beyond the dollar - rethinking the international monetary system (riia)

8/9/2019 Beyond the Dollar - Rethinking the International Monetary System (RIIA)

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Beyond the DollarRethinking the InternationalMonetary SystemA Chatham House ReportEdited by Paola Subacchi and John Driffillwww.chathamhouse.org.uki


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Beyond the DollarRethinking the International Monetary

SystemA Chatham House ReportEdited by Paola Subacchi and John DriffillMarch 2010www.chathamhouse.org.ukii

Chatham House has been the home of the Royal Institute ofInternational Affairsfor nearly ninety years. Our mission is to be a world-leading source ofindependentanalysis, informed debate and influential ideas on how to build a

prosperous andsecure world for all.www.chathamhouse.org.uk

ContentsForeword by Benjamin J. Cohen vContributors viAcknowledgments viiiExecutive Summary and Recommendations ixPaola Subacchi and John Driffill

1 Introduction: No New Bretton Woods, but a System in Flux 1Paola Subacchi2 Reconsidering the Reserve Currency Question 10

John Nuge3 Lessons from History 16Catherine R. Schenk4 Challenges for the Dollar as Reserve Currency 23Gianluca Benigno5 The Fall-back Position 30

John Driffill6 A Roadmap for SDR Evolution 36DeAnne Julius7 A Twenty-first Century International Monetary System: Two Scenarios 43

Jim ONeill8 China Debates: The Dollar System and Beyond 46Gregory Chin and Wang Yong9 IMF Surveillance: Getting Tough on Exchange Rate Policies 52

Jeffrey M. Chwieroth10 Systemic Changes in the International Monetary System and the Need forCoordination, 57Cooperation and EnforcementChristopher M. Meissner


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11 Small Developing Countries in the International Monetary System 64Christopher Adam, Paul Collier and David VinesI

ForewordDoes the international monetary system require fundamentalreform? The question is not new. I can remember it beingasked half a century ago, back in the 1960s, when the postwardollar shortage turned into a dollar glut and Robert

Triffin formulated his famous Dilemma. It was posedagain in the 1970s, after President Richard Nixon closedthe gold window, suspending the convertibility of thegreenback into gold, and the exchange rates of majorcurrencies began to float. The question was back in thespotlight in the 1980s, when the Latin American debt crisisseemed to threaten the solvency of international banks.And it was asked again in the 1990s, following the Asiancurrency crisis, when everyone talked about the need to

rebuild the global financial architecture. Plus a change,plus cest la mme chose.Today, once again, reform of the monetary system is onthe agenda and for good reason. In the past three years,the world has passed through its greatest economicchallenge since the 1930s, and we are still not out of thewoods. In many countries growth remains sluggish,financial markets stay fragile, and global imbalances are asserious as ever. Protectionism is a constant threat.Currency misalignments persist. And at the centre of thesystem, Americas dollar continues to be undermined bylarge payments deficits and a swelling burden of debt. Thetheme of reform may not be new, but the need for reform

has never been more urgent.What can be done? The authors of this Chatham Housereport are right that the system is in flux. They are alsowise enough to know that reform of the system is unlikelyto come in one fell swoop. In the absence of a broadconsensus among key governments, calls for a grandglobal bargain a New BrettonWoods are naive at best.

The original Bretton Woods system was born in exceptionalcircumstances that are unlikely to be repeated anytime soon, if ever. Change, if it is to come at all, will emergefrom a gradual process of incremental adjustment andadaptation. The world, in a sense, is always in transition.

The coming years will be no different.But that does not mean that we must limit our ambition.Quite the contrary, in fact, as this report suggests. Roomexists for improvements on a number of fronts. Institutionalarrangements can be strengthened to promote cross-borderdialogue and policy cooperation. The surveillance role ofthe International Monetary Fund can be reinforced toaddress more effectively problems of exchange rates andpayments disequilibrium. And perhaps most importantly,steps can be taken to safeguard the system against overrelianceon a weakened dollar, including expansion of the


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role of the IMFs Special Drawing Rights. The strategy laiddown in this report is by no means timid. But it is doableand deserves to be taken seriously.Benjamin J. CohenLouis G. Lancaster Professor of International PoliticalEconomy, University of California, Santa Barbara

www.chathamhouse.org.ukvwww.chathamhouse.org.ukvi

ContributorsChristopher Adam is Reader in Development Economicsat the University of Oxford and an associate of the Centrefor the Study of African Economies. A former VisitingScholar at the International Monetary Fund, he iscurrently Lead Academic for the International GrowthCentre country programme in Tanzania.GianlucaBenigno is Reader in theDepartment of Economics

at the London School of Economics. He gained his PhD inInternational Macroeconomics from the University ofCalifornia at Berkeley. He has published on exchange rateeconomics, international monetary policy cooperation,monetary and fiscal policy. He has been a consultant at theIMF, a senior economist at the Federal Reserve Bank of New

York and an economist at the Bank of England.Gregory Chin is Assistant Professor at York University(Canada), where he teaches global politics, Chinesepolitics and East Asian political economy. He is a CIGIsenior fellow. He is the author ofChinas AutomotiveModernization: The Party-State and MultinationalCorporations (Palgrave Macmillan, 2010). He has also

recently published in The China Quarterly, China Security,International Journal,Journal of International Affairs,Foreign Policyand Far Eastern Economic Review.

Jeffrey M. Chwieroth is Senior Lecturer in InternationalPoliticalEconomy in theDepartment of InternationalRelationsat the London School of Economics.He has publishedwidelyon the political economy of international money andfinance, including Capital Ideas: The IMF and the Rise ofFinancial Liberalization (Princeton University Press, 2010).Paul Collier is Professor of Economics at the University ofOxford and Fellow of St Antonys College. He is also thefounder and Director of the Centre for the Study ofAfrican Economies at the University of Oxford. He wasDirector of the Development Research group at theWorldBank from 1998 to 2003. He is author of the best-sellingThe Bottom Billion.

John Driffill is Professor of Economics at Birkbeck,University of London, and Director of the UK Economicand Social Research Councils Programme on WorldEconomy and Finance. He is a Fellow of the Centre forEconomic Policy Research. His research interests aremainly in monetary policy and macro economics.DeAnne Julius is Chairman of Chatham House and a


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non-executive director of BP plc, Roche Holdings SAand Jones Lang LaSalle Inc. She also serves on theadvisory boards of UK and US hedge funds and is VicePresident of the Society of Business Economists in theUK. From 1997 to 2001 Dr Julius was a founder memberof the Monetary Policy Committee of the Bank of

England. From 2001 to 2004 she served on the Court ofthe Bank.Christopher M. Meissner is Associate Professor ofEconomics at the University of California, Davis andResearch Associate at the National Bureau of EconomicResearch (NBER). He was previously Lecturer in theFaculty of Economics, University of Cambridge and aFellow of Kings College. He has held visiting positions atthe International Monetary Fund and the NBER. In 2006he was a Houblon-Norman/George Fellow at the Bank ofEngland.

John Nuge is a Senior Managing Director of State StreetGlobal Advisors (SSgA), with responsibility for SSgAscentral bank, sovereign wealth fund and other officialsectorclients. Prior to joining SSgA in 2000 he had a careerin official reserves management for the Bank of Englandand the Hong Kong Monetary Authority, and was also adirector of the European Investment Bank and EuropeanInvestment Fund.www.chathamhouse.org.ukContributorsvii

Jim ONeill is Head of Global Economics, Commoditiesand Strategy Research for Goldman Sachs, managing thefirms economics, strategy and commodity research andthe output of these teams around the world. He is thecreator of the acronym BRICs and, together with his

colleagues, has published much research about BRICs,which has become synonymous with the emergence ofBrazil, Russia, India and China as the growth opportunitiesof the future.Catherine R. Schenkis Professor of InternationalEconomic History at the University of Glasgow. She is theauthor of several books and many articles on internationalmonetary relations, including The Decline of Sterling:Managing the Retreat of an International Currency19451992 (Cambridge University Press, 2010). She hasbeen visiting scholar at the Hong Kong MonetaryAuthority and the International Monetary Fund.Paola Subacchi is Research Director, International

Economics at Chatham House. She is a contributor topeer-reviewed journals and current affairs publications.She is a regular media commentator with the BBC, CNN,Bloomberg, CNBC, Newsweek, the Financial Times, theWall Street Journal and the International Herald Tribune.An Italian national, she studied at Bocconi University inMilan and at the University of Oxford.David Vines is Professor of Economics at the University ofOxford and a Fellow of Balliol College. He is also Adjunct


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Professor of Economics in the Centre for AppliedMacroeconomic Analysis at the Australian NationalUniversity, and a Research Fellow of the Centre forEconomic Policy Research in London. Since June 2008 hehas been the Research Director of the European UnionsFramework Seven PEGGED Research Programme, which

is analysing the politics and economics of global economicgovernance.Wang Yong is Professor in the School of InternationalStudies, and Director of the Center for InternationalPolitical Economy, Peking University. He has publishedwidely, in Chinese, English, Japanese, Korean and Spanish,on Chinese foreign policy, Sino-US relations, internationalpolitical economy, trade politics and regional integrationin East Asia.

AcknowledgmentsThe editors would like to acknowledge all the participantswho took part in the various study meetings, workshops

and other sessions between June and December 2009.These discussions were held under the Chatham HouseRule. We also thank the following individuals forcontributing to this project: Rodrigo Delgado Aguilera,Nicolas Bouchet, Peter Chowla, Benjamin J. Cohen, MuiPong Goh, Amalia Khachatryan, Margaret May, VanessaRossi and the Communications team at Chatham House.We especially wish to thank our Visiting Fellow atChatham House, Yoshiki Takeuchi from the Ministry ofFinance, Japan, for his invaluable comments at every stageof the project.www.chathamhouse.org.ukviii

ExecutiveSummary andRecommendations

The international monetary system is a lightning rod fortensions in the world economy. Its shortcomings may fuelprotectionist pressure. It is also a system in flux, no longermeeting the needs of a changing world economy. This iswhy Chatham House and the ESRC World Economy andFinance Programme have looked at the current system,assessed the goals and principles that underpin it andmade some recommendations for the way forward.Countries are responding in different ways, and thesteps that some of them are taking signal tensions andchanges ahead. In times of stress, when countries aretrying to secure steady economic recovery, domestic policygoals may be in conflict with international obligations.

The United States, in particular, may find it difficult andburdensome to support the dollar as the primary reserve


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currency. Domestic policy goals i.e. growth and employment may lead the United States to benignly neglect thegreenback, but China and the Eurozone would undoubtedlynot be happy.

This decade will certainly be one of transition. We donot expect a big bang, but a long, gradual process of incremental

change and adjustment. However, whether thistransition and the rebalancing of the world economy willbe smooth remains to be seen.In this context, dialogue and policy cooperation play animportant role in helping the worlds main economies andcountries issuing the key currencies to coordinate theirefforts and rebalance the world economy. Such dialogueshould be informed by the recognition that the worldeconomy is much more complex and integrated than in the1970swhen the BrettonWoodsmonetary arrangementswereabandoned. As a result, the interests and requirements of theemerging economic powers should be taken into account.Policy cooperation should aim to avoid any protectionistreaction to exchange rate movements. It should also helpprepare the ground for a smooth transition to amore appropriatesystem by fostering the exchange of information andcooperation among the worlds main trading areas.

There is an argument for moving towards a multicurrencyreserve system in line with the multipolar world,as well as expanding the use of a supranational currencysuch as the Special Drawing Right (SDR) (see Box 1). Thepolicy recommendations below not only propose themeasures that we regard as necessary but also take intoaccount the political and economic costs involved in thetransition from the current inadequately functioningsystem to a more sustainable and functional one.

Recommendations for managing changeto the international monetary system11. A multicurrency reserve system for a multipolarworld economy1.1 Develop a multicurrency reserve system that isappropriate for a world of regional trading blocs Europe, Asia, the Americas alongside a still preeminentdollar. The disadvantage of losing networkexternalities would be compensated by gainingstability.Historical experience has shown that two ormore reserve currencies can operate simultaneously.1.2 Encourage a more extensive use of SpecialDrawing Rights as a supranational currency

alongside international reserve currencies that areissued by sovereign states or by sovereign statespooled together in a currency union, as is the casefor the euro.1 This list of recommendations has been drawn up by the editors based on the chapters in the report, discussions at thevarious workshops and other meetings.Not all contributors agree with all of the recommendations.

www.chathamhouse.org.ukix

1.3 Promote cross-border dialogue and policy cooperationin order to manage the transition from a


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system based on the dollar to a multicurrencyone. Institutional arrangements should bestrengthened, with a clear mandate to avoidmajor imbalances.2. Increase the use of the Special Drawing Rights2.1 Expand the supply of SDRs in a frequent,

predictable and politically independent way, soas to increase the existing stock at least in linewith world GDP, gradually reducing the accumulationof dollars.2.2 Establish a new committee (the InternationalMonetary Policy Committee) to produceregular recommendations to the IMF boardfor new SDR allocations. The constitution ofsuch a committee should be designed toensure that its decisions are independent andfair. It might be chaired by the IMF managingdirector and composed of the heads of thecentral banks whose currencies make up theSDR, along with independent experts to allowindependent decision-making on changes tothe composition of the basket of currencies inthe SDRs.2.3 Establish a substitution account under the IMFinto which member countries can depositdollars, euros, yen or sterling, and receive theequivalent amount in SDRs in their accountbased on the exchange rate then prevailing.

The size of this account should be limitedinitially and increased gradually, as experienceis gained of its use by member countries and ofthe pattern of deposits and redemptions.Initially the substitution account might allowonly one-way transfers, but it should worktowards allowing both purchases and redemptions.2.4 Take steps to increase the use of and demand forSDRs, beyond official circles, in internationaltrade and finance:2.4.1 The IMF should permit SDR accounts tobe opened by private-sector actors.2.4.2 The IMF or another suitable providershould create a settlement system, so thattransactions denominated in SDRs cantake place directly between buyers andsellers on a secure and transparentplatform.

2.4.3 The development of SDR-denominatedfinancial instruments and markets inwhich to trade them should be encouraged.In particular there needs to be amarket-maker willing to buy and sell SDRbonds at bid/offer spreads that arecompetitive vis--vis those in existingbond markets. These measures wouldgreatly strengthen confidence in the


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liquidity of SDRs (i.e. their marketability,acceptability by all countries, convertibilityto the dollar and other currencies,and use as a unit of account and settlementfor oil and other commodities).3. Promote dialogue and policy coordination to provide

stability, confidence and balanced adjustment3.1 Foster greater efforts in the peer monitoring andassessment of the full range of economic policiesthat impinge on countries balance of paymentsand exchange rates.3.2 Encourage international dialogue betweencountries issuing a reference currency and individualor groups of countries using the referencecurrency. Consultation would pre-specifycredible actions that would be taken in the caseof growing imbalances and required change inreference currencies.

4. Strengthen the role and legitimacy of internationalinstitutions4.1 Rebalance subscriptions to and voting rightswithin the IMF more rapidly and more radicallythan is currently taking place. These changes areneeded to improve governance of, and increaseinternational confidence in, the IMF. They areimportant in paving the way to wider use ofSDRs. Without them the IMF risks becomingmarginalized as an agent of a group of countrieswww.chathamhouse.org.ukBeyond the Dollarx

with a dwindling global presence. Following thereweighting of the voting rights, the composition

of the Executive Board should also be rebalanced.4.2 Strengthen the IMFs score-keeping capacityby allowing it to issue its own quarterly reportson exchange rate and other relevant policies.

These would help in the evaluation of the fullrange of economic policies that affect exchangerates and the balance of payments, andestablish a set of benchmarks against whichcountries actual policies and policy commitmentscould be assessed. The IMF wouldthereby become more vigorously engaged innaming and shaming. Both the managementand the board must adjust the incentives for the

staff to raise sensitive issues. IMF management,rather than the board, should have theauthority to approve such surveillance reports,to further insulate the staff from politicalpressures.4.3 Mandate the IMF to deal with currencymisalignments and promote monetary coordination,or establish an institution for thispurpose. Such an institution could start as a


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caucus of the countries issuing the reservecurrencies the United States, the Eurozone, theUnited Kingdom, Switzerland and Japan and alsoinclude countries with the largest accumulation ofreserves. This institution should eventually fulfilthe function in terms of international monetary

affairs that the World Trade Organization doesfor international trade.www.chathamhouse.org.ukExecutive Summary and Recommendationsxi

Box 1: The Special Drawing RightThe Special Drawing Right (SDR) is an internationalreserve asset created by the International MonetaryFund in 1969. The SDR is largely used as a unit ofaccount by the IMF, other international organizations(such as the Universal Postal Union), and agreementssuch as the Warsaw Convention and Montreal Convention.IMF member states can exchange the SDRs amongthemselves voluntarily. Private entities or individualscannot hold SDRs. The SDR is not a currency but a basketof currencies currently comprising the dollar, the Japaneseyen, the euro and the pound sterling. The relative weightsof these currencies are adjusted every five years. The nextadjustment will take place in 2010. The SDR was initiallycreated to be a potential supplement to the dollar and goldunder the fixed exchange rate regime of the Bretton WoodsAgreement. However, the demand for SDRs declined afterthe suspension of convertibility of the dollar for gold in 1971and the move by major economies towards a floatingexchange rate system through the 1970s. More attentionhas been paid to the SDR recently after China, the largestholder of dollars as reserves, suggested that it might be an

alternative international reserve currency. There have beenonly four allocations of SDRs made thus far. The last twoallocations of 161.2 billion and 21.5 billion were made inAugust 2009 and September 2009 respectively. The totalamount of SDRs is currently 204.1 billion. These SDRs aredistributed to the IMF member states in accordance withquotas that are largely decided by the size of their economyand its openness. The quota determines each membersvoting power in the IMF and its access to IMF funding as wellas its financial obligations to the IMF. The Fourteenth GeneralReview of Quotas is currently under way.xii

1. Introduction: NoNew Bretton Woods,but a System in FluxPaola Subacchi*Why the IMS?


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It was cross-border, it was cross-sector, but the 200809crisis was not a currency crisis. So why has the internationalmonetary system (IMS) since been under thespotlight with suggestions from President NicolasSarkozy of France and Governor Zhou Xiaochuan of thePeoples Bank of China to Governor Mark Carney of the

Bank of Canada that it should be reformed? Even if it wasnot at the heart of the financial crisis, the IMS is wheretensions from globalization and the conflict betweendomestic policy goals and international obligations tendto coalesce. As the economic recovery kicks in and weare no longer diving together the intrinsic asymmetry ofthe system becomes more evident. And the sense that theburden of adjustment is unfairly distributed may triggerprotectionist responses in some countries.But the IMS is also a system in flux. The steps that somecountries are taking signal tensions and changes ahead.Indeed, the paths that the worldsmain economies those ofthe United States, the Eurozone and China are taking maybe in contradiction, even if not in conflict, with each other.Domestic policy goals i.e. growth and employment maylead the United States to embrace an explicit policy ofbenign neglect vis--vis the dollar. Thismay trigger tensionswith both China as the largest holder of dollars and dollarassets and the Eurozone. China, on the other hand, maycreate tensions by keeping its currency undervalued whilepreparing for its internationalization. The Eurozone, in itsturn,may try to avoid the burden of being the second reservecurrency1 and be tempted to respond to the upwardpressures on the euro with competitive devaluations.In this context, dialogue and policy cooperation play animportant role in helping these countries to coordinate theirefforts and rebalance the world economy. Policy cooperationshould aim to avoid any protectionist reaction toexchange rate movements. It should also help prepare theground for a smooth transition to a multicurrency systemby fostering the exchange of information and cooperationamong the worlds main trading areas.

A systemic approachChatham House and the ESRC World Economy andFinance Programme have completed a joint project thattakes a hard look at the current system and the wayforward through a multidisciplinary approach. The aim isto close the gap in the debate on the IMS by providing anoverview of the system rather than some of its parts

and an assessment of the goals and principles thatunderpin it. Specialists from different areas of expertisehave worked together, closely examining the current IMSin a systemic and interconnected way. The main conclusionsof the project are summarized in this report. Itshould be emphasized that not all the contributors agreewith all of the policy recommendations, or with theconclusions drawn in this introduction.

The contributions in this report range widely inapproach and style, but several common themes emerge


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clearly and strongly. This introduction attempts to drawtogether the different strands of argument to offer acoherent overview. Such a summary, however, cannot* I am indebted for comments on earlier drafts to Benjamin J. Cohen, John Nuge, John Driffill, DeAnne Julius, VanessaRossi, Mui Pong Goh and all the participantsof the study groups..1 As the ECBs President Jean-Claude Trichet stressed in an interview to the French daily Le Monde in November 2009, theECB has no intention of strengthening

the role of the euro as a global reserve currency (Delhommais and Leparmentier 2009).www.chathamhouse.org.uk1

www.chathamhouse.org.ukBeyond the Dollar2

replace the detailed and nuanced analysis in the individualchapters that follow.

Themain conclusions of the project can be encapsulatedin four key points.In a currency-based IMS, maintaining confidence inthe primary reserve currency requires that thedomestic policies of the country that issues thatcurrency should not be in conflict with its internationalobligations, even if they cannot be aligned. Intimes of domestic stress, this can prove difficult andburdensome. When the issuer of the primaryreserve currency is seen to put its domestic concernsfirst, as is almost inevitable, foreign holders of theprimary currency become concerned about theconsequences for and possible losses on theirholdings.The erosion of confidence in the primary reservecurrency and the availability of other internationalcurrencies point to the emergence of a multicurrencyreserve system which could also include a supranationalcurrency. Such a system would provide a morebalanced counterpart to an increasingly multipolareconomic order.We do not expect a big bang, but a long, gradualprocess of incremental change and adjustment. Thesteps taken by some countries, notably Chinas policygoal of making the renminbi convertible by 2020,suggest strongly that this decade will be one of transition.However, whether this transition will be smoothremains to be seen.The shape of the IMS for the twenty-first century willbe significantly influenced by the views, interests andrequirements of the emerging powers.

A dj vu moment?The history of the IMS is punctuated by recurrent debatesand attempts at reform, especially in periods of turbulencewhen the confidence of both public and private actors isunder pressure. Awareness of the systems limitations hasalways been acute, ever since the framework established inBrettonWoods in 1944 was discarded.Many commentators2remember the reform attempts by the Group of Thirty, theCommittee of Twenty and the Plaza Accord, and they seevery little new in the current debate. Is it correct to think


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that we have been here before?From the early 1990s the world economy and internationalfinancial system have undergone such rapid andradical change that care is needed when making directcomparisons with earlier periods. Globalization and therampant expansion of the world economy have resulted in

worryingly large financial imbalances and a substantialaccumulation of foreign exchange reserves by countrieswith a balance-of-payments surplus. The speed andmagnitude of the recent crisis greater than all previouscrises in the post-war years have added to internationaltensions. The IMS is deemed to be no longer adequate tomeet the needs of a complex and integrated worldeconomy. It may even exacerbate instability rather thancontain it.A fresher approach is needed, one that takes intoaccount recent developments in the world economy. Suchan approach should be systemic rather than just focusingon particular components of the IMS such as currenciesand exchange rates. And the scope of the debate shouldinclude questions related to the changing dynamics of theglobal economic order.Given that confidence in a single national reservecurrency is what underpins the current IMS, we inevitablyhave to discuss the role of the dollar. Nonetheless, ourfocus is on the purpose and principles of the IMS.We startby asking whether the IMS can respond to the challenges2 See, for instance, Cline (2005) and Truman (2010).

A fresher approach is needed,one that takes into account recent

developments in the world

economy3 According to World Bank figures, between 1993 and 2008 it grew from $25.5 trillion to $40.3 trillion in constant 2000dollars.4 Figures from World Trade Organization.5 This is the earliest IMF year for world total.

www.chathamhouse.org.ukIntroduction: No New Bretton Woods, but a System in Flux3

posed by the shift of the world economic order. In sodoing, we bring in the view of emerging-marketeconomies. These economies, China in particular, areconcerned about the limitations of the existing system andthe increasingly asymmetric burden of adjustment that itimposes.

The role of the primary reserve currencywithin the IMS

The IMS is the set of rules, tools, policies and institutionsthat govern the flow of money across the world economy.Providing the liquidity necessary to regulate and facilitate


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the international trade of goods and services and capitalaccount transactions is its main purpose.We need currenciesthat can be used to invoice trade, that market playerstrust as means of payment and store of value, and that canbe readily available to meet demand. Because money isalso used by the official sector, we equally need currencies

that can be used as a reference for central rates, as a meansof intervention in foreign exchange markets and to formthe basis for reserves holdings.As John Nuge discusses in Chapter 2, the current IMSis currency-based. The demand for liquidity is metthrough the primary reserve currency i.e. the currencymost widely used in international transactions and held asa store of value. Such a system normally responds moreflexibly than a non-currency-based system, such as thegold standard, to demand for liquidity.

The country that issues the primary reserve currencyhas a vibrant economy, deep financial markets and a rangeof short-terminstruments for which there is strong foreigndemand. As confidence underpins the whole system, thiscountry must simultaneously maintain the stability of thecurrencys purchasing power and an inflation rate consistentwith the preferences of the primary reserve currencyholders. Ideally, from the point of view of the world, thesupplier of the global reserve asset would behave in apublic-spirited way and so exchange rate stability wouldtake priority over domestic policy objectives such asemployment and growth. For much of the time the twosets of objectives domestic and international may becompatible, and the balancing act sustained. But the risk isthat in times of crisis or when the two sets are mutuallyopposed, the reserve currency country will put itsdomestic concerns and objectives first, with the result thatconfidence will be eroded.Immediately after the Second World War the UnitedStates ran a current account surplus mainly thanks to itsoverseas investments. But over the years this provedincreasingly difficult and the United States became a largenet importer of goods and services while the rest of theworld became its creditor. However, because there was noreal competition to the dollar, confidence was never apressing issue.

An inadequate system for a larger andmore integrated world economyIncreased integration among the primary regions of the

world Europe, Asia and the United States theexpansion of global markets and the rise of the bigemerging economies have contributed significantly to theexpansion of the world economy since the early 1990s.3

Trade and capital flows have been the twin forcesbehind this expansion. Indeed they have grown at a farfaster rate than world GDP and have outstripped growth inUS GDP, which approximately doubled between 1993 and2008.World trade expandedmore than fourfold, from$3.7trillion in 1993 to $15.7 trillion in 2008. Of this $12.3


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trillion increase, $7.0 trillion came from growth of trade inthe United States, EU, Japan and China.4 During the sameperiod financial integration also developed significantly,with a big expansion in capital flows and foreign exchangereserves, reflecting growing trade surpluses in Asia inparticular. According to the available figures fromthe IMF,

capital flows increased from just under $0.5 trillion in19945 to $3.4 trillion in 2007. Of this, FDI rose from about6 Something that Peter Kenen stressed more than 20 years ago: stability cannot be achieved merely by endorsing it.Someone has to act differently (Kenen1988: 43).7 It reached a peak in 2006 at 6% of GDP, to drop to just below 5% as recession struck in 2008.8 Bureau of Economic Accounts, US Department of Commerce.9 The Triffin Dilemma originally referred to the tension inherent within the gold exchange system of the Bretton WoodsAgreement in which the dollar could beexchanged for gold. If the US stopped running balance- of-payment deficits, there would not be sufficient liquidity in theinternational economy. If the UScontinued its deficits, confidence in the dollar (or more specifically, the link between the dollar and gold) would beundermined. See also the discussion inChapters 8 and 10.


$0.25 trillion in 1994 to $2.2 trillion in 2007. Total foreignexchange reserves soared from just $1.5 trillion to $7.5trillion by the third quarter of 2009 (IMF 2009). Twocountries, China and Japan, accounted for $2.5 trillion ofthese reserves, a figure which further increased during200809.Globalization and the expansion of the world economyhave boosted the share of international transactions, highlightingthe limitations of a monetary system and policiesthat were designed for a less internationalized worldeconomy.6 A well-constructed IMS has two importantfunctions. First, it should allow countries to run currentaccount surpluses and deficits and accumulate net

financial claims on each other. This is a mechanicalclearing role, which the current IMS seems tomanage well.Secondly, it should provide some form of mechanism toencourage a return to more balanced trading. This iswhere the current system seems to have problems, and it isalso an area where policies matter.

A system under threat?As Gianluca Benigno shows in Chapter 4, the dollarremains the primary reserve currency, representingabout 60% of total foreign exchange reserves in 2008,higher than the level reached in 1995 when the IMFstarted systematic data collection. However, thepersistent current account deficit of the United States has

expanded in recent years, undermining the principle ofconfidence.7 Even if the recession has contributed toreducing the US trade deficit and boosting the USaggregate savings rate to nearly 9% in 2008, up fromabout zero in 20068 it is highly likely that the tradedeficit will simply pick up again if American consumersresume past patterns of behaviour.Concern over the potential fragility of the current IMS isalso widespread among holders of foreign exchangereserves. This is particularly true for China, which holds


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over $2 trillion in dollars and dollar-denominated assets asa result of its large current account surplus and FDI inflows.As in the 1960s the Triffin Dilemma is kicking in.9TheUnited States, as the main engine of growth for the worldeconomy and the country issuing the primary reservecurrency, runs a current account deficit and augments the

world supply of dollars. The fiscal stimulus and bankrescues in response to the recession have already causedthe deficit to balloon to record levels, and this has dramaticallyincreased the volume of debt issuance. This highdeficit could trigger a crisis of confidence in the dollar.

There is reasonable concern well expressed by JohnNuge that the United States may be approaching thetipping point at which over-issuance leads to the worldcommunity withdrawing its unquestioning faith in thedollar and dollar assets and such a loss in confidencewould damage the scope for the dollar to continue actingas the dominant reserve currency.However, the end of the dollar as the primary reservecurrency may still be some years away. As Benigno argues,this is due to the lack of strong contenders and also to thefact that the global crisis has served to strengthen thedollars role as a safe-haven currency.More fundamentally,no other country is likely to achieve the dominance thatthe US economy acquired in the aftermath of the SecondWorld War.Whatever the final outcome, the short-term options areclearly limited. In Chapter 3 Catherine Schenk confirmsthis view by providing a valuable historical view of howsterling was gradually replaced by the dollar as the reservecurrency. Contrary to popular conception that the dollarreplaced the sterling at the end of the Second World War,Schenk found that the transitional process was muchlonger, owing to the structure of the internationalmonetary system and collective global interest in itscontinuation.

From a primary reserve currency to amultipolar reserve currency

The current system is structured in such a way that allplayers are locked by mutual interest in a form of stabledisequilibrium. Disentanglement is likely to be long andcomplicated. This is evident in Chinas position as thelargest holder of dollar reserves and hence its interest inmaintaining the status quo.

There are few options for exiting the current system.

One is a partial or total switch to a multicurrency reservesystem. This would better respond to the need of a multipolareconomy and provide the necessary liquidity withoutthe constraints imposed by a single primary reservecurrency system.10Beijing seems to favour this shift. However, it has to begradual so as to avoid undermining the value of existingdollar reserves. In Chapter 8, Gregory Chin and Wang

Yong suggest two options that would suit China. The firstis to establish a multicurrency regime in which the dollar,


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the euro and a regional Asian currency share the role ofglobal reserve currency, backstopped by SDRs a supranationalreserve currency that could provide a new competitivemechanism to help discipline the issuing countries.

The second option is the internationalization of therenminbi. Both options require time and a gradual

approach, although the latter would probably precede theformer.Moreover, domestic policies can have an impact onthe internationalization of the Chinese currency; indeed,as Jim ONeill suggests in Chapter 7, Zhou Xiaochuan,Governor of the Peoples Bank of China, may be highlightingto domestic policy-makers the need to bringforward the full convertibility of the renminbi11 to pave theway for its inclusion in the basket of constituent currenciesof the Special Drawing Right (SDR) in 2015.Another possibility is to switch to the use of a supranationalreserve currency. This is unlikely to take place in thenear future. However, the greater use of SDRs might be anintermediate step in that direction. DeAnne Juliussproposal on SDRs in Chapter 6 eschews the radical bigbang approach, focusing instead on incrementallyincreasing the supply and demand of SDRs. She proposestwo ways to expand the SDR supply: first, a regular allocationof SDRs via a new International Monetary PolicyCommittee which is linked to the IMF; and second, thecreation of a substitution account whereby IMF membercountries could deposit various currencies and obtain theequivalent value in SDRs. By only allowing one-waysubstitution in its initial stage that is, countries are ableto obtain SDRs by exchanging their currencies, but notvice versa the issue of who bears exchange rate risk willbe avoided. By allowing private agents to open SDRaccounts with the IMF and by creating an SDR settlementsystem, these agents may find the use of SDRs more attractive.

Juliuss proposal takes into account the fact thatprivate-sector actors rather than state actors will be the keydeterminant of the success of any migration from onereserve currency to another.

Cooperative solutionsFrom the above discussion it is clear that the current IMSis inadequate, but cannot be easily or quickly reformed orreplaced, as the options currently available are eithernormatively undesirable or politically problematic. Anychange to the current system and their implementationwill take a long time. In the meantime, however, it is

critical to ensure the sustainability of the old system and toavoid its collapse with all the related shocks and coststhat this might entail.10 It would also free the US from the burden of providing liquidity. For instance, Bergsten (2009) makes the argumentthat the dominance of the dollar is nolonger in the United States national interest because it has made it easier for the US to run large trade and currentaccount deficits, thereby contributing tolow interest rates, excessive liquidity and loose monetary policy and hence leading to the overleveraging andunderpricing of risk that have characterized thecurrent crisis.11 The Chinese have announced that they will build Shanghai into an international financial centre by 2020, whichsuggests that the renminbi will be fully convertibleby then.


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www.chathamhouse.org.ukIntroduction: No New Bretton Woods, but a System in Flux512 It can be argued that, like the country issuing the primary reserve currency, emerging countries face the dilemma anddifficulty of putting what is good for theworld ahead of what is good for themselves.13 ASEAN +3 includes China, Japan and the Republic of Korea.14 In policy cooperation/coordination the concept of public goods is central. These are goods that either are not supplied

by the market or are supplied in insufficientquantity. They have two critical properties. First, it does not cost anything for an additional individual to enjoy the benefitsof the public goods. Second, it isin general difficult or impossible to exclude individuals from the enjoyment of the public goods.15 See Sarkozys comments in Davos in 2010, which are cited in Bennhold (2010).


The best interim solution, in everyones interest, is forgovernments to work together to make the current IMSfunction as smoothly as possible. This means achievingsome degree of policy cooperation, with countriesexchanging information about current and future policydecisions while retaining their ability to pursue policiesthat are in their best interest.

Such a solution is elaborated in Christopher Meissnerscontribution (Chapter 10), in which he argues for greaterconsultation and enforcement to ensure that thespillovers, which include the adjustment of asymmetricbalance of payments and other imbalances, areminimized.He calls for mandatory dialogues between the reservecurrency-issuing country and individual or groups ofcountries using this reserve currency, ensuring that theparties pre-specify actions to be taken to address theimbalances. This means, for example, engaging the two bigsurplus areas, the Middle East and East Asia, in devising atransfer of the burden of consumption towards surplusareas12 a task that Federal Reserve Chairman Ben

Bernanke recently called extraordinarily urgent (Guha2009).Many believe that this requires intervention on bothexchange rate flexibility, which involves monetary policyautonomy, and the level of the exchange rate itself.For the realignment of exchange rates, which could helpput the IMS on a more stable basis, policy cooperation isessential, especially where countries are largely engaged ininternational trade. As currency appreciation can damagethe international price competitiveness of the country thatimplements it relative to that of neighbouring countries,one reasonable policy option is to agree on collectivecurrency appreciation vis--vis the dollar, which does notdifferentially affect individual countries relative price

competitiveness. Asia, once again, is the region wherecountries need to coordinate their exchange rate policiesso as to avoid competitive devaluations against oneanother. This requires a convergence of exchange rateregimes. The existing policy dialogue processes among theregions finance ministers (such as ASEAN+313) andcentral bank governors (such as the ExecutivesMeeting ofEast Asia-Pacific Central Banks) can play a critical role.

Institutions and the balance of power


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Institutions are important in this context as a way to facilitatecooperation and the internalization of externalitiesthrough efficient bargaining among all players. This, inprinciple, does not require any formof supranational institution-building, but in practice transaction costs anddistributional problems make such an outcome very

difficult to achieve without the institutionalization ofobjectives, ways and means which is normally provided bya supranational framework.14Unlike the international trade system with the World

Trade Organization, there is no institution with themandate for the governance and management of the IMS.And as long as the worlds reserve currency was a nationalcurrency of one state, there was no need for such an institution.

The closest is the International Monetary Fund (IMF) inso far as its role inmonitoring internationalmacroeconomicand financial affairs includes issues related to the IMS. Therecent upgrading of the IMF by the G20 as the main forumfor international financial and economic affairs, and thewillingness of some G20 countries to include reforms to theIMS in the future agenda,15 signal that the IMF may becomethe key institution to deal with the functioning of the IMS.

There are of course several problems with this, from theIMF governance that has yet to change to match thedifferent political and economic landscape to the deepmistrust of the IMF that has built up over the years amongdeveloping countries, especially after the poor handling ofthe Asian financial crisis in 199798.Mistrust of the IMF is in part also due to the perceptionthat its surveillance is asymmetric, with the greatestattention paid to the weaker developing states or those insurplus, while the major deficit and surplus countries, theUnited States and China, are tolerated. In Chapter 9,

Jeffrey Chwieroth provides several proposals which willenable the IMF to adopt stronger and more consistentsurveillance. These proposals include the IMF issuing itsown quarterly report on exchange rate policies with a set ofbenchmarks to assess each states adherence to these;assessing a wider range of policies including for themonetary, fiscal, exchange rate and financial sectors instead of focusing narrowly on the exchange rate; andinsulating the IMF staff from political pressures from theirown board.

This is not to say that the IMF has made no attempt toovercome some of the more severe criticisms. In Chapter11, Christopher Adam, Paul Collier and David Vines show

that the IMF has shifted from a presumption thatcountries in external difficulty must always adjust to thisproblem, and do so rapidly, to one that sees financing as apossible alternative to short cuts and rapid adjustment.

The fall-back position and the way forwardLooking at the complexity of any plausible, albeit gradual,attempt to reform the IMS, there may be a case for doingnothing. John Driffill convincingly argues in Chapter 5that the world has slowly been learning to live with floating


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exchange rates for more than three decades and individualcountries have worked out a variety of arrangements formonetary policy, exchanges rates and financial stability tosuit their own individual perceived circumstances andneeds. Failed attempts to fix or manage exchange rates andunsuccessful experiments with policy coordination have

shaken peoples confidence in concerted action we havebeen there before! Driffill suggests that the fall-backoption business-as-usual, laissez-faire, muddlingthrough is not such a bad thing.But in the post-crisis world, where jobs and growth aredominating the policy agenda in many countries, the fallbackoption carries the risk of leaving the systemunmanaged and broadening the scope for governments tointervene by means of either uncompetitive devaluationsor protectionist measures. The United States may beheading towards increasing difficulty in reconcilingdomestic policy objectives with policy settings that areconsistent with global exchange rate stability. The governmentsof the Eurozone, on the other hand, may find itdifficult to justify a strong euro with their constituencies.Such a context calls for some greater level of cooperation.Only through a coordinated effort can countries newand old power centres share the task of exercising globalresponsibility.It is critical to restore and manage confidence, since itremains the key principle underpinning the IMS. Again,policy cooperation is essential. In fact, as soon as theforeign exchange market regains confidence in theUnited States, the dollar may even begin to appreciate.

This clearly risks triggering further problems withimbalances unless efforts are made to offset such a trend.A more desirable outcome is for China to return to itsprevious policy of steadily revaluing the renminbi onceglobal growth looks more secure. Such a combinationcould help defuse current concerns about the imminentcollapse of the IMS and dollar-based system, creating abreathing space in which to address wider reforms ofthis creaking system. For this it is important to ensurethe sustainability of the system and avoid its collapse with all the related shocks and costs that this mightentail. Countries should become more engaged inreforming the existing IMS arrangements, a strategythat, according to Chin and Wang, China seems to havealready embraced.www.chathamhouse.org.uk

Introduction: No New Bretton Woods, but a System in Flux7

It is critical to restore andmanage confidence, since itremains the key principleunderpinning the IMS. Again, policy


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cooperation is essential www.chathamhouse.org.ukBeyond the Dollar8

Table 1: Problems and possible solutionsExisting problem Proposed solution Knock-on problem Responsible actors Possible actions Likely difficultiesto be taken to be facedOver-reliance on single Greater reliance Little demand for SDR Private actors (i) Open SDR accounts Will need tonational reserve currency on SDR with IMF/suitable enhance liquidity inoperators to clear SDR markets totransactions (deepen overcomecapital markets) resistance to their use(ii) Issue bonds in SDROver-reliance on single Greater reliance Little demand for SDR National governments Offer SDR-denominated Will need tonational reserve currency on SDR f inancial products enhance liquidity ine.g. issue SDR bonds SDR markets toto develop capital overcomemarkets for SDR resistance to their useOver-reliance on single Greater reliance Lack of demand IMF Set up one-way Governments maynational reserve currency on SDR for SDR substitution account prefer flexibility oftwo-way substitutionOver-reliance on single Greater reliance Lack of demand IMF Set up two-way Who will bear thenational reserve currency on SDR for SDR substitution account exchange rate risk?Over-reliance on single Greater reliance Lack of supply IMF Issue SDR regularly A rapid expansion ofnational reserve currency on SDR of SDR in line with world GDP SDR supply may benecessary to achievea significant impactOver-reliance on single Diversification Non-convertibility of China Make the renminbi The Chinese bankingnational reserve currency of currencies the Chinese renminbi, convertible by 2015 sector may notcurrency of a huge be readyand growing economyOver-reliance on single Diversification Governance of the European Central Harmonize fiscal Will need a greaternational reserve currency of currencies Eurozone Bank policy in Eurozone political appetite inthe EU (not only inthe Eurozone) thanis currently availableLack of confidence Changes to Lack of confidence IMF Develop more multi- Difficult toin the governance governance structure in the neutrality faceted indicators agree what thesestructure of the IMS of IMF of IMF to review members indicators oughteconomic policies ( rather to bethan simply focusing on

exchange rates andbalance of payments)Lack of confidence Improved coordination Lack of confidence IMF Work more closely within the governance between IMF and in the neutrality the World Bank to ensurestructure of the IMS other multilateral of IMF that both macroeconomicinstitutions and microeconomicreforms are undertakenNegative spillovers Promotion of cross-border Lack of accurate IMF Improve surveillance Difficult to getdialogue and policy information governments tocooperation agree on indicatorsand to submit tosurveillanceNegative spillovers Promotion of cross-border Lack of legal sanction National governments Improve peer review Difficultto getdialogue and policy governments tocooperation prioritize internationalneeds overdomestic ones

www.chathamhouse.org.ukIntroduction: No New Bretton Woods, but a System in Flux9

ReferencesBennhold, Katrin (2010), At Davos, Sarkozy calls forglobal finance rules, The New York Times, 27 January.Bergsten, C. Fred (2009), The Dollar and the Deficits:How Washington Can Prevent the Next Crisis,Foreign Affairs 88(6) (November/December).Cline, William (2005), The Case for a New Plaza


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Agreement, Policy Briefs in International Economics,PB05-04, December.Delhommais, Pierre-Antoine and Arnaud Leparmentier(2009), Interview with Jean-Claude Trichet,President of the ECB, Le Monde, 17 November,http://www.ecb.int/press/key/date/2009/html/sp091

117.en.html.Guha, Krishna (2009), Bernanke warns on imbalancerisks, Financial Times, 19 October.IMF (2009), Currency composition of official foreign exchange(COFER), updated on 30 December 2009,http://www.imf.org/external/np/sta/cofer/eng/index.htm.Kenen, Peter (1988), Managing Exchange Rates (London:Royal Institute of InternationalAffairs/Routledge).

Truman, Edwin (2010), The International MonetarySystem and Global Imbalances, January,http://boodstore.iie.com/publications/papers/truman0110.pdf.

2. Reconsidering theReserve CurrencyQuestionJohn Nuge1. Introduction

The role of the dollar as the worlds reserve currency hasfrequently invited debate and, for countries that have largedollar asset holdings, also caused concern. More than 40years ago the then French finance minister Valry Giscard

dEstaing referred to the United States exorbitant privilegeof being the issuer of the reserve currency, and PresidentCharles de Gaulle publicly worried about the value ofFrances dollar assets and sought to convert them into gold.But the debate was given added impetus in 2009, whenvarious senior members of the Chinese government offeredsome observations on the question of the optimal reservecurrency arrangements for the worlds financial system. Inessence they were seeking to open a debate on whether thecurrent position, in which the dollar is the worlds dominantinternational currency, was ideal either for themselves or forthe world community in general, and invited commentfrom other governments and market participants.

This chapter contributes to that debate. The argument isdeveloped over four sections. Section 2 explores the backgroundto Chinas concerns, and considers the case forchange in the current position of dollar supremacy. Byanalysing the position of the reserve currency issuer inhistory, the section considers why the dollars period ofhegemony might be nearly over and whether its decline isinevitable. Section 3 builds on the conclusion that nocurrency can expect to remain the worlds sole or evendominant reserve currency for ever, but finds that there are


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no obvious alternatives to the dollar at present: the moredramatic reports of the dollars demise are premature, andthere is little prospect of any single currency supplantingthe dollar in the near future.Section 4 takes as its starting position that the dollar willcontinue to have a major role for a considerable time; it

considers existing supplementary arrangements to thedollar, and how the current regime might be augmentedand strengthened. It then looks in more detail at one ofthese suggestions, namely that there might be a larger rolefor the IMFs Special Drawing Rights (SDR). The sectionconsiders the mechanics of a supranational currency, andby drawing on lessons from the establishment of the euro,discusses a possible path for the SDR to gain wider usage.Section 5 concludes.

2. The case for change2.1 Chinas concerns

The views expressed by China and other nations over therole of the dollar can be summarized very simply as a

concern over future US inflation. The level of dollarissuance is high and has recently risen dramatically as theUS administration seeks to counter the financial andeconomic crisis, and overseas holders of dollars (in particularin the form of fixed income securities) are naturallyconcerned that they may be holding a depreciating assetwhich will be subject to inflation. Creditor nations drawattention to Americas current account deficit the counterpartto their own surpluses and are querying whetherthe political will exists in the United States to rectify theimbalances behind it, and therefore to stem the supply ofdollars to the worlds markets.In effect, these nations are expressing fears that the

United States might seek to defray its obligations to themby inflating them away. As well as harming Americascreditors directly, this would also render the dollar lesseffective at performing one of the three main functions ofa reserve currency, that of a reliable store of value. Therewww.chathamhouse.org.uk10

would be concomitant harm not just to current creditornations but to anyone seeking to use the dollar for thispurpose in future.1While Americas creditors are certainly entitled todebate how safe their assets are and the strength of thecommitment by the United States to repay their borrowingsin good coin, the existence of global imbalances, andin particular the large US current account deficit, is notnew and the cause of them has been the subject of considerabledebate for some years.2 However, a more fundamentalquestion is whether a reserve currency country canever run significant surpluses over the long term, orwhether something in the dynamics of a reserve currencyprevents this.It is not easy to address this question, not least becauseevery reserve currency issuer is to a certain extent sui


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generis, but in order to shed some further light on theissue, and to see whether the United States has a specificcase to answer over the imbalances that have promptedChinas remarks, the next section explores in a little moredetail some of the features of a reserve currency.2.2 The dynamics of a reserve currency

The establishment of a reserve currency is seldom decreedby law or agreed by governments. Rather, it arises naturallyas a result of choices made by a multitude of financialoperators, and since one of the main qualities that thosefinancial operators are seeking is general acceptance of thecurrency by other operators, the choice tends to be madeon the basis of consensus and critical mass rather thananything more scientific or precise.

This has two general consequences. First, althoughthere may be a number of international currencies at anyone time, some of which may even reach the status ofregional reserve currencies,3 there is commonly only oneglobal reserve currency at a time. Secondly, the process ofchanging the reserve currency is often a gradual one asadherents of the current reserve currency only slowlyrelinquish their use of it in favour of an alternative, until afinal tipping point when the critical mass switches to thenew currency.Neither of these rules is absolute. In particular, the endof a currencys reserve status can be quite sudden, as forexample when the pound sterling ceased fairly abruptlyafter the SecondWorldWar to be either a reserve currencyor even (because of exchange controls) an internationallytraded currency at all outside the sterling area. But withoutmajor external factors such as war or the imposition ofexchange controls, the decline of a currencys status as areserve currency can be prolonged. And this raises thequestion of why, in the early stages of this process when thestatus of the existing reserve currency is still not seriouslyin doubt, the consensus of market participants should startto edge away from it.

The dynamics of a reserve currency mean that theissuing country has to ensure that other countries haveeasy access to an adequate supply of its currency. This isessential: international operators need to be assured thatthe availability of the medium of international exchange isnot in doubt; and they need to be able to acquire it easilyand at reasonable expense. The latter condition is not oftena significant issue it mainly requires the reserve currencyto have deep and liquid markets open to international

players but the former can pose challenges. This is notleast because the issuer of a reserve currency, at least whenit first acquires that status, is almost by definition a strongcountry with a vibrant economy, and such economiesoften maintain significant current account surpluses.

This challenge for a surplus country to ensure thatenough of its currency is available to other nations is byno means trivial; indeed it dominated the discussions atBretton Woods as the post-war financial system was


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established. Since the United States emerged in 1945 asincomparably the most powerful economy in the world,the dollar was the only conceivable choice for the anchorcurrency for the global financial system. It is worth1 Note that moderate inflationper se does not seriously undermine the effectiveness of the dollars performance in theother two functions to which a reservecurrency is put that of a medium of exchange and of a unit of account. Indeed a currency is able to operate as aneffective medium of exchange even wheninflation becomes relatively aggressive; it is only in the later stages of hyperinflation that it ceases even to be usable forpayments.2 Including a series of conferences at Chatham House between 2005 and 2007 and a published study paper (Meade 2005)on the subject.3 Most obviously the euro has this status in much of non-Eurozone Europe and (to a lesser but still significant level) inNorth and Francophone West Africa, forexample. But some other currencies also perform this role; the South African rand is used as a regional reserve currencyboth formally in the Rand MonetaryArea and more generally in Southern Africa.

www.chathamhouse.org.ukReconsidering the Reserve Currency Question114 Note that despite this analysis, we cannot in fact answer the question posed at the end of section 2.1. All we can say isthat the evidence suggests thatreserve currency issuing countries tend to move into current account deficit as their position matures and that this is inpassing beneficial for the rest of theworld as it enables other countries to acquire holdings of the reserve currency.

5 In earlier times under precious metal-based monetary systems, the reserve currency issuer would overissue bydebasing its coinage (i.e. by mixing base metal withthe precious metal from which the coins were meant to be minted), and relying on their coins status as reserve assets toensure their continued acceptance.


recalling that one of the main questions facing theBretton Woods negotiators was how other countries,many of whose economies were in ruins, were to acquirethe dollars to be able even to form a part in the globaleconomy. If the United States continued to run currentaccount surpluses, it would drain the rest of the world ofwhat tradable currencies there were, or end up stockpilinggold, or be forced to act as the creditor of lastresort to other nations. The first two outcomes wouldhave been highly deflationary for the world economy,while the last of the three was deeply unattractive to theUS authorities.Experience shows, however, that the problem is oftenself-correcting, and for a number of reasons the issuer ofthe reserve currency seldom remains a surplus countryindefinitely. Partly, consumption tends to rise as thenation exploits its position of power and plenty. Moresignificantly, the twin facts that the issuer of a reservecurrency can pay for its imports with its own paper, andthat demand for that paper is strong, remove the mainbalance-of-payments constraints faced by othercountries: that of the need to finance imports withforeign exchange, and the need to persuade creditors tolend to them if their reserves of foreign exchange runshort. In effect, while for ordinary countries both theforeign exchange reserves and the creditworthiness andability to borrow to replenish them are assets in limitedsupply and in need of careful husbanding, neitherconstraint is binding on the issuer of the reservecurrency.4


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2.3 The current position of the United StatesOver the last 60 years the United States has followedalmost exactly the common trajectory of reserve currencyissuers. A large current account surplus in the years immediatelyfollowing the Second World War has given way tothe present position, where America is a large net importer

of goods and services, and the rest of the world is increasinglyits substantial net creditor.For many reasons, it was both understandable anddesirable that the United States should turn from theworlds major creditor nation in 1945 into the worlds mainconsumer nation. The privilege of issuing the worldsreserve currency both facilitated this transformation andin a way required it, and over the last 2030 years theworld has in general enjoyed a succession of longer periodsof stronger growth because of it. Unfortunately everyreserve currency issuer, going back to the Athenians in the5th century BCE, has ultimately abused this privilege;every reserve currency issuer has over-issued its currency5and eventually found trust in its credit withdrawn by therest of the world.

The concern is that the United States may beapproaching the point at which it too joins previousreserve currency issuers, and at which over-issuance ofdollars leads to the world community withdrawing itsunquestioning faith in the dollar and dollar assets.Many not least in the United States itself will holdthe view that this concern is premature, but as historyhas shown, it is inevitable that the reign of the dollarwill eventually end, and the only question is whether weare approaching that time. That is the issue the Chinese,as one of the main holders of dollars, have sought toraise.

The concern is that the UnitedStates may be approaching thepoint at which it too joins previousreserve currency issuers, and atwhich over-issuance of dollarsleads to the world communitywithdrawing its unquestioning faith

in the dollar and dollar assets3. The alternatives to the dollarThe transition from one reserve currency to a successorusually requires both an acceptance among market participantsthat the current reserve currency is becoming unableto continue in the role, and a successor country able andwilling to allow its currency to take up reserve currencystatus.Willingness is by nomeans aminor detail: when the


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status of the dollar was last seriously questioned, in the late1960s and early 1970s, as America struggled to finance itsmilitary operations in Southeast Asia, there was no alternativecountry and currency both able and willing to takeits place. Although both the other nations in the G3,Germany and Japan, were by then running successful

economies with strong currencies, neither was keen to seean internationalization of its currency, especially if thatimplied a convertibility to gold; and it is also debatablewhether their economies, vibrant though they were, werelarge enough to shoulder the burden.In many ways the position is not wholly dissimilar today.

The most obvious alternative reserve currency to the dollaris the euro. But while the Eurozone is a much largereconomic unit than Germany alone was 40 years ago, andpublic speeches by the leaders of Europes economies allpurport to seek a larger international role for the euro, thereremain questionmarks over the willingness of the Europeanauthorities to allow it to become the sole reserve currency,and even over whether Germanys traditional reluctance tointernationalize its currency has fully abated. Moreover, theEurozone economy is likely to stay in surplus for some timeand also relatively slow-growing, and the long-standingquestion remains of how the rest of the world would acquireeuros should it become the reserve currency.

The other G3 currency, the Japanese yen, is not a seriouscontender for global reserve currency status. The Japaneseeconomy remains too small to support a reserve currencyand it shares the position of the Eurozone of being slowgrowingand predominantly in surplus though there is atleast a ready supply of yen-denominated governmentbonds for investors to buy.

The other possible alternative reserve currency is therenminbi. Here there is no doubting the Chinese authoritieslong-termambitions, and in due course it is very likelythat they will both seek and facilitate an international rolefor their currency. But it is not even fully convertible yet,and it is therefore quite unable to act as an internationalreserve currency. The same is true of the other majoremerging economies such as India, Brazil or even Russia,with the added disadvantage that these economies are anorder of magnitude smaller than that of China today.

There are no thus obvious alternatives to the dollar atpresent and the more dramatic reports of the dollarsdemise are indeed premature.

4. Alternative reserve currency arrangementsIf, as the previous section has concluded, there are noobvious national currencies that stand ready to replace thedollar, how might the concerns of those who question itssuitability be addressed? Three main alternatives havebeen discussed: a return to a non-currency base for theworlds monetary system, a system of multiple reservecurrencies, and the use of a supranational currency.4.1 Non-currency base

This option is a clear harking back to the gold standard,


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when monetary gold underpinned the global financialsystem. Without here exploring in depth the full ramificationsof a commodity or specie base for money, it is onlynecessary to recall the challenges posed by the goldstandard (lack of ability to increase the money supply atwill; difficulty of maintaining the liquidity and range of

instruments in the specie base that modern markets need;settlement challenges) to realize that a specie base is notlikely to prove a way forward. Indeed, the gold standardonly really operated through the link between gold and thereserve currency of the day: it was underpinned by theconvertibility of first the pound sterling and then thedollar into gold, and there is no appetite at all inWashington or indeed anywhere else for a return to thedays when the dollar was convertible at the gold window.4.2 Multiple reserve currencies

This system, alongside a still pre-eminent dollar, is a morepossible scenario, and might indeed be how the worldwww.chathamhouse.org.ukReconsidering the Reserve Currency Question13


develops. In a world of regional trading blocs (Europe, Asia,the Americas) it is by no means an unimaginable solution oran unworkable one. It has the disadvantage, however, that oneloses economies of scale: each of the several reserve currencieswill tend to have less liquidity and less deepmarkets thanthe present single reserve currency. And for this reason sucha system has historically usually proved to be a temporaryinterlude, and a precursor to one of these currenciesbecoming dominant and the sole reserve currency.

4.3 Supranational currencyAgain this would operate alongside rather than instead ofthe dollar. Such as system has been considered before

John Maynard Keynes proposed a global currency, to becalled the bancor, as the centrepiece of his plans for stabilizingthe global economy after the Second World War.

There were many reasons for the failure of the bancor planto gain any acceptance, not least the problemthat America,as the then dominant creditor, would have ended up as themain holder of bancors, and that consequently the then USadministration was unclear whose liability the asset wouldbe or how it would be guaranteed.6

This lack of a fiscal authority to support a world currency

remains a significant stumbling block. A fiat currency ultimatelyrelies on the standing of the issuer, and it is far fromclear who would issue a global currency, or with whatauthority or fiscal resources they would do so. Indeed, thesame questions have at various times been asked of the euro,not least when problems in a number of European banksnecessitated a call on fiscal resources to support them. Theissues surrounding the euro which for all the cooperationof the member states that use it and for all the technical


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excellence of the ECB remains a currency without acompetent federal fiscal authority to support it suggestthat the challenge for any global fiat currency to supplantthe dollar completely would be too large.Nevertheless, this is not to suggest that there is noopening for a greater use of a global currency alongside the

dollar. And given the existence of the SDR now muchaugmented by the creation in August 2009 of some SDR183 billion, which brought the total of SDRs in existence to204 billion, or around $320 billion it is a legitimatequestion as to how its use could be increased, and whetherit could help solve some of the issues raised in the publicdebate earlier in that year.However, there are practical obstacles to the use of theSDR as a reserve currency. Not the least of these is its availability:at the moment only members states of the IMF cantransact in official SDR,7 and only with each other acrossthe books of the IMF. For the SDR to become a reservecurrency there would have to be a significant increase inboth supply and availability to non-official actors.Other contributors to this report have commented on thisat greater length and in more detail, but the history of theeuro offers some guidance as to how this might be achieved.

The euro started in the 1970s as the European Unit ofAccount, an untradable book entry unit for the EuropeanCommission, to enable it to facilitate payments betweenmember states. In this it fairly closely resembled the currentstatus of the SDR, and it was only when it was converted intothe European Currency Unit (ecu), and then later when aprivate market in ecus started up, that the unit of accountbegan to take on the form of a genuine currency onceprivate-sector agents could buy, sell and create obligations inecus, a genuine two-way market in ecus arose.

This is a significant precedent for any greater use of theSDR: if it is to gain wider usage it will require either greaterissuance and availability of the official SDR or the creationof private SDRs. The latter route may prove the moreattractive, as it does not put the issuer of official SDRs (theIMF) at risk of balance-sheet exposures it may not want.Other lessons from the ecus history and its evolution intothe euro also provide insight. First, in its later years there wasa general presumption held more strongly at some timesthan at others but never entirely lost that at some stage thethen European Community (now EU) would seek to6 The United States put forward a counter-proposal to the bancor called the unitas, its main champion being Harry DexterWhite, a senior US Treasury departmentofficial. The unitas was more a unit of account, and crucially as a result it did not create an extra supply of money for the

world monetary system. It isperhaps not surprising that the proposals of the United Kingdom (as the main debtor in the developed world at the time)and the US (as the main creditor)should differ in this way, nor that it was the US view that prevailed, and when the SDR was eventually created in 1969, 25years after the Bretton Woodsconference, it had much more in common with the unitas plan than with Keynes bancor proposal. The parallels betweenthe UK and US position in 1945 andthat between the US and China today will not be lost on the authorities in Washington and Beijing.7 Plus a few supranational bodies, but their activities do not materially alter the general position.

introduce a common currency and would in doing so effecta merging of the official and private ecu. This convertibilityend-game helped underpin the value of the private ecu and


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hold it relatively close to the sumof its basket weights in realcurrencies; without it, there would have been a significantrisk that, as a currency with no official issuer or fiscalbacking at all, it could have ended up unwanted andworthless. Would a private-sector SDR without guaranteedconvertibility into the underlying basket currencies have the

same degree of underpinning, or would it be at risk ofconsiderable volatility around its official value?8Secondly, use of the ecu only began to gather anymomentum when private-sector operators promoted ecudenominatedsecurities, and private- and official-sectorclearing systems and depositories made available settlementfacilities in the currency. The same facilities wouldhave to be established for a private SDR before any significantdevelopment of the market could take place.

The final lesson from the ecus history is slightly moresobering. For all the enthusiasm of certain private-sectoroperators for the ecu and for the market in ecu securities,9it remained a niche product until it was transformed intothe euro on 1 January 1999. Only then did general use ofthe currency, including its use as a regional reservecurrency, become a reality.

5. ConclusionDebates over the optimum monetary system for theworld are not new, and the debate over the role of thedollar follows in a long tradition. But that does notdetract from their validity or the urgency of addressingthem. What may be different today is that there is nounderlying asset such as gold into which dollars can beconverted to safeguard the value of reserve assets (asthere was in the 1960s), and there is no obvious alternativenational currency to the dollar as a medium of

exchange (as there was when similar concerns wereexpressed about sterling in the 1930s). It is in this lightthat the potential of the SDR to fill some of the gaps andalleviate some of the concerns expressed over the dollar isan interesting one.Realistically speaking, for the SDR or any othersupranational solution to gain significant traction andsupport will require a degree of international cooperationthat has not been commonplace in recent years.However, with memories of the global nature of thefinancial crisis still fresh, and with the impetus at theG20 and in other fora for a global solution to our globalproblems, it is not impossible to see some progress being

made. Ultimately, a world of nation-states must decidethat it has more to gain from pooling its interests thanfrom pursuing national objectives: if we are able to reachthat point, it may be that, 40 years after it was originallycreated, the SDR is an idea whose time has finallyarrived.

ReferenceMeade, Ellen (2005), Implications of ExternalImbalances for Monetary Policy-Makers: How MuchShould the Fed Worry and What Can It Do?,


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Chatham House Briefing Paper, IEP BP 05/05,May.8 A useful analogy here is between shares in an exchange traded fund (ETF) and shares in an investment trust. Theformer has a convertibility arrangementallowing holders of its shares to switch them for the ETFs component securities, with the result that ETF shares stay veryclose to the underlying asset value.

The investment trust does not, with the result that its shares can trade at considerable discounts (and, though less often,at a premium) relative to the underlyingvalue.9 Most notably Banque Paribas, but there were several other leading institutions promoting the use of the ecu at the timeas well.

www.chathamhouse.org.ukReconsidering the Reserve Currency Question15

3. Lessons fromHistoryCatherine R. Schenk*Moving from one global currency to another

The global reserves system is coming under increasedscrutiny both as a contributor to the current global crisisand as a threat to future stability. The conventionaleconomic view is that the role of the dollar as primaryinternational reserve asset, combined with the accumulationof substantial reserves in East Asia, contributed toAmericas ability to accumulate large balance-of-paymentsdeficits and cheapened government borrowing. DepressedUS interest rates fuelled the consumer and mortgage debtboom. Meanwhile the sustained decline in the value of thedollar from 2002 prompted a reconsideration of how longit could remain the worlds primary reserve asset and if,when and how it might be overtaken by another currencysuch as the euro. The prospect that more countries willaccumulate precautionary reserves in the wake of thecrisis, thereby renewing the cycle, has prompted questionsabout the costs and benefits of issuing an internationalcurrency, how international currencies emerge and howthey can be replaced without disrupting the globaleconomic system.

These questions are similar to those posed during the1960s when the system appeared to be unsustainableowing to persistent American deficits and declining confidencein the dollar. In the 1960s these problems provedintractable and were in the end resolved temporarily by theadvent of floating exchange rates (for core global currencies)and financial innovation, which together reduced theneed for national precautionary reserves. In the process,the secondary international reserve currency, sterling, wasretired. The case of sterling in the post-war decadesprovides an opportunity to examine the process of areserve currency in decline.Although the demand for reserve currencies can bemodelled with a range of variables including issuingcountrysize, share of world trade and return on assets,these exercises have reinforced the importance of institutional


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rather than economic determinants. The importantrole of inertia is usually attributed to network externalitiesthat prolong reserve currency status beyond the timepredicted by economic fundamentals (Chinn and Frankel2008: 4973). These externalities suggest a tipping point orlandslide effect should one major creditor switch its assets,

so that the retirement of a reserve currency is likely to benon-linear. Examining the case of sterling in the post-warperiod helps to understand the determinants and timing ofshifts from one major reserve currency to another. As inthe case of the dollar today, the demise of sterling waswidely anticipated but the process was more gradual thanexpected and its widely predicted abrupt collapse wasavoided. A major source of inertia in this case was institutionalsupport mechanisms to delay the tipping point forthe pound. This analysis also supports Eichengreenscontention that more than one important reserve currencycan operate at the same time, although this was artificiallymanaged in the 1960s through exchange controls andbilateral agreements (Eichengreen 2009: 5368).At the end of the Second World War, it was clear thatthe dollar would be the dominant international currencyin any global economic reconfiguration, and this becamethe core of the BrettonWoods system. Most rich countriespegged their currencies to the dollar, while the UnitedStates alone valued its currency directly in gold.Nevertheless, there continued to be a role for a secondaryinternational currency to be used as a reserve asset, anchorcurrency and currency of settlement because the supply ofdollar assets and gold was restricted in the immediatepost-war period by US balance-of-payments surpluses.www.chathamhouse.org.uk16

* This chapter summarizes the argument in Schenk (2010).The system thus assumed that more than one majorreserve currency could operate at the same time over aprolonged period. In the 1950s the sterling area (35countries and colonies pegged to sterling and holdingprimarily sterling reserves) accounted for half of worldtrade, and sterling accounted for over half of world foreignexchange reserves. In the early post-war years, this sharewas even higher: the IMF estimated that official sterlingreserves, excluding those held by colonies, were four timesthe value of official dollar reserves and that by 1947sterling accounted for about 87% of global foreignexchange reserves.1 It took ten years after the end of the

war (and a 30% devaluation of the pound) before the shareof dollar reserves exceeded that of sterling. This rathercontradicts Chinn and Frankels assertion that by 1945 thedethroning [of sterling] was complete. Figure 3.1 showsthe changing composition of foreign exchange reservesfrom 1950 to 1982.How should the gradual nature of the decline of sterlingbe explained what Paul Krugman (1984: 274) refers to asa surprising persistence? Was this due to British governmentefforts to prolong sterlings role because it increased


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the capacity to borrow, because it enhanced Britains internationalprestige, or because it supported London as acentre for lucrative international finan

beyond the dollar - rethinking the international monetary system (riia)

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