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.)"

The value of an SDR is defined as the value of a fixed amount of yen, dollars, pounds and euros, expressed in dollars at the current exchange rate

TO BE NOTED: From the Economist:

"Special Drawing Rights

Held in reserve

Apr 8th 2009
From The Economist print edition

A brief guide to the IMF’s “currency”

SPECIAL Drawing Rights, or SDRs, are often referred to as the IMF’s currency. Although that is useful shorthand, the SDR is not, in fact, a currency, but rather the IMF’s unit of account. The value of an SDR is defined as the value of a fixed amount of yen, dollars, pounds and euros, expressed in dollars at the current exchange rate. The composition of the basket is altered every five years to reflect changes in the importance of different currencies in the world’s trading system.

SDRs nevertheless represent a potential claim on other countries’ freely usable currency reserves, for which they can be exchanged voluntarily. Alternatively, countries with strong external finances can buy SDRs from countries which need hard currency. On April 2nd the G20 countries authorised the IMF to issue $250 billion in new SDRs. The advantage of a fresh SDR issuance is that it immediately augments countries’ foreign reserves without needing to be lent.

However, this benefit comes with a serious drawback. Although the G20 portrayed the new SDRs as a quick way of channelling resources into emerging economies, SDRs are in fact allocated in proportion to countries’ existing IMF quotas (see table).

This means that around $170 billion of the $250 billion of new SDRs that are to be issued will land in the reserves of rich countries, because they have the lion’s share of existing IMF quotas. Still, the increases in the reserves of some emerging economies are not trivial. South Korea’s will grow by $3.4 billion, India’s by $4.8 billion, Brazil’s by $3.5 billion and Russia’s by $6.9 billion. Another sign of the instrument’s bluntness can be seen from the fact that China’s vast reserves, already nearly $2 trillion, will go up by $9.3 billion.

Of course, the IMF hopes that some rich countries (or reserve-rich emerging ones) will lend their share of the new SDR allocation to those in greater need. But this is by no means guaranteed. America, for example, needs Congress’s approval to part with its share. The last proposed SDR allocation, of $21.4 billion, was approved by the IMF’s board in 1997. But although 131 countries with 78% of the total votes in the IMF accepted the proposal, it was never put into effect. Such decisions require 85% support—and America, with nearly 17% of the votes in the IMF, never approved it.

Meanwhile, Governor Zhou Xiaochuan of the People’s Bank of China has produced a remarkable series of speeches and papers

TO BE NOTED: From the FT:

"What the G2 must discuss now the G20 is over

Published: April 7 2009 19:57 | Last updated: April 7 2009 19:57

Did the meeting of the Group of 20 in London last week put the world economy on the path of sustainable recovery? The answer is no. Such meetings cannot resolve fundamental disagreements over what has gone wrong and how to put it right. As a result, the world is on a path towards an unsustainable recovery, as I argued last week. An unsustainable recovery might be better than none, but it is not good enough.

EDITOR’S CHOICE

Lex: US bank bail-out - Feb-10

Video: Martin Wolf on the slow path to recovery - Feb-16

Editorial: Son of Tarp follows in father’s footsteps - Feb-10

Clive Crook: A package far from tied up - Feb-10

Video: Big bail-out bang whimpers - Feb-10

Economists’ forum - Oct-01

This summit had two achievements: one broad and one specific.

First, “to jaw-jaw is better than war-war”, as Winston Churchill remarked. Given the intensity of the anger and fear loose upon the world, discussion itself must be good.

Second, the G20 decided to treble resources available to the International Monetary Fund, to $750bn, and to support a $250bn allocation of special drawing rights (SDRs) – the IMF’s reserve asset. If implemented, these decisions should help the worst-hit emerging economies through the crisis. They also mark a return to a big debate: the workings of the international monetary system.

This is the point at which the eyes of countless readers will glaze over. It is easier for most to believe that the explanation for the crisis is solely the deregulation and misregulation of the financial systems of the US, UK and a few other countries. Yet, given the scale of the world’s macroeconomic imbalances, it is far from obvious that higher regulatory standards alone would have saved the world.

This is not just a matter of historical interest. It is also relevant to the sustainability of the recovery. Fiscal deficits are now generally far bigger in countries with structural current account deficits than in those with current account surpluses. This is because the latter can import a substantial part of the stimulus introduced by the former. The Organisation for Economic Co-operation and Development forecasts a jump in US public debt of almost 40 per cent of gross domestic product over three years (see chart). It is quite likely, therefore, that the next crisis will be triggered by what markets see as excessive fiscal debt in countries with large structural current account deficits, notably the US. If so, that could prove a critical moment for the international economic system.

Intriguingly, the country raising these big questions is China. This is, no doubt, for self-serving reasons: China is worried about the value of its foreign currency reserves, most of which are denominated in US dollars; it wants to relieve itself of blame for the crisis; it wishes to preserve as much of its development model as possible; and it is, I suspect, seeking to countervail US pressure on the exchange rate of the renminbi.

Wen Jiabao, the Chinese prime minister, has noted his country’s concern over the value of its vast reserves. At close to $2,000bn, these are almost half of 2008 GDP. Imagine what Americans would say if their government had invested about $7,000bn (the equivalent relative to US GDP) in the liabilities of not altogether friendly governments. The Chinese government is beginning to realise its mistake – too late, alas.

Meanwhile, Governor Zhou Xiaochuan of the People’s Bank of China has produced a remarkable series of speeches and papers on the global financial system, global imbalances and reform of the international monetary system. These are both a statement of the Chinese point of view and a contribution to global debate. One may not agree with all he is saying. Yet the fact that he is speaking out is itself significant.

Governor Zhou argues that the high savings rate of China and other east Asian countries is a reflection of tradition, culture, family structure, demography and the stage of economic development. Furthermore, he adds, they “cannot be adjusted simply by changing the nominal exchange rate”. In addition, he insists, “the high savings ratio and large foreign reserves in the east Asian countries are a result of defensive reactions against predatory speculation”, particularly during the Asian financial crisis of 1997-98.

None of this can be changed swiftly, insists the governor: “Although the US cannot sustain the growth pattern of high consumption and low savings, it is not the right time to raise its saving ratio at this very moment.” In other words, give us US frugality, but not yet. Meanwhile, adds the governor, the Chinese government has produced one of the largest stimulus programmes in the world.

Moreover, the vast accumulations of foreign currency reserves, up by $5,400bn between January 1999 and their peak in July 2008 (see chart), reflect the emerging economies’ demand for safety. But since the US dollar is the world’s main reserve asset, the world depends on US monetary emissions. Moreover, the US tends to run current account deficits, for this reason. The result has been a re-emergence of a weakness discussed in the twilight years of the Bretton Woods system of fixed exchange rates, which broke down in the early 1970s: over-issuance of the key currency. The long-term answer, he adds, is a “super-sovereign reserve currency”.

It is easy to object to many of these arguments. Much of the extraordinary increase in China’s aggregate savings is the result of rising corporate profits (see chart). It would surely be possible to tax and then spend a part of these huge corporate savings. The government could also borrow more: at the 3.6 per cent of GDP forecast by the IMF this year, its deficit remains decidedly modest. It is also hard to believe that a country such as China should be saving half of its GDP or running current account surpluses of close to 10 per cent of GDP.

Similarly, while the international monetary system is indeed defective, this is hardly the sole reason for the world’s vast accumulations of foreign currency reserves. Another is over-reliance on export-led growth. Nevertheless, Governor Zhou is correct that part of the long-term solution of the crisis is a system of reserve creation which allows emerging economies to run current account deficits safely. Issuance of SDRs is a way of achieving this goal, without changing the fundamental character of the global system.

China is seeking to engage the US. That is itself enormously important. However self-seeking its motivation, that is a necessary condition for serious discussion of global reforms. Yet China must also understand an essential point: the world cannot safely absorb the current account surpluses it is likely to generate under its current development path. A country as large as China cannot hope to rely on such large current account surpluses as a source of demand. Spending at home must still rise sharply and sustainably, relative to growth of potential output. It is as simple – and difficult – as that.

martin.wolf@ft.com"