Zhou Xiaochuan, the governor of China’s central bank, came up with a novel idea this week reported in London’s Financial Times. Why not replace the US dollar as the world’s reserve currency and with a new currency based on the IMF’s SDR’s (Special Drawing Rights). Actually it is not a completely novel idea. John Maynard Keynes made a similar suggestion back in the 1940’s but the Chinese (among others no doubt) are getting particularly worried that the Federal Reserve plans to buy US treasuries and expand the Asset-Backed Securities Loan Facility (TALF) program which could result in the US dollar falling in value and devaluing the $2 trillion in dollar assets the Chinese are holding. Serves them right for managing the RMB exchange rate, boosting exports and running a massive trade surplus all these years you may say. Well yes but the problem is not just China’s. Any holder of significant dollar assets and that includes much of the Middle East and S.E. Asia would face the same catastrophic drop in their investments if the dollar went through a prolonged fall.
The Chinese proposal is to create a new currency managed by the IMF and supported by SDR’s which currently are based on just four currencies ” dollar, yen, euro and pound sterling. China is sensibly suggesting the SDR’s should be based on a much wider basket of currencies to create greater stability. Unfortunately the idea will not gain much traction and the Chinese probably know this. Their objective may be to try to influence thinking in Washington as regards the longer term impact on the currency resulting from unsustainable levels of borrowing. The reality is if a global currency was created based on a wide basket of currencies the Renminbi would have to be included by virtue of China’s position as a major trading power. Presently, the currency is far too tightly controlled by the Chinese government for that to happen so good idea that even the Chinese are not serious about it anytime soon.
David Bloom, currency chief at HSBC said that any switch towards use of SDRs has direct implications for the currency markets. At the moment, 65pc of the world’s $6.8 trillion stash of foreign reserves is held in dollars. But the dollar makes up just 42pc of the basket weighting of SDRs. So any SDR purchase under current rules must favour the euro, yen and sterling. The immediate impact on the dollar would be for a massive sell off.
Whilst removing some volatility for the US a world currency could, in the short term, increase risk and costs for US business (irrespective of currency movements resulting from such a change, which in the short term would probably also be negative). At the moment, US companies enter into foreign exchange contracts to a small fraction of the level that other countries have to manage when they trade overseas since most major products are dollar denominated ” oil, metals, agricultural products, etc. In the long run though it would give back to the US the means to manage it’s own currency instead of being at the mercy of large external holders of the currency or of seeing commodity prices rise and fall simply on the back of the dollar strengthening or weakening.