China, SDRs, and the Dollar
China wants a new international reserve currency that is “disconnected from economic conditions and sovereign interests of any single country.” Countries acquire portfolios of foreign exchange when they limit the appreciation of the currencies in the face of balance-of-payments surpluses. China, which holds a huge portfolio of foreign exchange, mostly in dollar-denominated assets, claims that credit-based national reserve currencies, like the dollar, are inherently risky, contribute to global imbalances, and facilitate the spread of financial crises. The Peoples Bank of China recently recommended supplanting the dollar with Special Drawing Rights (SDRs).
The International Monetary Fund created SDRs as an international reserve in 1969 to solve problems that rose out of the Bretton Woods fixed-exchange-rate system. By the mid-1960s, U.S. dollar liabilities to foreigners exceeded the U.S. gold stock, effectively nullifying the linchpin of the Bretton Woods system, the U.S. promise to convert all dollars held abroad into gold at a fixed price. As a consequence of this development, some countries, notably France, sought to replace the dollar with a reserve currency unrelated to a single national currency, if not solely related to gold.
The IMF initially defined the SDR in terms of a fixed amount of gold (at that point in time equal to $1) and allocated 9.3 billion SDRs between 1970 and 1972 to member countries in proportion to their quotas. Following the widespread acceptance of floating exchange rates in the mid-1970s, the IMF redefined the SDR as weighted average of the U.S. dollar, the British pound, the Japanese yen, and the currencies that eventually comprised the euro, and made a second—and last—allocation of 21.4 billion SDRs between 1979 and 1981.
The SDR never supplanted the dollar as a reserve currency unit; instead, it devolved by and large into a unit of account. Despite repeated complaints about the dollar’s role as a reserve currency, particularly when the dollar depreciated on a broad basis, the dollar remains the world’s key international currency. A substantial portion of international trade—even trade not directly involving the United States—is routinely denominated in U.S. dollars. This is especially true of trade in fairly standardized commodities, like oil, coffee, and wheat, and products that trade in highly competitive markets. As a consequence, traders finance a good portion of their trade in dollars, so they maintain accounts, seek loans, and undertake other types of banking arrangements in dollars. Foreign banks, eager to serve their customers, hold portfolios of dollar assets and liabilities. With dollars widely traded and held, other dollar-denominated financial markets flourished.
This trading and financial network affords dollar users huge economies, which other currency networks do not match. Consequently, many foreign individuals, households, companies, and even governments maintain significant proportions of both their assets and their liabilities in dollar-denominated instruments. China, Japan, Russia, and India, for example, hold very large portfolios of dollar-denominated reserves. In some countries, notably Panama, the dollar has replaced national currencies. According to a 2007 survey, roughly $3.2 trillion worth of foreign exchange changes hands each day and 86 percent of those transactions involve dollars. The euro, the second-most widely used international currency, lags well behind the dollar.
Establishing the SDR as a new international reserve currency may be technically feasible, but it will be a long time before it can truly function as an international currency. Countries may convert their reserves into SDRs, but until the private sector adopts SDRs, these countries will still need to acquire dollars or euros or some other national currency to spend their reserves. The private sector will only adopt the SDR if it offers network benefits, comparable to the dollar, but that could take decades.
In the meantime, countries worried about their expanding dollar portfolios might take a different tack: Allow their currencies to float and adopt a domestic monetary policy focused on long-term price stability.