Just too many reserve currencies

On November 30, the International Monetary Fund announced its decision to include the RMB or the yuan as the fifth currency in the SDR basket that is currently composed of the following four currencies: the US dollar, the euro, the Japanese yen and the British pound. Besides, the IMF has assigned a weight of 10.97 per cent for the Chinese currency above the Japanese yen and the pound sterling. This places the RMB in third position after the dollar and the euro, which have been assigned 41.73 per cent and 30.93 per cent weights respectively, while the Japanese yen and the pound sterling have been assigned a weight of 8.09 per cent each. The new weights will be effective October 1, 2016.

According to the IMF’s managing director, Christine Lagarde, the decision to include the RMB in the SDR basket is not only an important milestone in the integration of the Chinese economy into the global financial system but a recognition of the progress the Chinese authorities have made in the past years in reforming China’s monetary and financial systems.

This development marks the culmination of China’s efforts since the seventies and a major shot in its arm as the yuan has now the IMF’s endorsement as an international reserve currency.

The Special Drawing Rights or SDR is an international reserve asset created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. As the supply of two key reserve assets, gold and the US dollar, proved inadequate for the expansion of world trade and the economic development that was taking place, the international community decided to create a new international reserve asset under the auspices of the IMF.

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold, which, at that time, was equivalent to one US dollar. After the collapse of the Bretton Woods fixed exchange system in 1971, the SDR was redefined as a basket of certain select currencies,

The SDR basket of 16 currencies from 1974 to 1980 was replaced in 1981 by a basket of currencies that included the US dollar, the Deutsche mark (DM), the French franc (FF), the British pound, and the Japanese yen. After the euro was in place in January 1999, the SDR basket included only four currencies: the dollar, the euro, the pound and the yen. The US dollar value of the SDR is calculated as the sum of the specific amounts of four currencies valued in US dollars on the basis of exchange rate quoted at noon each day in the London market. It has limited use such as determination of fees by the International Postal Union and, as a spinoff, to determine the roaming charges for mobile telephones in certain regions except Europe.

The weight assigned to the US dollar in the 1981 and 1986 review was 42 per cent while the combined weight for Deutsche mark and the French franc was 39 per cent during 1991, 1996 and 1999, but the combined weight for the DM and FF remained at 32 per cent; that continued even after the euro came in. The dollar weight went up to 44 in 2001 and 2006 but declined to 41.9 per cent in the 2011 review. During the 1999 review the weight for the euro rose to 32 per cent, and declined to 31 per cent. It touched an all-time high of 37.4 per cent in 2011.

Over the years the IMF has not been fair in assigning the weight for the US dollar in the SDR basket. Even after the introduction of the euro in 1999, the dollar accounts for nearly 64 per cent of the global currency reserves as compared to 27 per cent held in euros, with 40 to 60 per cent of international financial transactions being denominated in dollars. In 2010, while the euro was assigned 37.4 per cent, the weight for the dollar was only marginally higher, namely, 41.9 per cent.

The steady decline of the euro during the last four years starting with problems in Greece, Portugal and Italy has contributed to the sharp change in the dollar-euro exchange rate: On December 31, 2010, 1 euro was equal to $1.3384. Currently 1 euro is equal to $1.05. It is just a question of time before one euro becomes equal to a dollar or less and the very future of this currency is uncertain. The SDR weightage to the euro is debatable.

Manipulators of currencies should have no place in the SDR basket. Both Japan and China have manipulated their currencies to boost their exports. In 1985, the Japanese yen at 220 to a US dollar almost killed the US auto industry till President Ronald Reagan imposed import quotas on Japanese cars. Had the IMF expelled the yen from the SDR basket in its 1986 review, an equally manipulative China could not possibly have staked its claim today.

With the end of recession and consequent recovery since March 2009, all the emerging economies in Asia witnessed surging capital flows causing significant appreciation of their currencies, with the Brazilian real and the Korean won gaining 42 per cent and 36 per cent respectively against the yuan. China, which had emerged as the third largest economy after the US and Japan and had surpassed Germany as the largest exporting nation, had chosen to peg its currency at 6.63 yuan to a dollar since July 2008. The percentage of forex traded is almost the same for the newcomer yuan and the yen. Therefore, there can be no justification in assigning additional weight to the former in the SDR basket.

Subject to fine-tuning, the dollar deserves a weight of 51 per cent while the weight for the euro should not be more than 25 per cent. The balance 24 per cent should be equally distributed among the yen, the yuan and the pound sterling. Inclusion of the yuan in the SDR basket is bound to provoke requests for inclusion of the Australian, Canadian and Singapore dollars. With the proliferation of a large number of currencies, day-to-day determination of the SDR value will become more difficult. There has been a demand to include gold in the SDR basket.

As long as oil is priced in dollars the possibility of replacing the dollar as a reserve currency by another currency may not materialise in the near future though China could be expected to mount pressure through the BRICS forum for a larger share in the global payment system.

The IMF should examine the possibility of having an SDR composed of only the US dollar and gold which would make the SDR administration simpler than having about eight different currencies in its basket.

The writer was with the IMF