Will the G-20 Finally Dump the Dollar as the World's Main Reserve Currency?

The Group of 20 (G-20) is meeting today (Thursday) and tomorrow (Friday) in Seoul, South Korea, and one of the main topics of discussion will be the role of the U.S. dollar in the post-crisis global economy.

Debate over the dollar's role as the world's main reserve currency rose to a fevered pitch in 2008 when the financial crisis, which began in the United States, first roiled global markets.

Emerging markets – particularly China, which holds some $2 trillion of foreign reserves – bemoaned the dollar's decline as it drained their dollar-denominated assets of value. Food and energy prices have climbed to record highs, as have many foreign currencies, further exacerbating the issue.

The fear among many foreign policymakers is that the United States is intent on further debasing its currency – to the detriment of their neighbors – in an effort to prop up its sagging economy.

Irate over the U.S. Federal Reserve's latest round of quantitative easing, G-20 members have pledged to make the dollar a focal point of discussion at today's summit. Leading the charge has been Brazil, whose finance minister, Guido Mantega, said a basket of currencies that includes the real, yuan, and euro, should replace the dollar as the world's main reserve currency.

"The U.S. economy used to reign absolute, it was the strongest economy in the world and stood out from the others." Mantega said at a press conference in Seoul. "Today that is no longer the case."

Mantega was one of the first high-ranking officials to use the term "currency war" to describe the current state of affairs.

"We're in the midst of an international currency war, a general weakening of currency," he told The Financial Times in October. "This threatens us because it takes away our competitiveness."

Mantega and other influential economists would like to take the opportunity presented by the world's systemic breakdown to remake the system – including the dollar's seemingly oversized role in the global economy.

"Now is the moment to think about a transition where there would be new currencies that would be the parameters for international trade," Mantega said.

The Red Dragon and the Dollar

Chinese policymakers for the past two years have made a case similar to Mantega's.

People's Bank of China Governor Zhou Xiaochuan last year published an essay entitled "Reform of the International Monetary System." In it, Zhou called for the "re-establishment of a new and widely accepted reserve currency with a stable valuation" to replace the U.S. dollar – a credit-based national currency. The central bank governor noted that the International Monetary Fund's (IMF) Special Drawing Right (SDR) should be given special consideration. 

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar.

"The SDR has the features and potential to act as a super-sovereign reserve currency," said Zhou. "Moreover, an increase in SDR allocation would help the Fund address its resources problem and the difficulties in the voice and representation reform. Therefore,efforts should be made to push forward a SDR allocation."

Zhou proposed the following actions to move the SDR in a direction that could better accommodate demand for a more stable reserve currency:

  • Set up a settlement system between the SDR and other currencies. Therefore, the SDR, which is now only used between governments and international institutions, could become a widely accepted means of payment in international trade and financial transactions.
  • Actively promote the use of the SDR in international trade, commodities pricing, investment and corporate bookkeeping. This will help enhance the role of the SDR, and will effectively reduce the fluctuation of prices of assets denominated in national currencies and related risks.
  • Create financial assets denominated in the SDR to increase its appeal. The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.
  • Further improve the valuation and allocation of the SDR. The basket of currencies forming the basis for SDR valuation should be expanded to include currencies of all major economies, and the GDP may also be included as a weight. The allocation of the SDR can be shifted from a purely calculation-based system to one backed by real assets, such as a reserve pool, to further boost market confidence in its value.

"The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies," said Zhou. "Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws."

Many analysts view the campaign by emerging markets for a new reserve currency as an attempt to gain more control in the IMF, which has traditionally been dominated by richer countries. But the new currency campaign is also further evidence that Beijing is becoming less and less comfortable with its large holdings of U.S. assets, and intent on winning a broader role for its currency, the yuan or renminbi.

"For Westerners who are struggling to come to terms with the notion of a disarrayed dollar, the thought of oil, gold or other commodities being priced in yuan instead of dollars has to seem about as likely as having another country put a man on the moon," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "But the Chinese yuan is already well on its way to becoming that globally accepted standard unit of exchange and the proverbial genie, as they say, is out of the bottle."

However, other analysts argue that China isn't likely to support a framework where the yuan becomes key foreign reserve because that would mean making the currency fully convertible and allowing more inflows into the country.

"This more shows the helplessness of countries like Brazil in the face of quantitative easing, there's not much they can do about it so they lash out," Beat Siegenthaler, a currency strategist at UBS AG (NYSE: UBS) told Bloomberg. "They can criticize the U.S. and bring up this idea of replacing the dollar in reserves but in reality the U.S. couldn't care less."

Out of the Woods

World Bank President Robert Zoellick said in an op-ed piece in the Financial Times on Nov. 7 that the G-20 should take a "package approach to economic cooperation" that includes remaking the monetary system devised under the outdated Bretton Woods accords.

"The G20 should complement this growth recovery programme with a plan to build a co-operative monetary system that reflects emerging economic conditions," said Zoellick. "This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account."

Zoellick suggested that gold should be used as a reference point for market expectations and future currency values.

"Gold is now being viewed as an alternative monetary asset. This is not the same as a gold standard," Zoellick told The FT yesterday (Wednesday). "Gold has become a reference point because holders of money see weak or uncertain growth prospects in all currencies other than the renminbi, and the renminbi is not free for exchange."

Gold careened to a record high $1,414.85 an ounce on Tuesday in a surge that was sparked by the Fed's plan to purchase $600 billion of U.S. Treasuries in a second phase of quantitative easing.

Zoellick said remaking the world's monetary system would take "relentless incrementalism," but he does not agree with Mantega's assessment that the world is mired in a currency war.

"I don't believe we are going to be in a currency war; I think this is an overstated description," he said. "I have had to deal with real wars in my career, so I know what they are and I'm sensitive to the use of the term. [But] I do think there are tensions in the system, and if not properly managed those tensions risk an increase in protectionism."

Currency War

Protectionism is indeed on the rise, as many foreign countries are stepping up their efforts to combat the effects of a falling dollar – namely asset bubbles that could arise from foreign capital inflows, or "hot money."

"The last thing a developing economy wants is for that liquidity to distort their asset markets and create a destabilizing bubble," Stephen Roach, Morgan Stanley's (NYSE: MS) nonexecutive Asia chairman, told Bloomberg Television in an interview. "The process is not going to work if they don't come up with a multilateral solution."

The Swiss central bank has been intervening to prevent the appreciation of the Swiss franc against the euro for six months now. The last time it intervened was in 2002.

Japan in September sold an estimated $20 billion yen, as the currency surged to a little short of 90 to the dollar, the strongest in 15 years. The last time it intervened to sell yen in the foreign-exchange market was in 2004, when the yen was around 109 per dollar.

Some analysts and Japanese policymakers had theorized that China was attempting to hamper Japan 's recovery by purchasing Japanese bonds to keep the yen excessively strong.

"I don't know the true intention" behind China's purchase of $6.9 billion (583.1 billion yen) of Japanese government bonds in July, Finance Minister Yoshihiko Noda said earlier this month.

China also nearly tripled its holdings of South Korean government bonds to $4.6 billion (5.15 trillion won) in the first nine months of this year, according to South Korea's Financial Supervisory Service.

China, of course, intervenes in the currency market simply and directly by pegging the yuan to the dollar, despite pressure from the United States to let the currency appreciate. The country took additional stems to stem capital inflows by increasing reserve requirements for its banks.

South Korea has shown as much alacrity in intervening to keep the won weak and could revive a 14% tax on domestic Treasury and central bank bonds held by foreigners as soon as January.

South Korea is awash in cash with $293 billion of foreign exchange reserves – more than 10-times the amount it held little more than a decade ago. It's currency, the won, has appreciated 7.7% against the dollar since August and is headed toward 2010 highs.

Brazil last month tripled a tax that foreigners must pay to invest in the country's debt after its currency, the real, hit a two-year high on Oct. 13. The real has more than doubled in value since 2003.

Additionally, central banks and governments in Colombia, Thailand, Poland, Taiwan, Russia, Peru, Mexico, and South Africa are now either intervening directly in foreign exchange markets to try to force their currencies down, or talking about it.

The G-20 nations united two years ago in an effort to save the global economy. But since then, the army of nations that met global catastrophe with $5 trillion of coordinated fiscal stimulus has devolved into a discordant mob bickering over exchange rates, trade surpluses, and quantitative easing. So it's hard to believe policymakers will make much headway over the next two days.

"The international community united as one spirit during the crisis," South Korean President Lee Myung Bak said on Nov. 3. "There are doubts over whether such cooperation can be achieved now that the global economy is entering a recovery phase, with each country growing at a different pace."

Still, some analysts assert that if the G-20 breaks the monumental task before them into smaller piecemeal challenges, the end result will be worth any amount of consternation.

"The development of a monetary system to succeed Bretton Woods II, launched in 1971, will take time. But we need to begin," said World Bank President Zoellick. "Drive or drift? How the G-20 decides could determine whether multilateral co-operation can achieve a strong economic recovery. "

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