The Dollar vs. the Euro: Then and Now

The U.S. dollar vs. the Euro view circa 2005-2006:

 The U.S. dollar vs. the Euro view today: 

What a change in perspective.  Barry Eichengreen reminds us, however, that eventually the dollar will be one of probably two or three reserve currencies.

A Crack in the Dollar's Reserve Currency Status?

Randall W. Forsyth points to two recent developments as part of a broader change in the global monetary system:

The new world monetary order continued to evolve with two separate developments Tuesday.  Japan said it would join China in buying debt securities to support beleaguered European sovereign creditors. In so doing, the world's No. 2 and No. 3 economies were acting to try to hold together the euro as a viable alternative to the world's reserve currency, the dollar, from the No. 1 economy, the U.S.  At the same time, China permitted trading of the renminbi in the U.S. for the first time -- a significant step in the RMB becoming a full-fledged international, convertible currency...[These two developments] are both part of the loosening of the global monetary system away from its dollar-centric mooring.

Maybe so, but there there are many hurdles for alternative currencies to clear before there arises any meaningful threat to the dollar's reserve status.  Just look at the dominance of the dollar in the global forex market over the past three years.  Even when this change in the globlal monetary system does come about, Barry Eichengreen believes the dollar will still be a dominant currency in the global economy. For better or for worse, then, the Federal Reserve will continue to be a monetary superpower for some time.

About That Bretton Woods 2 vs. QE 2 Showdown...

Apparently it was the topic de jour at the IMF annual meetings this past weekend.  Though framed as a "currency war" by some IMF participants, Martin Wolf explains it is really about two rebalancing acts in the global economy:

The first is internal rebalancing – a return to reliance on private demand in advanced countries and retrenchment of the fiscal deficits that opened in the crisis. The second is external rebalancing – greater reliance on net exports by the US and some other advanced countries and on domestic demand by some emerging countries, notably China.

As noted by Wolf, it just so happens that both of these rebalancing acts can be addressed by one policy response: aggressive monetary easing by the Fed.  That now seems to be happening in the form of QE 2.   The Fed, though, is not purposely trying to tackle both  rebalancing acts.  Rather, it is simply trying to shore up aggregate demand (AD) in the U.S. economy and spur an economic recovery.  Doing so would solve the first rebalancing act.  Now because the Fed is a monetary superpower, its attempts to shore up U.S. AD will get exported to many other countries in the world, particularly those those dollar bloc countries that pegged in some form to the U.S. dollar and do so in a manner  that maintains external competitiveness.  It is these same countries that are a  key part of the second rebalancing act. They are not pleased by this development as it implies either (1) letting their currencies appreciate against the dollar and losing some external competitiveness or (2) intervening in foreign exchange markets to prevent this appreciation from happening and allowing a large expansion of their domestic money supplies. Either way, the second rebalancing act will occur: dollar block countries' currencies will appreciate or their domestic prices will increase.  

For the dollar block countries they see a "currency war" and want to fight back. For the Fed it sees weakening AD  and is determined to stabilize it.  So who will win this global economic showdown at the OK Corral?  Martin Wolf says there is no doubt to the eventual outcome of this exchange:

The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

For all the talk of the U.S. demise, this showdown looks to be one where the United States gets to show it is still a superpower.

Meanwhile, Back in the Eurozone...

the legal noose tightens on Europe's monetary union according to Ambrose Evans-Pritchard:

The plot continues to thicken at Germany’s constitutional court, a body with power of life or death over Europe’s monetary union.

Contrary to general belief, Germany’s eurosceptic professors have not abandoned their legal efforts to block the EU rescues for European banks exposed to Greek debt, and since May 7 for banks exposed to debt from Spain, Portugal, and Ireland as well.

Should they succeed, of course, the eurozone risks disintegration within days, and perhaps hours. I am not sure that investors in New York, London, Tokyo, Beijing, or indeed Frankfurt quite understand this.

I certainly was not aware this German court had the Eurozone in its sights. Developments like these only serve to reinforce Kati Suominen's claim that the dethroning of the dollar as the main reserve currency will not happen anytime soon.

Eurozone Crisis Roundup

Here are some good articles on the Eurozone Crisis. :

The Three Stages of the Eurozone Crisis--Rebecca Wilder:

On to the Germans. What they are doing is actually quite striking: offering a bailout in order to appease markets so that international investors will pick up the Greek bill (never was going to happen anyway); and then telling markets that bond investors in Europe will take a haircut so that international investors won't pick up the Greek bill. I guess the light-bulb finally went off that there is a contagion brewing here because bunds are tight, while all Peripheries are wide...We’re in crisis mode – the calm before the storm. I see the Eurozone disaster happening in three waves:

The Holy Roman Eurozone--Nick Rowe:

It's not just Greece; I now think the Eurozone has gone. Not gone completely; it will live on in some form, just like the Holy Roman Empire, a shadow of the original, comprising maybe Germany, France, and Benelux.

Roubini on Greece and Spain--Felix Salmon:

Nouriel’s base case, then, is Argentina 2001: after all, Greece has a much higher debt-to-GDP ratio, much higher deficit-to-GDP ratio, and much higher current-account deficit than Argentina had back then. And if that’s the base case, there’s no way that Greek debt should be trading anywhere near its current levels.

Of course, this being Nouriel, it goes downhill from there: if Greece is worse than Argentina, he says, then Spain is worse than Greece. Its housing bubble and bust has left the banking sector much weaker than Greece’s; its unemployment situation, especially with the under-30 crowd, is much worse than Greece’s; and the cost of any Spain bailout would be so much more enormous than the cost of a Greek bailout as to be almost unthinkable. The only thing that Spain has going for it is that it isn’t quite at the edge of the abyss yet; if it gets its political act together and implements tough fiscal and structural reforms now, it can save itself. But clearly no one saw that happening, given Spain’s political history over the past 20 years.

There’s no good news here. The least bad course of action for Greece, in Nouriel’s eyes, is some kind of coercive yet orderly debt restructuring, which keeps the face value of the debt unchanged but which reduces coupons and pushes out maturities. And an exit from the euro. Alternatively, the ECB steps in and cuts interest rates so low that the euro gets pushed down towards parity with the dollar, which would accomplish something similar without nearly as much pain.

As Debt Fears Grow, Finance Ministers to Meet in Europe--Jack Ewing:

[I]t is becoming apparent that the international community may need to come up with a much larger sum to backstop not just Greece, but also Portugal and Spain.

“The number would be huge,” said Piero Ghezzi, an economist at Barclays Capital. “Ninety billion euros for Greece, 40 billion for Portugal and 350 billion for Spain — now we are talking real money.” Mr. Rogoff says that the I.M.F. could commit as much as $200 billion to aid Greece, Portugal and Spain, but acknowledges that sum alone would not be enough. In fact, analysts at Goldman Sachs suggest that Greece will need 150 billion euros over a three-year period.

What a growing number of investors suggest is really needed is a “shock and awe” figure, enough to convince the markets that peripheral European economies will not be left to fail.

Quote of the Day

Here is Nouriel Roubini via Felix Salmon:

[I]n a few days... there might not be a eurozone for us to discuss.

It is good to see that Dr. Doom is alive and well.

Forget Greece, Germany Should Leave the Euro...

So says Joachim Starbatty in the NY Times:

The Greek crisis is only the first of what could be several tremors resulting from the euro’s original sin. While few are willing to say it yet, the solution is clear: the only way to avoid further harm to the global economy is for Germany to lead its fellow stable states out of the euro and into a new and stronger currency bloc.

[...]

If Germany were to take that opportunity and pull out of the euro, it wouldn’t be alone. The same calculus would probably lure Austria, Finland and the Netherlands — and perhaps France — to leave behind the high-debt states and join Germany in a new, stable bloc, perhaps even with a new common currency. This would be less painful than it might seem: the euro zone is already divided between these two groups, and the illusion that they are unified has caused untold economic complications.

A strong-currency bloc could fulfill the euro’s original purpose. Without having to worry about laggard states, the bloc would be able to follow a reliable and consistent monetary policy that would force the member governments to gradually reduce their national debt. The entire European economy would prosper. And the United States would gain an ally in any future reorganization of the world currency system and the global economy.

Does this make any sense?

A Change In Perspective

The Euro view today:



The Euro view circa 2005:

The Eurozne Problem in One Picture

Stephanie Flanders directs us to to this picture from HSBC which nicely summarizes the problems the Euro has created for Greece over the past decade:


It is striking how the Eurozone periphery has lost so much competitiveness as indicated by the real exchange rate appreciation. Stephanie Flanders also makes the point that even if the European bail-out of Greece takes place it only buys time and does not address the real problems: Greece's debt overhang and its inability to restore fiscal order. Flanders recommends a more radical but meaningful solution of (1) restructuring Greece debts and (2) setting a higher inflation target for the ECB. She acknowledges these are "unthinkable" options, but when the alternative could be a Lehman II why not consider the "unthinkable"?

Shorting the Euro Big Time

Okay, maybe I should not put too much faith in the intrade.com contract on the Euro's future. Based on this FT article, Gregory White says the real action on the Euro is in Chicago:

The Chicago Mercantile Exchange has taken on more short bets on the Euro than ever before in the currency's history. According to FT $7.6 billion in Euro shorts have piled up over the past couple of weeks as there is increasing worry about how the currency area is going to deal with the debt problems of many of its members.

Now over 40,000 contracts against the currency have been taken out on the CME, putting even further downward pressure on the troubled currency.

Spain has been in the headlines today trying to come out on the offensive over concerns their debt will be the next to burst. They are even going so far as to label the the current downward pressure on the Euro and on their sovereign debt as a conspiracy or attack.

Wow.

The Eurozne: Deja Vu Argentina 2001 & Other Thoughts

The sovereign debt problems in the Eurozone periphery and the implications of this development for the future of the currency union attracted a lot of attention over the weekend. Here is the New York Times on the problems facing Greece and the Eurozone more generally. Carmen Reinhart, meanwhile, tells us that Greece has been in a state of default about 50% of the time since the 1830s (Why then, was it ever allowed to join the Eurozone?). More importantly, she indicates that if some of the Eurozone's periphery goes under then the problems in Eastern Europe become more severe. Here is CNN quipping that Europe's PIGS (i.e. Portugal, Italy, Greece, and Spain) don't fly. Here is Paul Krugman lamenting the monetary stratightjacket that is the Euro. Finally, here is Simon Johnson pulling a Roubini by forecasting these problems, if not addressed, risk causing another global depression. After reading all these pieces, here are some thoughts:

(1) I couldn't help but think of Argentina's crisis in 2001-2002. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union that did not meet the optimal currency area criteria. It too tried to cut wages and prices but found the deflationary price too high. Ultimately Argentina defaulted and broke the peso-dollar link, even though the currency board linking the two currencies was almost a decade old and considered an important institution. It seems possible some of the PIGS could go the way of Argentina.

(2) On the other hand, Tyler Cowen reminds us that there would be a great cost for Greece's banking system if the nation chose to leave the Eurozone. Barry Eichengreen lists other costly barriers any Euro nation would face in such a move. Maybe this is why the intrade.com contract on any country leaving the Eurozone in 2010 is hovering around 15% (down from a high of 40% in late 2008). Still, Argentina faced similar costs and it abandoned the dollar peg. Never say never.

(3) This New York Times article makes the case the ECB president, Jean-Claude Trichet, has more power because of this crisis. Since there is no EU Treasury to help Greece, the only institution capable of bailing out the PIGS is the ECB. According to the NYT, this makes Trichet the de facto president of Eurozone. Given all the animosity the Federal Reserve has generated for itself in the financial crisis from the new public awareness of its power, I wonder if something similar could happen to the ECB if it chooses to use its power for the PIGS. The U.S. public has always had some aversion to centralized monetary power (e.g. Andrew Jackson's Second Bank War, the hatred of Paul Volker in the early 1980s). Europe may be more open to such uses of monetary power given their longer history with central banking.

(4) Ultimately, this crisis speaks to the importance of a monetary union meeting the optimal currency area to be viable. I have made this point before, but will leave it with Paul Krugman to make the case here:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration)... what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.

The Future of the Euro (Part VIII)

It seems Martin Feldstein cannot avoid speculating about the demise of the Euro. Since the late 1990s he has been making the case that there are just too many institutional and economic differences in the EU nations for a single currency to work. In short, Feldstein believes the Euro area falls way short of being an optimal currency area. The past decade of relative success for the ECB has done nothing to change his view. In fact, earlier this year he discounted this period as a "lucky time" for ECB policymakers:

Mr. Feldstein pointed out that the past decade has been, until recently, a lucky time in Europe. European country economies weren’t buffeted by severe economic problems, or big unemployment problems, allowing the European Central Bank to focus on price stability. But now, economic conditions are deteriorating rapidly, and some countries are being much harder hit than others...“In my judgment, the next few years will be an important testing time for the EMU and Europe,” Mr. Feldstein said - one in which the possibility of one or more countries choosing to withdraw from the EMU cannot be ruled out.

That was written in January 2009 when Europe seem poised to implode. Now that ECB has weathered that storm Feldstein still questions the Euro's survivability:

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).

[...]

The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

Feldstein acknowledges there would be technical and political hurdles to overcome for a country to abandon the Euro. Barry Eichengreen argues these hurdles are probably large enough to prevent a country from leaving the currency union. Obviously, Feldstein is less confident on this point than Eichengreen. Interestingly, Desmond Lachman, who foresaw many of the emerging market crisis of the 1990s, sees a "ticking time bomb" for Spain, Greece, Portugal, and Ireland from the "straightjacket of the Euro-zone membership." He too does not see the hurldes to a breakup of the Eurozone as unsurpassable. As I noted in a previous post, Argentina in the 2001-2002 period provides a good example of a country for which the technical and political hurdles--including a financial crisis, the largest-ever sovereign default, and political chaos--were not enough to prevent it from leaving the dollar zone. Never say never.

More on the Dollar

From Barry Eichengreen:

[T]he dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial centre. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.

From David Lynch:

In the short run, the only currency that could challenge the dollar is the euro... But for all its attractions, the euro lacks some essential attributes. Although the European Union has a central bank, comparable to the Federal Reserve, there is no European treasury. Instead, there are 27 European treasuries. Investors can't easily track or influence fiscal policy on the continent.

The dollar is also buoyed by the existence of a massive government bond market. There's roughly $4 trillion worth of U.S. Treasuries floating around, and almost $100 billion changes hands each day, according to investment management firm Pimco. Trading that's carried on almost 24 hours a day, rolling east to west from Tokyo to London to New York, makes it easy to move into and out of dollar positions in a hurry.

Europe, by contrast, has no analogue to the U.S. Treasury market. Instead there is a fragmented scene with individual sovereign debt from Germany, Italy, France and other EU members. No individual market enjoys anything like Treasuries' liquidity and size.

[...]

There's another potential dollar rival on the horizon, though its day likely lies a decade or more in the future... But before it does, China will have to thoroughly overhaul its existing financial system. Today, the yuan isn't freely convertible into other currencies, and there are strict limits on the cross-border movement of the Chinese currency. Chinese officials publicly have committed themselves to freeing the yuan to float alongside the dollar, euro, yen and other major currencies. That change, however, won't happen overnight.

Much Ado About Nothing: the Dollar's Decline

There has been much angst by observers over the dollar's decline from the conspiracy laden to the serious and somber. Other observers say this discussion is pointless; the weakened U.S. economy needs some dollar depreciation so get over it. A quick look at the dollar's value in the figure below shows the dollar's decline is (1) only returning it to where it was 2007 and (2) pales in comparison to its slide between 2002-2007. (Click on figure to enlarge.)



Daniel Drezner provides great perspective on this development:

OK, let's be as plain as possible about this - as a reserve currency, the dollar is not going anywhere. Really.

The dollar's slide in value has been predictable, as the need for a financial safe haven has abated. By and large, a depreciating dollar helps the U.S. trade balance (though it would help much more if the Chinese renminbi got in on the appreciation).

Even the Chinese, who have spoken like they want an alternative to the dollar as a reserve currency, are in point of fact not doing much to alter the status quo. Why? To paraphrase Winston Churchill, the dollar is a lousy, rotten reserve currency - until one contemplates the alternatives.

Because all of the alternatives have serious problems. The euro, the only truly viable substitute for the dollar, is not located in the region responsible for the largest surge of growth. It would be unlikely for the ASEAN +3 countries to agree to switch from the dollar to a new currency over which regional actors have no influence (the Europeans wouldn't be thrilled either, as it would lead to an even greater appreciation of the currency). Oh, and the European Union has no consolidated sovereign debt market. The euro is worth watching, but it's not going to replace the dollar anytime soon.

The other alternatives are even less attractive. Most other national currencies beyond the euro - the yen, pound, Swiss franc, Australian dollar - are based in markets too small to sustain the inflows that would come from reserve currency status. The renminbi remains inconvertible. A return to the gold standard in this day and age would be infeasible - the liquidity constraints and vagaries of supply would be too powerful. There's the using-the-Special-Drawing-Right-as-a-template-for-a-super-sovereign currency idea, but this is an implausible solution. As it currently stands, the SDR is not a currency so much as a unit of account. Even after the recent IMF authorizations, there are less than $400 billion SDR-denominated assets in the world, which is far too small for a proper reserve currency.

So, what's really going on here with the dollar obsession? I suspect that with the Dow Jones going back over 10,000, Republicans are looking for some other Very Simple Metric that shows Obama Stinks. The dollar looks like it's going to be declining for a while, so why not that? Never mind that the dollar was even weaker during the George W. Bush era -- they want people to focus on the here and now.

The thing is, I'm not sure this gambit is going to work. People who already think Obama is a socialist will go for it, sure, but that's only rallying the base. I'm not sure how much fence-sitters care about a strong dollar, however. If anything, populist movements tend to favor a debasing of the currency rather than a strengthening of it.

Read the rest of Drezner's article here.

Update: Martin Wolf has a great column on this issue titled "the rumours of the dollar's death are much exagerated."

The Future of the Euro (Part VII)

Speaking of optimal currency areas, Barry Eichengreen has a new article on whether some Euro countries may abandon the currency union:

Although housing prices have fallen euro area wide, they have fallen more dramatically in some countries than others. Although the crisis has meant large losses for banks throughout the euro area—often on those same housing-related investments—it has produced larger losses in some countries than others. It has led to rising unemployment throughout the euro area, but more in some countries than others. The result is more deflationary pressure, actual or potential, in some euro area countries than others. There are also more strains on the public finances of some euro area countries, as reflected in the widening of spreads on sovereign bonds and their associated credit default swaps.

Under these circumstances, different euro area countries presumably would prefer a different monetary policy response. But the members of the euro area are necessarily subject to a one-size-fits-all policy, such being the intrinsic nature of monetary union. This tension has revived the pre-1999 debate over whether monetary union in Europe is a good idea. It has also given rise to chatter and speculation about the possibility that one or more euro area countries might now choose to abandon the euro. This article weighs the implications of such a move and, although finding it risky, costly, and complicated, concludes that it is not inconceivable.

Read the rest of the article here. Here is the intrade contract on whether "any country currently using the Euro to announce their intention to drop it on/before 31 Dec 2010." (Click on figure to enlarge.)

This figure indicates the probability is only about 15% now, a big drop from the 40% high last year.

Are the Dollar's Days as the Main Reserve Currency Numbered?

Helmut Reisen says maybe:

If history of the last switch in reserve currency (from pound sterling to the US dollar) is any guide, the Chinese renminbi can be expected to replace the US dollar as a reserve currency around 2050.

Reisen notes there are a number of problems in making the transition to the Renminbi as a reserve currency. Therefore, he suggests a modified version of the IMF's Special Drawing Rights could serve as the reserve currency. As I discussed here before, it is not clear to me how this move would eliminate the problems creating the global economic imbalances in the first place. Yes, the SDRs would make it easier for countries holding too many dollars to get out of them, but it would not address the structural and policy reasons why some countries run persistent current account surpluses.

Putting Some Teeth into the SDRs

The WSJ's RTE blog is reporting that the IMF will soon be issuing bonds denominated in the IMF's currency called the SDRs. Interestingly, those countries eager to see alternative reserve currency emerge are some of the first to express interest in these bonds:

The International Monetary Fund is putting final touches on its plans to issue its first bonds. Russia has already said it would buy $10 billion of the bonds, which would be priced in the IMF’s quasi-currency, “special drawing rights.” SDRs are a basket of currencies consisting of the euro, yen, pound sterling and U.S. dollar. As of Friday, 1 SDR equals $1.55.

China, Brazil and India also have said they are interested in buying IMF bonds, with China likely to purchase more than $20 billion of instrument. The IMF wants to issue bonds as a way to build up its lending war chest as the global economic nosedive continues.

Might this development be the starting point for making the SDRs an alternative reserve currency?

How to Make a New Reserve Currency

As a follow up my earlier posts on the SDRs as reserve currency, here are two related article worth reading. The first one is by Owen Humpage of the Cleveland Federal Reserve who does a nice job quantifying why the dollar is the reserve currency. Humpage concludes the SDRs are unlikely to supplant the dollar anytime soon. The second article is from Barry Eichengreen who agrees there are many hurdles to clear before the SDRs could become a reserve currency. Eichengreen, however, does spell out some ways to clear these hurdles:

If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. Better still, it could encourage other G-20 countries to do likewise. They would pay a price, since investors in these bonds would initially demand a novelty premium. But nothing is free. That price would be an investment in a more stable international system.

Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims. Back in the 1970’s, there was some limited issuance of SDR-denominated liabilities by commercial banks and SDR-denominated bonds by corporations. But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.

Overcoming that advantage now would require someone to act as market-maker for private as well as official transactions and subsidize the market in its start-up phase. The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, private as well as official, at narrow bid/ask spreads competitive with those for dollars.

The dollar originally acquired international currency status in the 1920’s, when the newly established Federal Reserve started buying and selling dollar acceptances, backstopping the market and enhancing its liquidity. If the international community is serious about the SDR as an international currency, it will have to empower the IMF to do likewise.

Again, there would be a cost. The IMF would be using real resources to subsidize the market until private market-makers saw it as attractive to provide those services at comparable cost. The Fund’s shareholders would have to agree to incur those costs. But, again, what is this if not an investment in a more stable global monetary system?

Transforming the SDR into a true international currency would require surmounting other obstacles. The IMF would have to be able to issue additional SDRs in periods of shortage, as when the Fed provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. At the moment, countries holding 85% of IMF voting power must agree before SDRs can be issued, which is no recipe for liquidity.

The IMF’s management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps. For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.

Working through the IMF and its member countries makes some of the above suggestions difficult. I wonder if there might be a role for an Asian Monetary Fund in China's efforts to promote an alternative reserve currency.

More on the SDRs as a Reserve Currency

In my last post on the SDRs Rebecca Wilder questioned whether the SDRs will actually make a difference to the global economic imbalance problem. As a follow up to her question, I asked a friend who formerly worked at the IMF and the U.S. Department of Treasury his thoughts on the matter. Here is what he had to say (note that "Fund" is short for IMF):

This is a very long, tricky subject that I think starts with what is an SDR really? An SDR is basically a claim on another countries' reserves held via your account at the Fund. So when a country needs more USD it cashes in the SDRs at the Fund and the Fund tells the US Treasury to provide the USD. The country then runs a debit on its account at the Fund, which it pays interest, while the US gets interest on the "surplus" SDRs it has. The main point of these accounts is that some countries have hard currencies, while others (lets call them Argentina) have currencies from time to time that no one wants - so it's just a more complicated way of giving more countries access to currencies of other countries that are in demand at that time.

This doesn't really seem to me to be a workable currency yet - (1) it's not freely exchangeable in the market; (2) you can't just park reserves you accumulate in SDRs - if China has surplus USD, it can't simply go to the Fund and say I'd like to swap these for SDRs please; the IMF would have to fundamentally alter the way SDRs work to get to a system where the SDR could be usable as a reserve currency; (3) who controls the stock of SDR outstanding? When the Fund "creates" SDRs, all it is really doing is putting in place an agreement across its members to allow their currencies to be tapped by other Fund members when needed. The Fund can't grow the underlying SDRs out of thin air - every country would have to agree to put more of their currency on call. For the US , the Treasury Department would likely issue debt to raise the USD to give to a country that wants USD for its SDRs. Other countries might simply have their central banks print the money - but ultimately it's finite.

Beyond that, Rebecca's point is a decent one - if China is determined to keep its currency undervalued, then the real question is what currencies does it do so against. But that begs the question of why China would need SDRs in the first place; it could simply set an fx reserve accumulation policy of buying some USD, some EURO, some yen, and some GBP; I guess that would help the US by spreading some of china's capital outflows across more countries - and hence allow the USD to depreciate more relative to the CNY - since they would engineer a broader nominal effective depreciation.

If China's motive is more feeling the need for fx to insure against sudden capital outflows, then the Fund could help in theory. In practice it's hard since until the FCL the only way the Fund could deliver assistance was via programs which both had stigma and because they carried conditions meant that access to IMF resources wasn't automatic - so not a great way to insure yourself if you are a country; much better to have your own stockpile of USD.

A reformed SDR could play a role in this I think by being say a unit of account for parking reserves; but really the way the IMF could fulfill its function as insurer of last resort better is instead of telling a country to go run CA surpluses, accumulate a bunch of USD and bring them to us (and then what? does the Fund buy US Treasuries on China's behalf? that doesn't seem to solve any problems) is instead the Fund should act as a central clearinghouse for Central Bank fx swap lines. So when demand for a country's currency falls, it could go to the Fund and get more of the currency that demand has shifted into. Of course we go back to square one - is the country's currency falling because of unsustainable policies which require external adjustment - or is it just a temporary capital account fluctuation?

In short, the SDRs are not a panacea for the global imbalance problem.

Update: for a pro gold standard perspective on SDRs see here.

About that Proposal for a New Reserve Currency...

Yes, I am talking about China's proposal that the IMF's special drawing rights or SDR currency be expanded and adopted as the new reserve currency. From Justin Fox we learn this idea is not original. It has been promoted for some time by C. Fred Bergsten. Here is what he had to say about it in December 2007:

There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund (IMF) through which unwanted dollars could be converted into special drawing rights (SDR)... The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.

The fund’s members would authorize it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80 billion would more than suffice.

All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 percent dollars, 34 percent euros, 11 percent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimizing the loss on their remaining dollar holdings as well as avoiding systemic disruption.

The United States would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar...

For these reasons Justin Fox champions the SDR and argues it would be in the best interest of the United States and the rest of the world if it truly became the new reserve currency. The Economist magazine, meanwhile, explains some of the technical details of the SDR while the historian Paul Kennedy wonders if all the buzz about the SDR is just another symptom of a much larger tectonic shift in the global balance of power toward Asia.