Towards a multiple reserve currency system
By Shahid Javed Burki
Monday, 19 Sep, 2011
THE global financial system is fast losing confidence in the US dollar. The disenchantment with the once mighty dollar may come as a surprise only to the people in the United States, including those responsible for making public policy. Elsewhere it is treated as a fact of life in the new global economic order.
Given the way the world economy is restructuring — the United States is losing its preeminent economic position while some of the large emerging markets are gaining on it — the American dollar cannot remain the dominant currency in the global market place. The world is headed towards a system of multiple reserve currencies.
How soon will this change happen? The answer to the question is “not very soon”. It might take a decade or two but there can be little doubt that the dollar will be joined by a number of other currencies nations around the globe will use for making transactions. Given its economic and financial difficulties, Pakistan will have to be a passive player in the new currency game. As discussed below, it will have to look to Beijing for guidance.
The emergence of the dollar as the sole reserve currency happened quite quickly as the Second World War drew to a close. At that time, the European nations were in debt to the US, owing it large amounts of money.The US was prepared to forgive a part of the debt in exchange for an international monetary system it could control. This led to the creation of the Bretton Woods system in which all currencies were pegged to the dollar while the US pledged to settle any claims the world had on it in terms of gold which was to be traded at the fixed rate of $35 to a troy ounce.
A new institution, the International Monetary Fund, was established to administer the system. The US obtained veto power over the decisions the Fund would be making; any change in the “articles of agreement” — the Fund’s charter — would not be made without the consent of Washington. The United States thus emerged as the world’s economic leader, unchallenged by any other state.
The Bretton Woods system lasted for a quarter century. In 1971, President Richard Nixon took the unilateral decision to un-peg the dollar to gold. After his move, the US was no longer obliged to settle its account in gold if that was demanded by the creditors states.
At that time Germany and France had large balances in their favour and there was a fear in Washington that they may want those to be settled in gold. Had that been demanded by Bonn and Paris, it would have nearly emptied the US gold reserves. The US moved unexpectedly and the Europeans were left with heavy losses in terms of the value of their US assets in gold since the price of the metal climbed quickly after the announcement by President Nixon to de-link the dollar.
This memory of the demise of the Bretton Woods system lives even after half a century. The countries that will see their currencies become international reserve currencies would first want to create an in stitutional structure in which no country has the veto over decisionmaking. This would mean a major change in the way the IMF now works. A reformed Fund would have to have sharing of power and policymaking on the basis of consensus. With no Second World War type of emergency being confronted by the international community, the reform of the Fund would take time.
It will also take time since learning a lesson from the Standard & Poor’s downgrade of the United States – the agency brought the rat ing of the US government debt a notch, from AAA to AA+ — the holders of large foreign currency reserves will want to have a say in the way the large countries with reserve currencies manage their fiscal systems.
Most of the large reserves are held by the countries in Asia but they have, at best, played a marginal role in global financial affairs. The Chinese have already laid the ground for increasing their influence. They, for instance, asked the United States to better manage its budget and reduce the amount of debt the country has accumulated over time. They have given the same advice to Europe. In both cases they were heard but with some resentment.
The new multiple currency reserve system will, in all probability, be built around four currencies – the dollar, the euro, the Japanese yen, and the Chinese renmenbi. Among these, the Chinese currency is the only one that is not fully convertible. It will have to be that for it to become a reserve currency. This too will take time. The Chinese have a strong preference for moving with great care when it comes to adopting major changes in the way they manage their economy. They call it “crossing the river by feeling the rocks”.
They also like the change that has been tested first in pilot projects. This is the way they reformed land ownership in the countryside and the transformation of some of the state-owned enterprises. In moving to towards the convertibility of the renmenbi, the Chinese are also feeling the rocks. They have opened the Hong Kong market to some extent for international transactions in renmenbi. They are also negotiating currency swap arrange ments with a number of trading partners in which payments will be made in local currencies rather than in the dollar or the euro.
Pakistan is included in the group of countries with whom the Chinese would like to conclude a swap arrangement that would cover part of the trade between the two countries and would remain in place for three to five years. Beijing is working on these arrangements with the countries in its immediate neighborhood not with the countries with which it has large trade balances.
For these reasons, it is clear that while the days of the dollar being the predominant currency in the international market place are numbered, the transition to a new system will happen very slowly. Given the uncertainty that currently surrounds the future of the dollar, some ad hoc arrangements will be made until the new system is formally ushered in. This will take a while in normal circumstances but that may not be the case if the world economy plunges once again into a recession making the slowdown that began in 2008 into a double-dip event.
Even if that does not happen, new competitors will arrive on the scene to challenge the dollar. According to one analyst writing for the Financial Times, “the currencies that are appreciating the most are part of the emerging China bloc, such as the Aussie dollar, the Brazilian real, and, increasingly, the Canadian dollar at a time when China’s economic performance continues its fine balancing act.” Some of the other currencies in the region in which China now is the dominant economy, may also become a part of the bloc.These include the Korean won, the Thai Baht and the Singaporean dollar.
Towards a multiple reserve currency