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What Will be the Next World Reserve Currency?

Currencies / Global Financial System Mar 31, 2009 - 06:16 PM GMT

By: Joseph_Toronto

Currencies

  • Best Financial Markets Analysis ArticleWhat exactly is a “reserve currency”?
  • Replace the dollar as the world's reserve currency?
  • Why the dollar will remain the most important reserve currency.
  • What are the Chinese really up to?

John Hutchins recently wrote to me inquiring about my views on the new proposal to begin using SDR's (special drawing rights) of the IMF (International Monetary Fund) as a new international reserve currency to take over that role now being performed by the US dollar. To begin with, let's find out exactly what a “reserve currency” is. There are those who scoff at the use of Wikipedia as a source of information, but to me, sometimes there is no better place to get complex issues concisely explained in layman's terms.

A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.

This permits the issuing country to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 18th and 19th centuries. The dire economic cost of fighting the First and Second World Wars, the increasing dominance of the USA in world economics (and, importantly, the establishment of the U.S. Federal Reserve System in 1913) as well as economic weakness in the UK at various intervals during the second half of the 20th century resulted in Sterling losing its status as the world's most reserved currency.

The United States dollar is the most widely-held reserve currency in the world today. Throughout the last decade, an average of two thirds of the total allocated foreign exchange reserves of countries have been in U.S. dollars. For this reason, the U.S. dollar is said to have “reserve-currency status”, making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact. Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the U.S. economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly.

The euro is currently the second most commonly held reserve currency, being approximately a quarter of allocated holdings. After World War II and the rebuilding of the German economy, the German Deutsche Mark gained the status of the second most important reserve currency after the US dollar. When the euro was launched on January 1, 1999, replacing the Mark, French Franc and ten other European currencies, it inherited the status of a major reserve currency from the Mark. Since then, its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.”

Replace the dollar as the World's reserve currency?

The government of China has recently proposed that SDR's be used as a new form of worldwide reserve currency. SDR's are special drawing rights issued by the IMF. They are not issued by any sovereign government or by the central bank of any government. In fact SDR's are little more than a basket of currencies important in trade and finance issued by various countries.

At present, the currencies in the basket are, by weight, the United States dollar, the euro, the Japanese yen, and the pound sterling. Before the introduction of the euro in 1999, the Deutsche Mark and the French franc were included in the basket. The amounts of each currency making up one SDR are chosen in accordance with the relative importance of the currency in international trade and finance.

China after having had a large run of economic growth, weak currency and large trade surpluses has amassed a huge stockpile of foreign reserves. It is in essence a portfolio of foreign currency reserves the largest portion of which is the US dollar.

So this literally begs the question. Why does China want to replace its portfolio of foreign currency reserves with shares (SDR's) of another portfolio of foreign currency reserves? It's like a stock market investor who has a bunch of blue chip stocks in his account suggesting that he and everyone else like him replace those stocks with shares of a blue chip mutual fund. What could the motivation be? It can only be that China doesn't like the favorable allocation (65%) given to the US dollar in current world currency reserves and would like to see the “better” allocation (45%) used in the IMF SDR's. Why can't China just do this by changing allocations in their own portfolio? Well, they can. But their obvious objective is to get “everyone” else to do the same thing. Why? Perhaps they just don't like the idea that the U.S. has a virtually unlimited line of credit in performing this role while the rest of the world has to maintain a good credit rating. Your guess is as good as mine. Will it work?

Why the dollar will remain the most important reserve currency.

All currencies in the world today are fiat currencies. That is, they are deemed currency by government decree. They are not backed by, or convertible to any asset such as gold or silver but are only pieces of paper (or electronic blips) that are only backed by the full faith and credit (the creditworthiness) of the issuing government. So what makes a currency valuable?

Since the beginning of time there really is only one variable that makes a currency valuable and that is, will merchants accept it in payment for goods and services. And what causes merchants, large or small, to accept a currency? Here's an example. During the Civil War, Abraham Lincoln approached the New York bankers for loans to fund the war effort and was turned down because the war was not going well at the time. So he committed the unforgivable sin (to the banking cartel) and instructed the Treasury Department to print “greenbacks” and pay for war supplies with them. Why would merchants accept such pieces of paper from a financially struggling government as payment for goods? Because the U.S. government said that it would accept them in return in payment for taxes. What happened? Lincoln won the war and greenbacks circulated as currency for nearly a hundred years thereafter.

Currencies are only as valuable as people, merchants and governments deem them to be. Value is determined over time and by economic fundamentals. A reserve currency generally grows into usage by the banking community over time because of the strength and stability of the economy in which it is used. This can take a relatively long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook the UK as the world's largest economy before the dollar overtook Sterling as the dominant global reserve currency.

Here are some of the reasons why global merchants and governments will continue to seek to obtain and hold dollars regardless of what is the “officially designated” reserve currency such as SDR's:

  • The U.S.  is the largest economy in the world, the largest trading partner in the world, and there is no commodity or product in the world which cannot be purchased in any quantity with U.S. dollars.
  • The U.S. has a very long history of commerce law with the most well established enforcement institutions of any in the world. It has a highly developed body of commerce law with powerful commerce friendly courts that can and will enforce contracts and deliver relief to commercial litigants from anywhere in the world.
  • The U.S. is the single most politically stable country in the world. It is not remotely threatened by any hostile power in its own hemisphere. The likelihood of civil war or insurrection or domestic unrest is, if not zero, very close to zero.
  • The U.S. has the single most powerful, effective and reliable military force in the world for protecting trade routes and defending its vital economic interests worldwide.
  • While the U.S. has been accused of abusing its military and economic might for its own selfish interests, it still remains far and away, more disciplined by rule of law and less subject to corruption than virtually any other major currency issuing country.

If you were a country with a very long time horizon for political and economic development (China), which currency would you want to hold in your national savings account? What possible reason could you possibly have for proposing policies that could be seen as contrary to your economic interests?

Well, what would you do if you had the largest stockpile or inventory of any given product or commodity, and as a market maker had the power to manipulate it's price in the open market to your advantage? Would you be tempted to manipulate the price lower when you are acquiring more or higher when you need to unload some? Isn't this called engaging in tactical market maneuvers to maximize your inventory portfolio? Do you really think the Chinese are above price manipulation to their advantage if it doesn't undermine their long term strategic interests?  You tell me.

Regardless, global bankers, merchants and governments worldwide will readily and happily (while frequently complaining) continue to accept dollars in payment of goods, services and taxes. The dollar will not go away anytime soon although it will fluctuate greatly in value as traders seek to maximize their inventory just as all forms of money and goods in trade fluctuate in price.

What are the Chinese really up to?

One could argue that the Chinese are simply attempting to diversify and protect their reserves from inflation. Inflation is indeed one of the oldest and most insidious means of debt repudiation known to man. Is the U.S. above doing that? I don't think that is our intent at present, but when crunch time hits, most governments subject to political pressures (that's all governments right?) will succumb to doing whatever it takes in their self interest.

In any event, the Chinese can re-allocate their portfolio of currencies to mirror that of SDR's without actually using SDR's. The effect in the open market would be the same as selling their inventory and replacing it with SDR's. I'm a little cynical. I think it has more to do with temporary price manipulation.

Inasmuch as all currencies are fiat currencies, they can only gain or lose value against each other and in turn, other commodities. A person's risk in holding currencies (or assets valued or priced in a given currency) therefore is its value with respect to other currencies. If not for commodities' prices in a given currency, in a sense, it's a zero sum game.

I think the real question is a question of the chicken and egg theory. For example, will the given allocation in an SDR basket affect a currency's value with respect to others, or, will a currency's market value as determined by economic fundamentals thereupon then determine its allocation in an SDR basket?

The Chinese, control freaks and manipulators that they are, obviously opt for the former thinking that SDR's are a vehicle for greater control of exchange rates. The U.S. on the other hand, by its ambivalence towards the prospect, believes in the latter. And as usual, the Europeans are caught in the middle and can't decide.

Current U.S. economic dogma stipulates that governmental efforts at exchange rate manipulation through open market operations or other manipulation is temporary at best and that no one, not even China has sufficient capability to much affect the massive amounts of currency that changes hands in the banking system in commerce and trade on a daily basis. Even central banks with their massive resources are ultimately easily overwhelmed by the overall trading in the banking system. Experience seems to support that theory.

For myself, I also tend towards the latter, that creditworthiness, economic strength, fiscal and monetary policies will ultimately determine the market price or strength of a given currency which in turn will determine its ultimate allocation in any given basket of reserves such as SDR's. However, it's an interesting question and one that deserves to have the experiment run. Such an experiment will yield an immense amount of data for use in future policies and in future generations.

Very Best Regards,

Joseph Toronto

Affiliated Investment Advisors, Inc.

http://joesinvestoblog.com

joe@aiadvisors.com

Joseph Toronto, has managed stock and bond portfolios for 26 years for some of the largest institutions in the west. He began in 1982 as a portfolio manager and analyst for the LDS Church Investment Trusts. In moving to the Trust Division of West One Bank he became senior investment officer and managed assets in excess of $100 million. Later, as the senior portfolio manager of Pacific American Investors, Inc. he managed stock and bond portfolios for high net-worth individuals nationwide. In 1993, Mr. Toronto founded Affiliated Investment Advisors, Inc., as a registered investment advisor for serious investors seeking professional management for superior safety and returns. Mr. Toronto is a Chartered Financial Analyst and is a member of the Salt Lake City Chapter of the Financial Analysts Society and the Association for Investment Management and Research. He has a Master's degree in investment securities and a B.A. degree with a dual major in finance and management.

Currently, Affiliated Investment Advisors, Inc. manages investment portfolios for retirement plans, profit sharing plans, individuals, IRA's and other trusts.  We believe Affiliated offers professional portfolio management with superior investment returns while steadfastly safeguarding and protecting your capital. As a registered Investment Advisor, Affiliated's portfolio management services are “fee only” and takes no commissions or performance incentive.  It is not a stock broker or financial planner and does not sell any investment or insurance fund or product. joe@aiadvisors.com

© 2009 Copyright Joseph Toronto - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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