Shifting wealth: Is the US dollar Empire falling

If history is any guide, the Chinese renminbi will soon be due to overtake the US dollar, just as the dollar replaced the pound sterling last century. But will the renminbi be ready for reserve currency status? This column discusses the issues at hand and explains why some experts would prefer the IMF’s Special Drawing Rights as the next global reserve currency.

Just ahead of the G20 London Summit in April, Zhou Xiaochuan (China's central bank governor) proposed replacing the US dollar as the international reserve currency with a new global system controlled by the IMF. The main global reserve currency would be represented by a basket of significant currencies and commodities, an extended version of the Fund’s Special Drawing Rights (SDRs). China's call for an overhaul of the global currency reserve system has been echoed by Russia's President Medvedev as an important building block of a new global financial architecture.

Major emerging economies, often net creditors to the rest of the world an with substantial holdings of US government debt, fear the potential inflationary risk of the US Federal Reserve printing money to finance bank bail outs. Their fears may be based on the “Triffin Dilemma” that postulates the necessity of US external deficits as long as the US dollar is the only global reserve currency. In a famous warning to Congress in 1960, the Belgian Yale economist Robert Triffin explained that as the marginal supplier of the world’s reserve currency, the US had no choice but to run persistent current account deficits. As the global economy expanded, demand for reserve assets increased. These could only be supplied to foreigners by America running a current account deficit and issuing dollar-denominated obligations to fund it. If the US stopped running balance of payments deficits and supplying reserves, the resulting shortage of liquidity would pull the global economy into a contractionary spiral (Triffin, 1961). Note that demand for foreign exchange reserves forces developing countries to transfer resources to the countries issuing those reserve currencies – a case of “reverse aid”.

China holds a huge official portfolio of US government bonds. It has already suffered valuation losses on its sovereign wealth funds that invested heavily in US financial intermediaries. But could China suffer valuation losses as a result of inflation and dollar devaluation, as is often maintained? Dollar weakness – against other key currencies – will not by itself inflict valuation losses on China's central bank as there would be no change in the renminbi value on the dollar component of China's huge FX reserves. It is renminbi appreciation against those currencies held in the FX reserves – often claimed by the West – that would inflict valuation losses as measured in renminbi.

In the recent decade, the US has used (and perhaps abused) the privileges that its reserve currency status has conveyed to the host country. To see this, look at Table 1, which displays a matrix of the global functions of money often attributed to Peter Kenen (Group of Thirty, 1983).

Table 1. Matrix of international currency use