Hostage to the Dollar

Positioning and propaganda in the lead-up to the recent G20 meeting in London are at last focusing attention on the role reserve currencies play and the dollar in particular. But change is going to be very hard to achieve.

China has been in the forefront of this by arguing for a greater role for International Monetary Fund units of account, Sor pecial Drawing Rights (SDR) and a big new issue of SDRs. It has also begun to prepare the ground for its currency, the yuan, to play a role by agreeing currency swap deals with central banks of several countries including Malaysia , Indonesia and Argentina. And it has publicly raised concerns about the safety of its US investments in the wake of massive bank bail-out and stimulus deficits to which Washington is committed.

The US, for obvious reasons, is less than keen on changes that would reduce the role of the dollar and hence its ability to fund its deficits in its own currency. Europe may like to see a greater role for the euro but is worried that any move out of the dollar would push the euro too high and damage its trade, and the cautious Germans in particular are worried that a big SDR issue would simply boost future global inflation.

Europe is also aware that a big SDR issue which would increase the unit's role would not be supported by China and other emerging market countries such as Brazil, India and South Africa unless accompanied by a massive revision of IMF quotas (on which SDR issues are based) to reflect the current balance of the global economy. The EU countries plus Switzerland and Norway combined currently control 29 percent of IMF quotas and votes, compared with only 16.8 percent for the US and just 3.8 percent for China. As changes require 85 percent of the vote, both the US and a combination of just three or four large European countries can veto change.

Although it is now generally accepted that China and others must be offered major increases – though this cannot in practice happen till 2011 – it will not be easy to achieve a consensus as the western countries resists the dilution of their influence.

The need for SDR increases is only partly related to a move to reduce the role of the dollar. Indeed, the SDR was created to increase global liquidity at a time when dollars were in short supply. Now of course dollars are over-abundant. The flood of them in recent years has given rise to excess reserves being held by a few, mostly Asian, countries headed by China. This dollar liquidity has both facilitated trade growth and created global asset bubbles which are now deflating.

Looking ahead, the US looks set for a prolonged recession which will drastically reduce its external deficit and hence the supply of additional dollars to the world. Both alternative reserve currencies, the euro or yen, are both based on economies with ageing populations and at best near-zero growth. They cannot fill the gap. So new liquidity will be needed, particularly for the one group of countries with ability to grow – middle-income developing ones.

At the recent G20 it was agreed that a $250 billion quota issue be made. But most of this will, in accordance with quotas, go to developed countries, not the ones who need it most. Thus there are very good practical reasons for needing a quota redistribution quite apart from the "fairness" argument.

There have also been suggestions that China's worries could be assuaged by exchanging with the IMF its US Treasury assets for SDRs. However, the question is who would bear the cost of a fall of the dollar against the SDR, of which the dollar comprises only 40 percent. The US is unlikely to agree to its debts being redenominated in SDRs, the IMF does not have the resources to fund a gap, and China might anyway prefer to deal directly with Washington than vias the IMF.

China's concerns about it dollar investments are at the same time both reasonable and hypocritical. They are reasonable in that any creditor on this scale is actually in a weak bargaining position, particularly vis-a-vis a rival for global political influence. It cannot readily reduce its dollar holdings without drastically driving down their value. And it has to wonder how the US is ever going to repay other than in dollars devalued either deliberately or through the return of high inflation.

However it is also true that China was warned often enough of the dangers of tying its own currency to the dollar to generate export driven growth and of failing to diversify its reserves because to do so would have weakened the dollar and increased pressure to revalue the yuan. The US and China locked themselves into a bargain which worked well in the short term but has left a huge legacy of debt and dependence.

China is now simultaneously worrying about its dollar assets yet earnestly seeking a recovery in US demand for Chinese goods – particularly hard hit because discretionary items form a significant part of its exports. It cannot have both.

The yuan currency swaps with other emerging countries make good public relations and over time may lead to use of the yuan in trade other than cross border stuff with Hong Kong, Vietnam etc. It may encourage mainland firms to offer yuan-denominated export credits which would help China's exports. But the yuan will remain of limited use as long as it is not fully convertible, and demand for yuan credit will be very limited so long as it is perceived to be undervalued. There is also the question of whether China can usefully use the currencies it gets in exchange. Malaysian ringgit may be sound enough, but who wants to hold Argentinian pesos for too long?

The dollar may be a poor store of value but it remains king as a transaction currency and will likely remain so. Only a few countries have such a huge dollar surplus that they have to worry about its long-term value. Generally, willingness to hold dollars for transaction purposes has enabled the US to overspend, which has benefited most of the world until now. In any case there is probably not much more reason to worry about the dollar in the long term any more than any other fiat currency. All currencies which can be created at the whim of a government or central banks are prone to gradual debasement.

Of course the euro and yen are transaction currencies too. There is some use of the euro in Asia and also of the yen, particularly in invoicing of Japan's exports to Asia. But the yen's role in trade has actually diminished in recent years as Japan's dominance of trade in Asia has been eroded by China and South Korea, both countries which more or less have stuck to a dollar standard. So too have the export oriented countries of Southeast Asia.

If the IMF fails to move with the times and give due weight to newer powers, and the US recession is long and deep enough, one may now well see further moves to currency cooperation within Asia, building on the Chiang Mai initiative which began after the Asian crisis. That would boost the role of the yuan and yen and maybe of the Korean won, increasing regional lending in all three currencies, causing southeast Asian currencies to align themselves more closely with their larger Asian neighbors and generally reduce their linkages to the dollar.

But for all the major players that is a second-best solution. In practice, however much they may like the idea of reducing their dependence on the west, they see themselves as global players who cannot just think in Asian terms. South Asia, the Middle East, Africa, South America. All are important to their long-term trade and diplomatic objectives.

Thus though they will continue to make a lot of noise about regional cooperation and compete with each other to demonstrate concerns for smaller neighbors, they really want a much bigger role on the global stage. And that can only be acquired incrementally and without upsetting key existing relationships. However uncomfortable they now feel, China and the US have created a level of mutual dependence which requires changing the system – but gradually.