We’ve been treated as being a bit daft when we dared suggest that the dollar’s status as reserve currency was at risk. But after the Fed moved officially to quantitative easing last week (after saying it they might go that route back in December), the euro strengthened. Many have argued that that the ECB lacked the full suite of tools a modern central bank needed, and thus the euro was too shaky a currency to serve as a store of value. But do enough to damage the dollar, and former second best options may start looking a lot more atractive.
So far, this move is merely a shot across the bow, but the fact that China is raising doubts about the dollar is not trivial. And while the Fed may want a cheaper dollar (weakening the currency is a standard remedy for a country suffering a financial crisis), a disorderly fall in the dollar would be another matter entirely, and could constrain the Fed.
In addition, the Fed has been called the second least independent central bank in the world, and if a fall in the dollar led to markedly higher oil prices, there could be political pushback.
From the Financial Times:
China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.
In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”…..
“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.
Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.
“The outbreak of the [current] crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Mr Zhou wrote.
China has little choice but to hold the bulk of its $2,000bn of foreign exchange reserves in US dollars, and this is unlikely to change in the near future.
To replace the current system, Mr Zhou suggested expanding the role of special drawing rights, which were introduced by the IMF in 1969 to support the Bretton Woods fixed exchange rate regime but became less relevant once that collapsed in the 1970s.
Today, the value of SDRs is based on a basket of four currencies – the US dollar, yen, euro and sterling – and they are used largely as a unit of account by the IMF and some other international organisations.
China’s proposal would expand the basket of currencies forming the basis of SDR valuation to all major economies and set up a settlement system between SDRs and other currencies so they could be used in international trade and financial transactions…
Mr Zhou said the proposal would require “extraordinary political vision and courage” and acknowledged a debt to John Maynard Keynes, who made a similar suggestion in the 1940s.