Reserve Currency

[Michael]

Reserve Currency

This is a rather esoteric topic, not likely to be of interest to many, but this is the key place where 'politics' meets 'economics' in a very real and tangible way.

A couple of news items, if taken separately, don't mean much, but so close together, there is definitely a pattern developing here.

First news article:
MOSCOW, March 19 (Reuters) - China and other emerging nations back Russia's call for a discussion on how to replace the dollar as the world's primary reserve currency, a senior Russian government source said on Thursday. Russia has proposed the creation of a new reserve currency, to be issued by international financial institutions, among other measures in the text of its proposals to the April G20 summit published last Monday.

Calls for a rethink of the dollar's status as world's sole benchmark currency come amid concerns about its long-term value as the U.S. Federal Reserve moved to pump more than a trillion dollars of new cash into the ailing economy late Wednesday.

Russia met representatives of China, India and Brazil ahead of the G20 finance ministers meeting last week, as the big emerging powers seek to up their influence on decisionmaking globally. Their first ever joint communique did not mention a new currency but the source said the issue was discussed.
Source (http://www.reuters.com/article/usDollarRpt/idUSLJ93633020090319)

No surprises here. The longterm US fiscal position has always looked a bit shaky. It has recently just taken a serious nosedive and now looks downright ugly. Anyone who is NOT concerned about the longterm value of the USD is a fool.

And here's another news article:

BEJING, March 23, 2009. China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.

“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.
Source (http://www.ft.com/cms/s/0/7851925a-17a2-11de-8c9d-0000779fd2ac.html?nclick_check=1)

The US taxpayer and US consumers are going to be paying a very high price for bailing out these billionaire bankers on Wall Street. This is a policy that is going to hurt the US for years to come.

Just to put this into perspective, the ONLY thing that is keeping the US economic recovery hopes alive is the fact that US Treasuries serve as a 'reserve currency' for large parts of the world. These are the people who are presently financing the US $1.8 trillion deficit. These articles are all about finding a way to avoid the US Treasuries. If that were the case now, the US would be a basketcase with double-digit interest rates.

Or to put it another way, the world's most important bondholders have decided that the USA is no longer a suitable place to park their billions.

[Greendruid]

Can anyone simplify for me how such a currency would practically function? If the current situation is based on credit holdings and the relative values of one currency to another, and a new unified world currency would be ostensibly valued in each current currency's units, how would this proposed new currency be different? I just can't see how introducing a new standard would change things. Would it be somehow more stable because it would be built on the strengths of multiple players' markets rather than one player's market (currently the US)? Global economics really confuses me so ... be gentle.

[Michael]

Can anyone simplify for me how such a currency would practically function? If the current situation is based on credit holdings and the relative values of one currency to another, and a new unified world currency would be ostensibly valued in each current currency's units, how would this proposed new currency be different? I just can't see how introducing a new standard would change things. Would it be somehow more stable because it would be built on the strengths of multiple players' markets rather than one player's market (currently the US)? Global economics really confuses me so ... be gentle.
First of all China/Russia have tentatively proposed the creation of a new "reserve currency", not a new currency. This 'new' currency really would primarily serve this function (of sovereign reserve). No one is suggesting that anyone but various sovereign central banks would be interested in using such a currency. That is to say, this 'reserve currency' would technically add to the world's supply of currency, not replace any of it in any way.

Secondly, all existing currencies (USD, Sterling, Euro, Yen, Quan) are "fiat money", that it so say, they are paper money that exist by the order of a sovereign nation. Nothing backs these currencies other than the theoretical guarentee that the issuing sovereign nation will always honor it.

Because this 'guarentee' is a bit questionable - especially with some countries that have poor historical records of honoring agreements (like Russia or Argentina for example), the central banks of countries like Russia and Argentina are forced to hold large quantities of foreign currency as "official reserves" in order to 'support' the issuing of their own currencies. No one trusts the Russian rouple so therefore the Russian Central Bank holds billions of US dollars (mostly US Treasuries to be specific) in a vault (literally).

These 'official reserves' serve to theoretically support the Russian currency in international currency transactions (necessary for foreign trade). Even if you don't like or trust the Russian rouple, you can rest assured that the Russian Central Bank could honor rouple debts with 'real' US dollars (or Euros or Sterling) if necessary. Thus, every country on the globe holds such currency reserves. Traditionally, this has almost always been done in US dollars, British sterling or Swiss Francs and now Euros are increasingly popular.

Reserve currency requirements are 'arch-conservative' by definition - the world's central banks are looking for the most long term safety and security here. And that is the real issue at hand here. At present, the vast majority of the world's Central Bank reserves are held in US dollars. We are talking huge numbers here. Between China and Japan, they hold about three trillion of US dollars in such reserves right now. These are the two largest 'hordes' out there, but every central bank in the world holds such reserves.

Anyway, to make a long story short, the real issue here is the significant change in the long term status of the US dollar and recognition of the inherent risk in having ANY sovereign nation controlling such an important world resource. Essentially, the US is directly on path to go into inflation mode in the next few years and that will deflate the value of US dollar holdings and the central bankers who hold the biggest hordes of US dollar reserves are not liking the prospects of that.

Thus, the idea of a 'new' reserve currency that would NOT belong to any one nation, but rather be an international initiative. Essentially this would entail a 'world central bank' that would serve as a banking 'window' only to other sovereign central banks. This currency would serve for this purpose.

On the whole, not a bad idea at all. It is probably a long way off, but this is likely where things are heading. Bottom line is that this is a 'political message' of concern over present US fiscal policy. The longterm bondholders of US sovereign debt are getting a bit nervous over the longterm US dollar.

:)

[Sucre]

Here is the Chinese proposal, just published recently on 24 March :
http://www.pbc.gov.cn/english//detail.asp?col=6500&ID=178

It clearly explains the advantages of an international currency.

I am all in for such an international currency - not the dollar, linked to one country, not the Euro, linked to one region but a "reference", some kind of basket of the different currencies, similar to the ECU in Europe between 1979 and 1999.

Keynes made a similar proposal at the Breeton Wood conference after WWII. The international currency would have been called the "Bancor". But he failed and the dollar was chosen as the reference.