The next reserve currency

Last week’s G8 saw more rumblings of dissatisfaction from China about the US dollar’s continuing role as the world’s reserve currency: State Councillor Dai Bingguo said in a statement to the G8+5 that,

We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies’ exchange rates and promote a diversified and rational international reserve currency system.

This is the latest in a series of such statements from China, building on Wen Jiabao saying he was “worried” about China’s stash of US T-bills in March, central bank governor Zhou Xiaochuan‘s essay on reform of the international monetary system a couple of weeks later, and then China’s $120bn contribution to an Asian emergency currency pool in May – potentially an important step towards an “Asian IMF”.

So if / when the dollar does lose its perch as the world’s reserve currency – something that isn’t likely to happen in the short term, admittedly – then what are the candidates to replace it?

One possibility is the Euro. Europe’s monetary policy has been much more conservative than America’s since the credit crunch kicked off, with the result that budget deficits are under tighter control. But on the other hand, China worries that Europe’s future is hallmarked by low-growth sclerosis and inability to compete.  Another problem: markets for Euros are comparitively illiquid.

A second scenario is the Yuan. As Business Week noted back in May, China has already been quietly doing currency swaps (providing yuan to other central banks for trade with China) with economies including Argentina, Hong Kong, Indonesia, Malaysia, South Korea and others – in the process taking the dollar out of the equation, theoretically at least. Agreements like this were worth $95 billion in 2008 (not counting another mega-swap with Brazil, the amount of which wasn’t disclosed); that’s nearly a third of the value of trade between the US and China.

Although the yuan faces a hurdle in the absence of a serious market for yuan-denominated bonds, this looks potentially set to drop. While yuan-denominated bonds are so far only sold by Chinese banks and multilateral institutions like the Asian Development Bank, HSBC has now announced that it will start to sell these bonds in China too. 

The really big question, though, revolves around the fact that the yuan is not fully convertible with other currencies – which makes other central banks hesitant to hold it in large amounts. But moves in the last few months have started to convince observers that this change could be on the way: the Petersen Institute’s Nicholas Lardy is quoted as saying that  the yuan could become convertible within “two or three years”.

That said, it’s important to remember that such a change would represent a major break with China’s current policy of managing its exchange rate to keep its exports competitive (and disallowing its citizens from taking yuan out of the country) – and force China to let go of a big plank of its current protectionist posture. Historically, of course, that’s just what economies tend to do when they become ‘top nation’ – but that’s a way off yet for China.

A third possibility: a super-sovereign reserve currency, i.e. one that isn’t just issued by one country.  As I noted in a post in March, that was of course exactly what John Maynard Kenyes proposed (and the US vetoed) at Bretton Woods when he mooted the idea of the ‘bancor’ – an international currency for clearing trade balances, that would at the same time work in such a way as to prevent up dangerous trade imbalances (like the one that exists now between the US and China). While that precise idea hasn’t been remooted by China, it’s not a million miles from the proposal on Special Drawing Rights made by Zhou Xiaochuan in March, in that both are valued according to baskets of currencies and/or goods.

Another idea for a super-sovereign currency is to make carbon part of the basket (or just to use carbon permits as currency in themselves). While emissions trading markets are as yet in their infancy, the long term prospect is for a singe, global cap-and-trade market and a global system of binding targets for all countries. In such a set-up, carbon permits would become one of the key scarce resources in the world – and on the basis that it makes sense for economic systems to focus on the scarce resource whose use they seek to minimise (see e.g. Richard Douthwaite on this), the long-term role of carbon permits in the global economy is a big unexplored area.

Finally, of course, there’s gold. Until the US came off the gold standard in 1971, gold was effectively the world’s reserve currency – and it remains the most obvious alternative to fiat currencies (money which is money simply because a government says it is, and people believe them).  Today, of course, it’s gold that’s priced in dollars ($913 for a troy ounce, since you ask), rather than vice versa, and it’s hard to find many politicians around the world who would argue for a return to the gold standard (although Mahathir Mohamad used to call for a gold-based currency for Muslim countries).

Still, if fears about the US’s yawning budget deficit and / or the risk of a protracted global slump intensify, then gold may be the most obvious switch.  Gold dealers are certainly benefiting from that perception, at any rate: today, as has been the case on and off for some weeks now, the front page of my Financial Times has a large advert for a company called Ascent Gold. Their strapline: “the new global payment unit”.