By Ravi Kant
The International Monetary system is passing through a historic change after the collapse of the Bretton Woods system. The Bretton Woods system marked a historic milestone for a national currency (US Dollar) to serve as the global reserve currency for such a long period. Reserve currency is a currency held by central banks and other major financial institutions as a means to pay off international debt obligations or to influence the domestic exchange rates. The US dollar serves as an international reserve currency mainly due to the size of its economy and large liquid dollar-denominated bond market.
It was decided at the Bretton Woods Conference that the US Dollar would be used as global reserve currency. | Source: United NationsTriffin Dilemma
However, in recent decades, serious questions have been raised among policymakers over the sustainability of a national currency to serve as a global reserve currency. These concerns are primarily due to persistent current account deficit and large foreign debt held by the United States. Robert Triffin had rightly identified these problems five decades ago. According to Triffin,
“A national currency which also serves as global reserve currency always has to maintain a current account deficit”.
In simple words, the country whose currency a foreign nation wishes to hold, must be willing to provide an extra supply of its currency to the world. This extra supply of national currency fulfils the demand of reserve currency and may result in a trade deficit.
[su_pullquote align=”right”]Countries like China and Russia, which are enormous dollar dominated debt holders, are understandably frustrated by the lack of alternative reserve instruments.[/su_pullquote]
The Triffin’s Dilemma argued that the demand for an international reserve currency means that excess supply will undermine its value. Countries like China and Russia, which are enormous dollar dominated debt holders, are understandably frustrated by the lack of alternative reserve instruments. They are also worried about the value of their hoards in case USA defaults on its debt obligations. More so, they are aspiring for power that makes no secret of Washington global hegemony and bats for a more equitable world order. However, the solution does not lie in replacing the dollar with another national currency but moving towards a multi-currency system and making greater use of the only true global currency i.e., “Special Drawing Rights” (SDR).
The 2007 US Housing Bubble Burst emphasised the drawbacks of Triffin Dilemma. | Source: Chicago TribuneThere is a fundamental incompatibility between the attainment of Global Economic Stability and having a single currency performing the role of the World Reserve Currency. The underlying conflicts identified by the Triffin Dilemma have always remained. The ease with which the US could borrow and carry debt was tolerated for decades. This tolerance was undoubtedly due to gold no longer being a monetary anchor. But in 2007, it reached a point where it could no longer be tolerated because market structure could no longer cope with more debt.
Special Drawing Rights: The Road Ahead
Robert Mundell once said, “Great powers have great currencies!” US with its $19 trillion debt obligations and an almost average zero percent growth for the past decade is not going to be a great economic power in the near future. There are major debt bubbles in form of real estate, bond, stocks and derivatives looming across major global economies like US, Japan, EU and China. This is leading to an apprehension among policy makers that US dollar will be no longer able to provide enough liquidity or act as an anchor if the next economic crisis happens. This is due to the dollar having lost all its firepower in battling the recession in 2008 caused due to the US housing bubble collapse in the form of quantitative easing. So, the only way forward is to look for another currency which can act as a source of major liquidity in case of any crisis.
[su_pullquote]SDR’s have never been alien to the world monetary system and were issued to increase the global liquidity during major international crises.[/su_pullquote]
SDR was created by IMF in 1969 as a supplementary reserve asset in the context of the Bretton Woods system since gold and dollar proved inadequate for supporting the expansion of world trade as well as financial flows that were taking place. SDR’s have never been alien to the world monetary system and were issued to increase the global liquidity during major international crises. Examples include the 1971 oil crisis, 1997 Asian financial crisis as well as the recent 2009 “US housing bubble” collapse.
In last November, the IMF decided to include the Chinese currency “Yuan” in its special drawing rights basket as the fifth currency effective from October this year.
Initially, the value of SDR was defined as 0.888671 grams of gold, which at that time was also equivalent to one US dollar. After the collapse of Bretton Wood system, the SDR was redefined as a basket of currencies. The basket consists of the US dollar, Euro, Japanese Yen and Pound Sterling. The membership in the SDR basket gave a symbolic IMF approval to hold these currencies as a reserve instrument for foreign governments. In recent months, the IMF executive board has decided to increase the role of “SDR” in global financial architecture. In last November, the IMF decided to include the Chinese currency “Yuan” in its special drawing rights basket as the fifth currency effective from October this year. The decision marks an important milestone in the integration of the Chinese economy into the global financial system. It can also be seen as a vote of confidence in China’s growing financial clout. The G20 Summit in China held in September, 2016 has added more impetus to this shift.
[su_pullquote]Later this year, countries will be able to exchange the dollar and treasuries for SDR from the IMF.[/su_pullquote]
When the policy makers decided to increase the role of SDR in the global monetary system in order to avoid crisis, it was agreed that the SDR will replace the dollar to settle trade from October. Later this year, countries will be able to exchange the dollar and treasuries for SDR from the IMF. China and IMF have been pushing the idea of the creation of SDR denominated bond market from a long time. The idea came to be realised in August 2016, when the World Bank decided to issue a $2.8 billion SDR bond in the Chinese domestic market. It thus fulfilled one of the prerequisites to become a reserve currency. Renminbi will be included in the SDR basket as a fifth currency along with US dollar, Euro, Japanese Yen and the British Pound. Renminbi will have a weightage of 10.92% in the new SDR basket, while the weightage of other currencies will be 41.73% for the US dollar, 30.93% for Euro, 8.33% for the Japanese Yen & 8.09 % for the British Pound. The process is quite slow as no one wants the dollar or treasuries to collapse soon as this would have a negative impact on global trade. SDR bonds will not compete with dollar-denominated bond market anytime soon but the groundwork is being laid. As Confucius said, “A journey of a thousand miles begins with a single step.”
Ravi Kant is an engineer who has a deep interest in Finance, Economics, and Cyber Security. He writes for various media outlets like “The Market Mogul” and many others.
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