The debate over reforming the international monetary system never ends; it only changes form and focus. The old debate what to do about the exchange rate seems to have been resolved in favour of flexibility, just not too much flexibility, at least not yet. The new debate in contrast what to do about the reserve system is still very much up in the air.
Here one encounters a variety of proposals for replacing the dollar as the dominant form of central bank reserves. These proposals are based on the belief that allowing a national currency to be the dominant form of international reserves requires the country issuing that currency to run current account deficits, making it necessary to eliminate the dollars exorbitant privilege in order to resolve the problem of global imbalances.
It is important to understand that the requires part of this assertion is a non sequitur. To see this, observe that the euro has gained ground as a reserve currency even though the euro area has not run significant current account deficits. Or recall that countries accumulated dollar reserves under the original Bretton Woods System even though the US ran a balanced current account and even substantial surpluses for most of the Bretton Woods period. All that is required is that the reserve currency country with a balanced current account should invest abroad in an amount equal to the incremental demand for reserves in the rest of the world.
Hence the argument that being the sole supplier of reserves creates a tendency for a country to run chronic current account deficits must be a different one. It must be that the desire of other countries to accumulate reserves reduces the incentive for the reserve issuer to run a balanced current account. Knowing that other countries require additional reserves and are prepared to finance the reserve centres current account deficit if that is the price of obtaining them, policy-makers in the reserve issuing country have less incentive to adopt painful policies that raise national savings to the level of national investment. Think of it as a problem of moral hazard.
The SDR route
To the extent that this moral hazard is present, the question is what to do about it. One possibility is ongoing issuance of Special Drawing Rights (SDRs) to provide a non-national source of incremental reserves. The IMF would issue SDRs on a regular basis in amounts equal to the increase in global reserve demand.
The problem is that SDRs can be used only for transactions with the IMF and among consenting governments. Unlike national currencies, they cannot be used for foreign exchange market intervention and other transactions with market participants. For central banks and governments that see reserves as insurance that anticipate having actually to use them this illiquidity renders SDRs unattractive.
Making SDRs attractive would require making them liquid. This would mean developing private markets on which SDR claims can be bought and sold. It would mean building a broad and liquid market on which governments and, for that matter, financial and non-financial firms could issue SDR bonds at competitive cost. Banks would have to find it attractive to accept SDR-denominated deposits and extend SDR-denominated loans.
For their part, pension funds and insurance companies that are the dominant sources of private demand for bonds would have to be attracted to holding bonds denominated in a basket of currencies. This would not be easy, given that their liabilities tend to be dominated in a single national currency. They could of course swap out the currency risk, but this would be an additional cost of the investment strategy, which would presumably render it unattractive or require an interest rate premium of the issuer, which would make issuance less attractive.
Long time passing
Some day, perhaps, the liabilities of pension funds, insurance companies and the like might also be denominated in SDRs, in turn making these entities enthusiastic investors in SDR bonds. Some day, in other words, pensioners and individual purchasers of insurance would willingly accept payouts in SDRs. At this point the SDR will begin to function as a true global currency. But putting the point this way is a reminder that the day when there will be a liquid market in SDRs is very, very far away.
While all this is conceivable in principle, it will not be easy in practice. Recall that there was a previous attempt to commercialize the SDR in the 1970s which never really got off the ground. Succeeding this time would take decades rather than years. Our recent financial crisis is a reminder that building stable, liquid markets in novel assets is not a process that can be completed overnight.
As part of this effort, the IMF would have to be authorized to issue additional SDRs in periods of shortage, much as the Federal Reserve provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. At the moment, countries holding 85% of IMF voting power must agree before SDRs can be issued, which is not a recipe for quick action. IMF management would have to be empowered to decide on emergency SDR issuance on its own, just as the Fed can decide to offer emergency currency swaps.
For the SDR to become a true international currency, in other words, the IMF would have to become more like an independent central bank. The idea of an independent IMF has its advocates, including this author. But it is not clear that China, Russia, Brazil and other advocates of replacing the dollar with the SDR are aware that this is the implication of their proposal.
The other approach to reducing the dominance of the dollar would be to diversify the sources of international reserves. The moral hazard felt by any one nations policy-makers would then be limited. Imagine 20 years from now three economies of roughly comparable size, each with a convertible currency traded on liquid markets that can be used to satisfy the incremental demand for reserves. No one of them will be able to reduce its saving relative to its investment by a substantial margin simply because global demand for reserves is growing.
One way of understanding how global imbalances grew so pronounced in the years leading up to 2008 is that the incremental demand for reserves was increasingly large while the weight of the reserve issuing country in the global economy was unusually small. So it was that the United States came to account for some 75% of global current account deficits. Diversifying the sources of international reserves would change this. With the US, the euro area and China all issuing reserves to reveal my forecast of the three plausible reserve centres 20 years from now the incentive and ability of any one reserve issuer to run such massive deficits would be less. Given the existence of alternatives, an issuer prone to excessive deficits would quickly see other countries accumulating reserves in currencies other than its own. That, in turn, would create an incentive to avoid excesses. It would be a source of external discipline.
This clearly is the direction in which we are heading. The euros share of global reserves has risen since the new European currency was created in 1999. And Chinese officials have now mounted a campaign to transform the renminbi into a true international currency. They are encouraging domestic and foreign firms to settle their transactions in renminbi, signing agreements with foreign governments to do likewise, extending renminbi swaps to foreign central banks, and relaxing restrictions on the ability of foreign financial institutions to issue renminbi debt in Hong Kong.
But, again, the euro and the renminbi will match the dollar as an attractive form of reserves only when securities denominated in those currencies possess equally deep and liquid markets. And for now the liquidity of the market in US treasury securities remains unsurpassed. Europe and China may eventually succeed in creating equally liquid markets, but the time frame relevant to doing so is measured in decades, not years.
Europes problem is that the stock of government debt securities is not homogeneous. Different government bonds differ in their risk, returns and liquidity. German bunds have a reputation for stability but, since they tend to be held to maturity by institutional investors, the market in them lacks liquidity. Other euro area countries have plenty of bonds but also deep financial problems. Italian government bonds are in fact the most important euro area debt securities in value, but the countrys economic and financial problems mean that they are hardly attractive as reserve assets.
The crisis has encouraged talk of issuing euro area bonds and putting the full faith and credit of the entire set of members, starting with Germany, behind them. Were this done on a significant scale and were such debt to replace the national debt securities of EU member states, the euro area would possess something more closely akin to the US treasury market. But this kind of radical fiscal federalism is not something to which the German government is going to agree anytime soon.
For the renminbi, an important precondition for the creation of a deep and liquid market freely accessible by international investors, including central banks, is full capital account convertibility. Full convertibility is coming, but not tomorrow. And even that is just a necessary, not a sufficient, condition, for making the renminbi a serious contender for reserve currency status. In addition, there will have to be deep and liquid markets in renminbi-denominated assets. Chinese officials have targeted 2020 as the date by which Shanghai becomes an international financial centre, meaning that its markets are both reasonably liquid and open to foreign investors free of capital account restrictions. This is nothing if not an ambitious agenda.
Some day we will have a multiple reserve currency system not unlike the one that existed before 1913, when the British pound, French franc and German mark shared this role. But not tomorrow.
Barry Eichengreen is George C Pardee and Helen N Pardee professor of economics and political science at the University of California, Berkeley