Monday, June 22, 2009

Weekly Hurriyet Column: Building a new monetary system with BRICks

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. As usual, I have a few additional points: First, I have to admit that the first sentence is a really lame joke. Second, the speech by the Chinese Central Bank Governor from March was what brought the debate to attention at first. Third, it was actually Keynes who said that even the most practical man of affairs was usually in the thrall of the ideas of some long-dead economist. Fourth, I should have made this more explicit, but just imagine for a moment what would happen if the governments decide to get rid of their dollars. The bond market would be the one to be frightened, for a change. And last but not the least, the wise man is Peter Parker's uncle. BTW, I have no idea how I managed to mistype minuscule:) I mean with Word, even a dyslexic should be able to type error-free:)...

Despite claims from the sage of Omaha that he had nothing to do with it, the dollar was buffeted last week by debates over its status as a reserve currency during the inaugural summit of Brazil, Russia, India and China, the so-called BRICs.

While the summit officiated a term created by Goldman Sachs chief economist Jim O’neill nearly a decade ago, it would be a bit ambitious to coin it the “epicenter of world politics”, as Russian President Dmitry Medvedev put it. While the summit had a noble agenda, including a fairer world order and more say for emerging markets, the dollar debate took the attention.

In fact, the argument is not that new. It first appeared in the height of the financial meltdown, and after being on and off, resurfaced again in the St. Petersburg Economic Forum early in the month. At the time, the Russian plan, which envisaged a set of regional reserve currencies accompanied by IMF’s special drawing rights (SDRs), did not get much attention, as Russia has traditionally used the forum to argue for the ruble as a reserve currency.

While it has certain advantages, the use of a national currency as reserve is bound to create conflicts of interest between domestic and global issues. Keynes had actually put forward the “bancor”, to be based on the value of thirty representative commodities, during the formation of the post-war monetary system in Bretton Woods, but the idea was rejected by, surprisingly, the US. While the global crisis has acquainted everyone with him, it turns out that this long-dead economist has other ideas in his sleeve that continue to thrall us.

On a more practical level, there aren’t enough dollar assets out there to satisfy the appetite of governments: Out of the seven trillion dollars of central bank reserves, two thirds to three fourths are in dollars, with the bulk in long-term US government debt. In fact, more than one half all long-term US Treasuries is parked in official bodies, definitely not a healthy concentration for any financial asset, for the issuer as well as the holders. No wonder the Chinese got jittery during the great upward move in yields.

However, setting up a new reserve currency is more easily said than done. Let’s take SDRs: Notwithstanding their limited use as country deposits with the IMF and the lack of a payment system set up with SDRs, illiquidity is the primary issue that needs to be surmounted before they could even be a candidate for a reserve currency. Issuance of SDR bonds by the IMF is definitely a step in the right direction, but the amount is minuscule, and it is not clear whether the bonds will be tradable.

Then, a second-best solution would be to decrease the role of the dollar, replacing it with other currencies. In fact, agreements within the BRIC to use their national currencies for trade transactions and Chinese currency swaps are steps in the right direction. However, these steps are very small, and while BRICs would indeed need to lead the way, they would have to sacrifice a lot more. For one thing, China, which holds nearly one third of the official reserves, would need to increase its consumption from the current one third of GDP to at least a half. As a more general point, BRICs and other emerging markets would have to shift their saving patterns for the correction of global imbalances and be able to swallow the appreciated exchange rates that come with the package.

A wise man once said that with great power comes great responsibility. It is obvious that BRICs have the power, and they have not been shy to show it of late. But until they have the guts to take on the responsibility that comes along with it, we are all stuck with the greenback, like it or not.

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