Diversification of reserve currency on the cards?
Written by Sushovan Rudra, IIM Indore (batch of 2011) Saturday, 08 August 2009 21:00
China has been flexing its muscles in international affairs for some time now. Hence, it was of little surprise that it did the same at the recently concluded G8 summit held at the earthquake ravaged Italian town of L’Aquila.
”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,” said Mr Dai Bingguo, the Chinese state councilor. He implied that the days of the US dollar, which has been the central currency of the international financial system since World War II, were nearing its end. The remark unsettled the leaders of the world’s biggest economies. “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised”, said the British PM Gordon Brown.
Currently, the US dollar is the most widely used reserve currency. Goods like oil and gold, which are traded in the international market, are priced in US dollars. To pay for these goods, the reserve currency is held by various governments and financial institutions. The reserve currency is also used by governments to leverage their domestic exchange rates. The exchange rate is a tool to control the net trade balance.
The US economy is in a shambles. Washington has been on a spending spree to counter recession. In mid-February, the US Congress passed the American Recovery and Reinvestment Act of 2009 which pumped $787.2 billion into the ailing US economy. This is in addition to the $700 billion financial rescue plan signed into law by former US president George W. Bush in October 2008. The huge deficit spending may lead to inflation that will erode the value of China’s holdings of around $2000 billion of US treasury debt. The Chinese government has been accused of manipulating the exchange rate to run a huge trade surplus which in turn leads to a huge trade deficit in the rest of the world. Last year, the US dollar appreciated taking the Chinese renminbi, which is pegged to the dollar, with it. This has an effect of reducing China’s trade surplus. Apart from that, China wants to keep the renminbi-dollar rate stable for two more reasons. One, a fixed exchange rate serves as an effective monetory anchor for China’s internal price level. Two, the Chinese government is planning a big fiscal stimulus and it would be most effective if the exchange rate is stable.
A diversified reserve currency would reflect the shifting balance of power in an increasingly multipolar world. This is most suited to China’s goal of being the superpower of the twenty-first century. (448 words)
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