Sunday, 29 March 2015

The Slow Demise of the Dollar Empire

The US dollar is strong these days. But this is just a snapshot. The gradual end of the dollar empire is in the making.

The IMF has just announced that it will review the composition of basket of special drawing rights (SDRs ) later this year. To maintain the external pressure for further liberalization of the Chinese economy, the People Bank of China (China´s central bank) has an interest to have the renminbi (or yuan) included in the SDR basket already in 2015. So far, only four global currencies share the honor to be part of that basket. All are part of the Western bloc (dollar, €uro,pound and yen). To qualify for inclusion in the SDR, the Chinese authorities need to initiate a series of liberalizing reforms : financial openness to promote currency convertibility and a wider intervention band for flexibility and market determinination of the renminbi.

SDRs are a kind of artificial money held at the IMF, money not traded on foreign exchange markets. That´s why SDRs are at times dubbed the Esperanto of global currencies as it does not perform all the functions of money. Although SDRs can act as part of official foreign exchange reserves, they can neither be used for intervention in currency markets nor as an anchor currency. Nonetheless, the inclusion of the Chinese currency in the SDR basket would be a very big step in the recalibration of the current world order, which was largely built after WWII. Why is that?

The BRICS have been calling for quite some time to replace the US dollar as the international reserve currency, possibly with the SDR basket. This request was reiterated several years ago by the UN Commission on the Reform of the International Monetary and Financial System, headed by Joseph Stiglitz. True, the US dollar so far is fulfilling an important  network role for the global economy. Like English as a world language, it has features of a natural monopoly. But as the SDR basket consists only of currencies in rich countries, any demand of poorer countries for a reserve currency´(to build up FX reserves, say, for precautionary motives) is akin to ´reverse aid´ to the four SDR countries.

Seigniorage is an 'exorbitant privilege' (ValĂ©ry Giscard d'Estaing in 1960) for the country whose currency is the international reserve currency. In addition, the one-sided dependence of the SDR basket (about 80% of which are currently based on dollar and euro) acts pro-cyclically on commodity prices as commodity-based currencies are missing in the SDR basket.


The inclusion of the renminbi in the SDR basket would have both  signal and real effects for China and the international monetary system. China's high-risk currency mismatches would be mitigated by the internationalization of the renminbi; the international monetary system would be more balanced. A further opening of the Chinese financial system might perhaps improve the efficiency of resource allocation, but it is almost certain to also increase China's financial risks. China´s promotion of financial reform and capital-account opening by joining the SDR basket might perhaps be compared in retrospect to the stimulatory effect of China's WTO accession on SOE Reform. Unless it served as a major step to a big financial crash...

If history is any guide, it will take thirty to seventy years until the dollar empire is replaced by a multiple currency system or even a renminbi empire. Already today, China is in the lead as the world's largest economy, exporter and net creditor. Great Britain´ pound sterling lost only during WWII the dominant reserve currency role to the US dollar although she had lost the lead as an economic power to the United States as early as 1872 and in 1914 had turned into a the net debtor country. It was only the growing convertibility of the US dollar after WWI that enabled the dollar´s steady climb to a pole position as international reserve currency . Now it is China's turn ...

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