Friday, November 28, 2014

After the Dollar

NEW YORK – It is symbolic that the recent BRICS summit in Fortaleza, Brazil, took place exactly seven decades after the Bretton Woods Conference that created the International Monetary Fund and the World Bank. The upshot of the BRICS meeting was the announcement of the New Development Bank, which will mobilize resources for infrastructure and sustainable development projects, and a Contingent Reserve Arrangement to provide liquidity through currency swaps.

The Bretton Woods Conference marked one of history’s greatest examples of international economic cooperation. And, while no one can say yet whether the BRICS’ initiatives will succeed, they represent a major challenge to the Bretton Woods institutions, which should respond. Rethinking the role of the US dollar in the international monetary system is a case in point.

One key feature of the Bretton Woods system was that countries would tie their exchange rates to the US dollar. While the system was effectively eliminated in 1971, the US dollar’s central role in the international monetary system has remained intact – a reality that many countries are increasingly unwilling to accept.

Dissatisfaction with the dollar’s role as the dominant global reserve currency is not new. In the 1960s, French Finance Minister Valéry Giscard d’Estaing famously condemned the “exorbitant privilege” that the dollar’s status bestowed upon the United States.

The issue is not merely one of fairness. According to the Belgian economist Robert Triffin, an international monetary system based on a national currency is inherently unstable, owing to the resulting tensions among the inevitably divergent interests of the issuing country and the international system as a whole.

Triffin issued his warning more than 50 years ago, but it has recently gained traction, as China’s rise has made the world increasingly disinclined to tolerate the instability caused by a dollar-denominated system. The solution, however, lies not in replacing the dollar with the renminbi, but in strengthening the role of the world’s only truly global currency: the IMF’s Special Drawing Rights.

Following the creation of SDRs in 1969, IMF members committed to make them “the principle reserve asset in the international monetary system,” as stated in the Articles of Agreement. But the peculiar way in which SDRs were adopted limited their usefulness.

For starters, the separation of the IMF’s SDR account from its general account made it impossible to use SDRs to finance IMF lending. Furthermore, though countries accrue interest on their holdings of SDRs, they have to pay interest on the allocations they receive. In other words, SDRs are both an asset and a liability, functioning like a guaranteed credit line for the holder – a sort of unconditional overdraft facility.

Nonetheless, SDRs have proved to be useful. After initial allocations in 1970-1972, more were issued to increase global liquidity during major international crises: in 1979-1981, in 1997, and, in particular, in 2009, when the largest issue – the equivalent of $250 billion – was made.

While developed countries, including the US and the United Kingdom, have drawn on their allocations, the major users have been developing and, in particular, low-income countries. In fact, this is the only way in which developing countries (China aside) share in the creation of international money.

Several estimates indicate that, given the additional demand for reserves, the world could absorb annual allocations of $200-300 billion or even more. This has prompted many – including People’s Bank of China Governor Zhou Xiaochuan; the United Nations-backed Stiglitz Commission; the Palais-Royal Initiative, led by former IMF Managing Director Michel Camdessus; and the Triffin International Foundation – to call for changes to the international monetary system.

In 1979, the IMF economist Jacques Polak, who had been part of the Dutch delegation at the Bretton Woods conference, outlined a plan for doing just that. His recommendations include, first and foremost, making all of the IMF’s operations in SDRs, which would require ending the separation of the IMF’s SDR and general accounts.

The simplest way to fulfill this vision would be to allocate SDRs as a full reserve asset, which countries could either use or deposit in their IMF accounts. The IMF would use those deposits to finance its lending operations, rather than having to rely on quota allocations or “arrangements to borrow” from members.

Other provisions could be added. To address developing countries’ high currency demands, while enhancing their role in the creation of international money, a formula could be created to give them a larger share in SDR allocations than they now receive.

The private use of SDRs could also be encouraged, though that would likely be met with strong opposition from countries currently issuing international reserve currencies, especially the US. Keeping SDRs as pure “central-bank money” would eliminate such opposition, enabling them to complement and stabilize the current system, rather than upend it.

Just as the Bretton Woods framework restored order to the global economy after WWII, a new monetary framework, underpinned by a truly international currency, could strengthen much-needed economic and financial stability. Everyone – even the US – would benefit from that.

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    1. CommentedHenri Erti

      The international monetary system (IMS) has arrived at a crossroads, as dangerous imbalances in the IMS are largely due to the dollar's privilege as the most used currency in international trade and investment. The idea of Special Drawing Rights (SDRs) replacing the USD as de facto international reserve currency has gained significant support. Though the list of SDR-weaknesses is abundant, a difficult transition towards its use as a proxy is a necessary alternative to an IMS collapse.

      Detrimental instabilities in the current paradigm have existed in the core of the IMS ever since the Bretton Woods system, but the global economic conditions have dramatically changed due to globalization and technological improvements. Consequently, a comprehensive reform is needed in order to shift further from the Triffin Dilemma, which exacerbates the existing instabilities in the IMS through the need to accumulate reserves, protect against volatile capital flows, insufficient adjustment mechanism and external imbalances. An ambitious resurrection of the SDR as a potential tool to initiate the IMS reform has gained a great deal of attention. The international community is growing increasingly bitter towards the unavoidable dollar-standard; hence the current attitudes may in fact provide the IMF an opportunity to present the SDR as a potential solution. Therefore, this paper examines the current instabilities in the International Monetary System and studies whether the Special Drawing Rights can become a new dominant reserve currency to facilitate global economic activities.

      Several prominent world leaders and thinkers have proposed the idea of a more representative currency instrument, which would address the current imbalances. The idea of SDRs replacing the U.S dollar as de facto international reserve currency has gained significant support. Adopting a synthetic global currency that would be based on a basket of existing currencies and operated by the IMF could, in theory, gradually end the world's dependency on the dollar anchor in international trade and investments. By expanding the quantity of SDRs in circulation, central and commercial banks would gradually have a larger incentive to hold such an instrument. A more stable and safe global asset could produce greater stability in exchange rates and also facilitate the correction of large imbalance in the IMS.

      We can expect the IMS to move towards a system where multiple reserve currencies operate in their regions. However, the dollar is likely to remain at the top of the pyramid, facilitating the distribution of economic power. However, the success in global collaboration requires the participation of all major stakeholders of the IMS. Therefore, leading countries may have to embrace more responsibilities in restructuring the IMS using IMF and the SDR as a proxy and comprehensive synthetic financial instrument. The transition period will be difficult and full of mechanical difficulties. However, that will be a small price to pay in order to avoid a total collapse of the IMS.

    2. CommentedAdrien Fabre

      It is very interesting but one can not fully understand this article unless one knows perfectly well the global monetary system. Could you tell us what should we read to embrace this field, especially the SDRs ?

    3. Portrait of Pingfan Hong

      CommentedPingfan Hong

      But the BRICS New Development Bank will continue to use the US dollar, rather than RMB or the currencies of other BRICS members.