Thursday, July 2, 2009

The Decreasing Importance of the U.S. Dollar in International Finance

The National Public Radio (NPR) story "In IMF Bonds, A Possible Rival For The U.S. Dollar" reveals that the U.S. dollar is decreasing in importance in international finance as assets become increasingly denominated in other currencies. "The U.S. dollar has long been the world's reserve currency — a haven in times of economic trouble. Countries like China and Russia would like to change that. They may have found a way in new bonds from the International Monetary Fund."
All Things Considered, July 2, 2009 · In times of global economic crisis, the International Monetary Fund lends money to nations in trouble. But in the current recession, the IMF has found that it, too, is running out of money.

"We have made quite a large number of commitments of our resources in the last year," says Craig Beaumont, division chief of the IMF's finance department. The organization has loaned out about $150 billion, leaving it with just another $50 billion on hand.

Now the IMF has decided to raise an additional $70 billion the same way large companies do — by issuing bonds (a first for the IMF).

That part of the story is simple enough, but the IMF bonds touch on a far more profound topic: namely, what the world's reserve currency should be. Reserve currency acts as an anchor and a safe haven. It's the currency everyone measures their own against, and the one everyone reaches for in times of trouble. Right now, the world uses the U.S. dollar.

But emerging players like China and Russia have said they wouldn't mind if that changed.

And that's where this story gets more complicated. The IMF's new bonds aren't denominated in U.S. dollars. Instead, they'll be issued in a kind of hybrid called Special Drawing Rights. SDRs are a mixture of the U.S. dollar, the British pound, the euro and the Japanese yen.

The IMF uses SDRs internally, to calculate the money it lends to various nations. A few months ago, the head of China's central bank suggested that SDRs could become the basis for a new kind of global currency.

"The emerging markets are hoping, and China in particular is hoping, that this will start the debate," says Eswar Prasad, a Cornell University professor who once led the China division at the IMF. The bonds could "also start some real progress toward challenging the U.S. dollar's dominance in international financial markets. The Chinese would dearly like to break free of the embrace they have of the U.S. dollar, because they have no alternative, and they would desperately like to have an alternative."

The Problem Of Dollars

Beaumont, of the IMF, is quick to point out that Special Drawing Rights are absolutely not a currency. They're more of an accounting tool, a way to track where the IMF's money is going.

"No one ever carries SDRs around in their pocket," he says.

The problem for China is that it has more money coming in than it knows what to do with. It sells tons of stuff to the U.S. and gets billions of American dollars in return. Where should it put those dollars? Often, China buys U.S. Treasury bonds, because they're the safest investment around.

The IMF bonds will also be very safe, because they're essentially backed by the entire world.

China has pledged to buy what amounts to $50 billion of the new bonds. Russia has pledged to buy up to $10 billion, and so has Brazil.

Against the scale of the global economy, Prasad says, these amounts are relatively small. But if countries decided they didn't trust Treasury bonds so much anymore and began moving a lot of money elsewhere — say, to IMF bonds — that could be a big deal. It could spook the U.S. bond and currency markets, he says, and they are in a fragile mood.

There are a lot of reasons to think China, for all its trash-talking about the dollar, doesn't want to knock it too much. Brad Setser, an economist at the Council on Foreign Relations and an expert on the relationship between the Chinese and American economies, says Beijing would hurt its own cause by moving away from the greenback. "I don't think this is a step toward a new currency that is going to rival the dollar," Setser says.

That's because China needs the dollar to remain strong. It happens to hold more than $700 billion in U.S. Treasury bonds. And it's still buying more.

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