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It started out as a call from the likes of George Soros and Ted Truman.
But the IMF’s little known international accounting system of special drawing rights [SDRs] has now been propelled straight into the limelight thanks to both China and Russia. However, while Soros and Truman saw the units as a means to help induce a global helicopter cash drop to kick-start the world economy and save the peripheral states from financial implosion, the Chinese and Russians are advocating the accounting system as a means towards a new global reserve currency.
And this does make some sense. Many months ago, when the topic was firmly off the agenda we asked Ken Rogoff, Harvard economics professor and former chief economist of the IMF, about the role of SDRs in the future. His said they were basically not very meaningful in the absence of a consensus to have a world currency. So is that really what China, Russia, Soros and Truman are advocating?
Worth considering is the following quote from Paul Volcker:
One historic way of getting yourself out of this situation — or trying to — is to inflate. Either you do it deliberately or you allow it to happen,” [Vlocker] said. “And if we permit that to happen then I think all these dollars will come tumbling down on us.” …
If inflation really is on its way on a large Volckerian scale, the dollar reserve system could be under serious pressure – from the point of view it would threaten China’s and other surplus countries’ reserves to such a degree they would be forced to do something about it. Preparing a new alternative system based on SDRs therefore seems a logical contingency for them.
Of course, talk about China dropping the dollar system has generally tended towards the hot-air empty threat arena — not a serious consideration.
As CFR blogger Brad Setser points out in his latest post, despite all the rhetoric, China has actually been actively adding to its treasury holdings. This is largely because its experiment with Fannie/Freddie agency debt failed on a major degree and consequently has little alternative choice.
What’s interesting, however, is that even Brad Setser sees growing credence for China’s apparent plan B. As he explains:
I have tended to put more weight on what China has done over the past several months – including pegging tightly to the dollar – than on what China has said over the past few months. But I increasingly think that the apparent rise in the Treasury and dollar share of China’s portfolio may have led me to discount Chinese rhetoric expressing concern about its dollar exposure a bit too heavily.
But China is now – some might argue belatedly – worried about the scale of its resulting exposure to low-yielding dollar assets. Plan A, taking on more credit and equity market risk to offset the dollar’s decline while continuing to add massive quantities of dollars to its reserves, didn’t work. The end result has been more Treasury exposure than China really feels comfortable with; if nothing changes, China soon really will have a $1 trillion Treasury portfolio.* It already has over trillion dollars of Treasuries and Agencies. China consequently does seem to be looking seriously for a Plan B.
And it is Setser’s opinion that the US shouldn’t necessarily be opposed to the idea of a host of countries like China dropping their pegs to the dollar system as a result of their concerns. The US should therefore be prepared to give up some of its global reserve hegemony and be open to the development of an Asian reserve currency or even a set of Asian reserve currencies to compete with the dollar much like the euro has done.
Certainly there is and has been talk in Asia of potential pegging to the yuan, as even Standard Chartered points out in their morning note on Wednesday — although they don’t see this happening any time soon. As they put it:
Another possible condition for a change in the HKD peg, the CNY becoming fully convertible, is unlikely to happen anytime soon, in our view. This is echoed by the latest comments from Chief Executive Donald Tsang that the HKSAR government could consider a ‘linkage’ with the CNY if the Chinese currency became fully convertible. This official indication of the possibility of a CNY peg is obviously intriguing, but we think the focus should instead be placed on the caveat.
However, if the stability of USD was to be threatened in anyway:
We are aware that the US Federal Reserve’s latest decision to make major additional purchases of securities to its existing balance sheet could add a new dimension to the HKD peg debate. The idea of the Fed printing money has clearly hurt the USD over the past week or so, spurring talk of the demise of the USD. The resulting unease around the HKD peg is understandable. In the end, the strength and credibility of the USD are at the core of Hong Kong’s Linked Exchange Rate System. It is these qualities that anchor market confidence in the HKD and hence the currency’s stability – so much so that the negative side effects of the currency regime (e.g. the lack of monetary policy autonomy to tackle cyclical inflation and growth concerns that are temporarily out of line with those of the US) seem bearable. These negatives are outweighed by the benefit of maintaining confidence in the HKD – something that could otherwise be hard to come by for a relatively small but highly liquid market that guarantees free inflows and outflows of money.
A collapse of the USD would require a complete loss of faith in the currency among global investors (as an investment choice, a means for global trade settlement, and the major reserve currency for most central banks around the world). In our view, we are nowhere near such a scenario, and it would be in no one’s interest (especially central banks’) if it ever happened. But hypothetically, if it did happen, it could pave the way for the HKD peg to change. The next logical question is, which alternative currency regime should Hong Kong adopt? (Please see the Appendix for a detailed list of options.) A CNY peg should remain out of the question, given that the CNY is far from becoming a fully convertible and internationalised currency. Re-pegging to the EUR or to a basket of currencies could be the least of all evils in formulating a contingency plan or a near-term exit strategy.
So while Standard Chartered feels repegging of the Hong Kong dollar is unlikely given the current status of the yuan (it’s non full convertibility) the idea of pegging to the euro or a basket of currencies is still a potential alternative. It is worth stressing, however, that Standard Chartered conclude sticking to the dollar is probably the best scenario for Hong Kong. That said, if the yuan did become linked to an SDR basket rather than the dollar on account of the G20 proposals could this philosophy possibly change?
What’s more, it might not even take a ‘new reserve currency’ to rebalance the global economy in the way China wants. As Setser points out a bit more exchange rate adjustment, a bit more floating and a bit less reserve growth might just do the trick. But, at the same time, he says the world shouldn’t exclude the prospect of new additions to global reserve currencies, and the SDR basket — currently made up of the dollar, sterling, euro and yen. As he puts it:
It isn’t all that hard to imagine a world where a convertible RMB places a much larger role in the global financial system — and is something of an anchor for a group of Asian currencies that float against the world’s other major currencies.
Zhou’s proposals lead naturally to a discussion not just of reserve currencies, but exchange rates, exchange rate regime and reserve growth. That is a discussion that the G-20 ultimately needs to have.
With all of the above on the table, perhaps the G20 for once will conclude with more than just empty rhetoric?
Related links:
G20: Discussing the shape of international reserves to come – FT Alphaville
One giant drop of cash for mankind? – FT Alphaville
A paper gold reserve system? – FT Alphaville
