous enough comment, as the IMF is likely set to see its funding levels increase dramatically.”

Deal Journal is wrong; Geithner never said he was only open to “abandoning the U.S. dollar as the primary global reserve currency.” He was open to increased “use of the IMF’s special drawing rights” but he also said this was “rather evolutionary, building on the current architectures, than — rather than — rather than moving us to global monetary union.”

Indeed, Zhou’s call for a one time SDR allocation (an SDR allocation is complicated ** but it effectively is a way for the advanced economies to help meet emerging economies need for hard currency reserves) is less radical than Martin Wolf’s call for an annual SDR allocation. Soros also wants an annual allocation as long as the crisis lasts. Wolf hopes an annual SDR allocation would allow emerging economies to build up reserves without running large current account surpluses.

A one time SDR allocation to increase the emerging world’s access to dollars and euros (the main current reserve currencies) is quite different than redenominating all of the world’s reserves into SDR. The world’s reserves couldn’t actually be redenominated in SDR unless the US and a host of eurozone countries started issuing a ton of SDR debt to replace all the dollar-denominated Treasuries and euro-denominated bunds, OATs and BTPs*** — now held as part of the world’s reserve portfolio. That isn’t about to happen.

I am still struggling to understand precisely what motivated Governor Zhou’s white paper.

One possibility is that he wanted to highlight the fact that the IMF doesn’t operate in dollars to help “sell”a bigger Chinese contribution to the IMF at home. Zhou can argue that China isn’t handing dollars over to a US dominated institution, as some might think. Or helping to bail out a bunch of countries in Eastern Europe peripheral to China’s national interest. By providing the IMF with SDR, China can argue that it is contributing in a small way to the creation of a new reserve currency.

The Journal’s Batson hints as such a motivation when he reports:

“China has resisted the U.S. push to make an immediate loan to the IMF because that wouldn’t give China a bigger vote. Ms. Hu said Monday that China, which encourages the IMF to explore other fund-raising options, would consider buying into a bond issue. The IMF has been working on a proposal to issue bonds, probably only to central banks”

Of course, Zhou’s call for a new global reserve currency was also intended to signal China’s concern about the direction of US policies. And just perhaps, to signal that China’s government is taking domestic criticism that it has squandered China’s savings to heart.

It some ways Zhou’s call is a sign of weakness as much as a sign of strength, as China’s leaders are now is clearly worried about the value of its reserve portfolio. Or perhaps they are just worried about being blamed for losses on China’s reserve portfolio.

Chinese policy makers are sophisticated enough to know that the US is not going to embrace a true supranational currency. Agreeing to a world where the IMF calculate its accounts in a basket of dollars, euros, pound and yen is one thing. Agreeing to a new currency that supersides the dollar is quite another.

Moreover, China’s call for a change in the global order is rather undermined by China’s ongoing desire to peg to the plain old dollar.

A discussion of reserve currencies ultimately is also a discussion about the exchange rate regimes that led a host of emerging economies to accumulate reserves. Zhou’s call puts some issues that China hadn’t wanted to discuss at the last leaders meeting on the table for international discussion.

Perhaps China’s leaders wanted to insulate their dollar peg from criticism, both at home and abroad, by arguing that they cannot change their peg without a broader change in the international monetary regime. China can argue that if the US doesn’t want to abandon the dollar, China shouldn’t be pushed to abandon its dollar peg.

The only problem is that there is no real link between the two issues. China could easily join those emerging economies that already allow their currencies to float against the dollar and the euro even in the absence of any agreement on a new global currency.

In a lot of ways, though, the most surprising proposal in Zhou’s paper wasn’t his call for a new global currency; it was his call for “international” management of national reserves. Zhou wrote:

Compared with separate management of reserves by individual countries, the centralized management of part of the global reserve by a trustworthy international institution with a reasonable return to encourage participation will be more effective in deterring speculation and stabilizing financial markets …. With its universal membership, its unique mandate of maintaining monetary and financial stability, and as an international “supervisor” on the macroeconomic policies of its member countries, the IMF, equipped with its expertise, is endowed with a natural advantage to act as the manager of its member countries’ reserves

That would really be a change. China currently isn’t willing to tell the IMF the currency composition of its reserves. And now it seems to be hinting that it might allow the IMF to manage a portion of its reserves!****

Chinese policy makers increasingly seem to view China’s large reserves as a burden, not as an opportunity.

Unfortunately, China is already stuck with this burden. In some sense, the current debate in China over the cost of maintaining a large reserve portfolio is a debate China should have had four or five years ago. Back then it was clear that China had put itself on a path that would lead it to accumulate huge reserves at a substantial cost to itself. It didn’t change though. As a result, it ended up providing a lot of dollar-denominated credit to the US over the last four years.

Now it is struggling to accept the consequences of the policy choices that left it with over 50% of its GDP in reserves or quasi-reserves.

That presumably is why previously unthinkable options – like global management of China’s reserves – seem to be getting serious consideration.

*”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.”
** As I understand it, the IMF grants all countries SDRs. And then emerging economies can use their SDRs as collateral to borrow dollars and euros and the like from the central banks of the world’s advanced economies. It is a way countries that don’t have currencies of their own that the Fed is willing to accept as collateral in swaps can get hard currency reserves. If there is a better explanation, I am all ears.
*** German, French and Italian government bonds
**** Dr. Summers, in his academic days, made a similar proposal."

is concerned about the potential inflationary risk of the US Federal Reserve printing money

TO BE NOTED: From the FT:

"China wants dollar replaced as reserve currency

By Jamil Anderlini in Beijing

Published: March 23 2009 12:16 | Last updated: March 23 2009 14:22

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

The goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies,” Zhou Xiaochuan, governor of the People’s Bank of China, said in an essay posted in Chinese and English on the central bank’s website.

Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

“The outbreak of the [current] crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Mr Zhou wrote.

Analysts said the proposal was a clear indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China. (NB DON )

“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC. ( NB DON )

For now, China has little choice but to hold the bulk of its $2,000bn of foreign exchange reserves in US dollars and this is unlikely to change in the near future.

To replace the current system, Mr Zhou suggested expanding the role of Special Drawing Rights, which were introduced by the IMF in 1969 to support the Bretton Woods fixed exchange rate regime but became less relevant once that system collapsed in the 1970s.

Today, the value of SDRs is based on a basket of four currencies – US$, Yen, Euro and Pound Sterling – and they are used largely as a unit of account by the IMF and some other international organizations.

“The US dollar is still the most important currency for settling international trade, pricing and payment in the current international monetary system,” Hu Xiaolian, director of the State Administration of Foreign Exchange, which manages the country’s foreign exchange reserves, said at a press conference earlier in the day. “Investing in US Treasury bonds is an important element in China's forex reserve investment and we will continue this practice.”

China’s proposal would expand the basket of currencies forming the basis of SDR valuation to all major economies and set up a settlement system between SDRs and other currencies so they could be widely used in international trade and financial transactions.

Countries would entrust a portion of their SDR reserves to the IMF to manage collectively on their behalf and SDRs would gradually replace existing reserve currencies.

Mr Zhou said the proposal would require “extraordinary political vision and courage” and explicitly acknowledged a debt to the theories of John Maynard Keynes, who made a similar suggestion in the 1940s.

More recently, US economist and Nobel prize winner Joseph Stiglitz, who is visiting China this week, has suggested expanding the role of SDRs to lay the foundation for the creation of a world currency.

In the short term, China expects the IMF to “at least recognize and face up to the risks resulting from the existing system, conduct regular monitoring and assessment and issue timely early warnings,” Mr Zhou’s essay said."

And:

Reform the International Monetary System

Zhou xiaochuan

The outbreak of the current crisis and its spillover in the world confronted us with the long existing but still unanswered question��i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF? There were various institutional arrangements in an attempt to find a solution, including the Silver Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system. The above issue, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system.

Theoretically, an international reserve currency should first be anchored to a stable benchmark and issued according to a clear set of rules, therefore to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country. The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history. The crisis called again for creative reform of the existing international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply, so as to achieve the objective of safeguarding global economic and financial stability.

I. The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries' demand for reserve currencies. On the one hand��the monetary authorities can not simply focus on domestic goals without carrying out their international responsibilities��on the other hand��they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they tries to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triniffin Dilemma, i.e., the issuing countries of reserve currencies can not maintain the value of the reserve currencies while providing liquidity to the world, still exists.

When a national currency is used in pricing primary commodities, trade settlements and is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies. While benefiting from a widely accepted reserve currency, the globalization also suffers from the flaws of such a system. The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies. Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.

II. The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.

1. Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back to the 1940s, Keynes had already proposed to introduce an international currency unit named "Bancor", based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may be more farsighted. The IMF also created the SDR in 1969, when the defects of the Bretton Woods system initially emerged, to mitigate the inherent risks sovereign reserve currencies caused. Yet, 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.

2. A super-sovereign reserve currency not only eliminates the inherent risks of credit-based sovereign currency, but also makes it possible to manage global liquidity. A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country's currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.

III. The reform should be guided by a grand vision and start with specific deliverables. It should be a gradual process that yields win-win results for all

The reestablishment of a new and widely accepted reserve currency with a stable valuation benchmark may take a long time. The creation of an international currency unit, based on the Keynesian proposal, is a bold initiative that requires extraordinary political vision and courage. In the short run, the international community, particularly the IMF, should at least recognize and face up to the risks resulting from the existing system, conduct regular monitoring and assessment and issue timely early warnings.

Special consideration should be given to give the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency. Moreover, an increase in SDR allocation would help the Fund address its resources problem and the difficulties in the voice and representation reform. Therefore, efforts should be made to push forward a SDR allocation. This will require political cooperation among member countries. Specifically, the Fourth Amendment to the Articles of Agreement and relevant resolution on SDR allocation proposed in 1997 should be approved as soon as possible so that members joined the Fund after 1981 could also share the benefits of the SDR. On the basis of this, considerations could be given to further increase SDR allocation.

The scope of using SDR should be broadened, so as to enable it to fully satisfy the member countries' demand for a reserve currency.

l Set up a settlement system between the SDR and other currencies. Therefore, the SDR, which is now only used between governments and international institutions, could become a widely accepted means of payment in international trade and financial transactions.

l Actively promote the use of the SDR in international trade, commodities pricing, investment and corporate book-keeping. This will help enhance the role of the SDR, and will effectively reduce the fluctuation of prices of assets denominated in national currencies and related risks.

l Create financial assets denominated in the SDR to increase its appeal. The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.

l Further improve the valuation and allocation of the SDR. The basket of currencies forming the basis for SDR valuation should be expanded to include currencies of all major economies, and the GDP may also be included as a weight. The allocation of the SDR can be shifted from a purely calculation-based system to one backed by real assets, such as a reserve pool, to further boost market confidence in its value.

��. Entrusting part of the member countries' reserve to the centralized management of the IMF will not only enhance the international community's ability to address the crisis and maintain the stability of the international monetary and financial system, but also significantly strengthen the role of the SDR.

1. Compared with separate management of reserves by individual countries, the centralized management of part of the global reserve by a trustworthy international institution with a reasonable return to encourage participation will be more effective in deterring speculation and stabilizing financial markets. The participating countries can also save some reserve for domestic development and economic growth. With its universal membership, its unique mandate of maintaining monetary and financial stability, and as an international "supervisor" on the macroeconomic policies of its member countries, the IMF, equipped with its expertise, is endowed with a natural advantage to act as the manager of its member countries' reserves.

2. The centralized management of its member countries' reserves by the Fund will be an effective measure to promote a greater role of the SDR as a reserve currency. To achieve this, the IMF can set up an open-ended SDR-denominated fund based on the market practice, allowing subscription and redemption in the existing reserve currencies by various investors as desired. This arrangement will not only promote the development of SDR-denominated assets, but also partially makes the management of the liquidity in the form of the existing reserve currencies possible. It can even lay a foundation for increasing SDR allocation to gradually replace existing reserve currencies with the SDR.

Submit Date:2009-3-23 17:39:00