The head of China’s central bank is calling for countries to replace the U.S. dollar as an international reserve currency with something called SDRs. Created by the IMF way back in 1969 for that purpose, SDRs never caught on. While SDRs may be declared an official international reserve asset today, they are not likely to become the world’s key international currency anytime soon. In the meantime, countries in China’s current predicament—acquiring more dollars than they think prudent—could avoid such risks in the future by allowing their currencies to appreciate.
Yi Gang, governor of the Bank of China, wants a new international reserve currency, one that is “disconnected from economic conditions and sovereign interests of any single country.” He claims that credit-based national reserve currencies, like the dollar, are inherently risky, facilitate global imbalances, and foster the spread of financial crises, but China’s concerns may also be a bit more parochial. The country holds a huge portfolio of dollar-denominated assets that could incur valuation losses, if recent U.S. actions to limit financial turmoil and stimulate the economy generate inflation and dollar depreciation. The People’s Bank of China has offered a fix to the dollar problem. They recommend supplanting the reserve-currency role of the U.S. dollar with Special Drawing Rights (SDRs), a composite currency issued by the International Monetary Fund (IMF). Others, including Nobel Prize winner Joseph Stiglitz and a U.N. panel of experts, have endorsed the idea. Adopting the SDR as an official international reserve asset may be technically feasible and it could conceivably occur fairly quickly, but substituting the SDR for the dollar more broadly as the world’s key international currency will not happen anytime soon. People reap substantial economies from conducting cross-border commerce in dollars, and until the SDR matches these benefits, central banks will still need dollars. In the interim, countries that want to limit their exposure to credit-based reserve currencies, like the dollar, might simply allow their currencies to appreciate. Something Old, Something New Complaints about the dollar and a fascination with SDRs are not new. The IMF created SDRs as an international reserve currency in the late 1960s to solve problems, similar to Dr. Zhou’s concerns, which rose out of the Bretton Woods fixed-exchange-rate system. Although Bretton Woods was at its heart a gold-based currency arrangement, the U.S. dollar quickly emerged as the key international currency, both for financing international commerce and as an official reserve currency. Today, as during Bretton Woods, countries accumulate foreign exchange when they prevent or limit the appreciation of their currencies in the face of persistent trade surpluses and foreign financial inflows. Once acquired, official reserves then provide these countries with a buffer stock that they can draw down to mitigate the disruptive economic effects of unexpected trade shortfalls and temporary outflows of foreign funds. Absent such reserves, these countries would either have to allow their currencies to depreciate or quickly tighten their monetary policies, but such abrupt adjustments could be disruptive and might not be compatible with these countries’ current goals for inflation or real economic growth. At its heart, the desire to acquire and hold official foreign-exchange reserves reflects a desire to prevent, or at least limit, exchange-rate adjustments. About 15 years into the Bretton Woods era—just like today—many countries began to view their holdings of official U.S. dollar reserves as excessive, and they worried that the United States might be forced to devalue the dollar. A dollar devaluation would saddle these countries with foreign exchange losses, since a devalued dollar would buy less abroad. As the situation unfolded, some countries, led by France, sought to replace the dollar with a reserve currency unrelated to a single national currency, if not solely related to gold. The IMF—then the guardian of the Bretton Woods parity grid—came up with the SDR. The IMF initially defined the SDR in terms of a fixed amount of gold, then equal to one dollar, and allocated 9.3 billion SDRs between 1970 and 1972 to member countries in proportion to their quotas in the IMF. Before the SDRs even hit the shelf, however, President Nixon threw a wrench in the Bretton Woods works. He closed the U.S. gold window on August 15, 1971, refusing thereafter to convert dollar reserves into U.S. gold. Countries holding dollars were stuck. By March 1973, the large developed countries had all allowed their currencies to float against the dollar, ending their need to acquire dollar reserves. With the advent of floating exchange rates, the IMF redefined the SDR as a weighted average of the U.S. dollar, the British pound, the Japanese yen, and the currencies that eventually comprised the euro. The dollar has the largest weight, currently about 40 percent, so changes in the dollar impact the SDRs more than similar changes in the pound, yen, or euro. Because of its construction, however, the SDR will likely be more stable relative to other currencies than the dollar; so, holding a portfolio of SDRs is liable to present a country with less exchange-rate valuation risk than holding dollars. While many in the late 1960s and early 1970s believed that the SDR would supplant reserve currencies and possibly even gold in official portfolios, the SDR basically died at birth. The IMF made a second allocation of 21.4 billion SDRs between 1979 and 1981, again in proportion to member countries’ quotas, but the SDR quickly devolved for the most part into a unit of account, primarily on the IMF’s books, as the large developed countries accepted floating exchange rates as the norm. If countries are willing to allow their exchange rates to adjust freely to trade flows and to cross-border movements of financial funds, they do not need official foreign-exchange assets. Despite the widespread acceptance of floating exchange rates, however, no country—including the United States—has completely tossed out their portfolio of foreign-exchange reserves. They keep some around just in case they may sometimes want to support their exchange rates. In doing so, they accept that the exchange value of these reserves will fluctuate from time to time. The Dollar The reserve currency of choice is the dollar (figure 1). The IMF estimates that 64 percent of the world’s official foreign-exchange reserves are held in dollar-denominated assets. The euro, the second most widely held international reserve currency, lags well behind, followed by the British pound and Japanese yen. These currencies’ rankings as official reserves parallel their status in international commerce more generally. This correlation should be of no surprise. Why hold a currency that no one uses?
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