Friday, May 8, 2009

How to Make a New Reserve Currency

As a follow up my earlier posts on the SDRs as reserve currency, here are two related article worth reading. The first one is by Owen Humpage of the Cleveland Federal Reserve who does a nice job quantifying why the dollar is the reserve currency. Humpage concludes the SDRs are unlikely to supplant the dollar anytime soon. The second article is from Barry Eichengreen who agrees there are many hurdles to clear before the SDRs could become a reserve currency. Eichengreen, however, does spell out some ways to clear these hurdles:
If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. Better still, it could encourage other G-20 countries to do likewise. They would pay a price, since investors in these bonds would initially demand a novelty premium. But nothing is free. That price would be an investment in a more stable international system.

Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims. Back in the 1970’s, there was some limited issuance of SDR-denominated liabilities by commercial banks and SDR-denominated bonds by corporations. But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.

Overcoming that advantage now would require someone to act as market-maker for private as well as official transactions and subsidize the market in its start-up phase. The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, private as well as official, at narrow bid/ask spreads competitive with those for dollars.

The dollar originally acquired international currency status in the 1920’s, when the newly established Federal Reserve started buying and selling dollar acceptances, backstopping the market and enhancing its liquidity. If the international community is serious about the SDR as an international currency, it will have to empower the IMF to do likewise.

Again, there would be a cost. The IMF would be using real resources to subsidize the market until private market-makers saw it as attractive to provide those services at comparable cost. The Fund’s shareholders would have to agree to incur those costs. But, again, what is this if not an investment in a more stable global monetary system?

Transforming the SDR into a true international currency would require surmounting other obstacles. The IMF would have to be able to issue additional SDRs in periods of shortage, as when the Fed provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. At the moment, countries holding 85% of IMF voting power must agree before SDRs can be issued, which is no recipe for liquidity.

The IMF’s management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps. For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.

Working through the IMF and its member countries makes some of the above suggestions difficult. I wonder if there might be a role for an Asian Monetary Fund in China's efforts to promote an alternative reserve currency.

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