Last week I blogged that China is concerned about the value of its investments in US Treasuries. This week, Zhou Xiaochuan, the governor of the People's Bank of China, proposed a new international reserve currency to replace the U.S. dollar. The full essay can be found here.
Zhou's main argument is that countries that issue reserve currencies face a conflict of interest: between their domestic monetary policy goals (inflation targeting) and the demand for the currency abroad. So, inflation-control measures at home would not meet international demand and, as China fears now, fiscal stimulus measures at home could create excess liquidity in global markets and reduce the value of Chinese dollar-denominated assets. Instead, Zhou argues that an international reserve currency would eliminate the 'inherent risks of credit-based sovereign currency' and allow the IMF to 'manage global liquidity'.
Zhou wants the IMF's Special Drawing Rights (SDRs) to be given an expanded role. (SDRs were created in 1969 to bolster official forex reserves, to be allocated to countries based on their IMF quotas. But their use has fallen since the collapse of the Bretton Woods fixed exchange rate system in 1973.) In the short to medium run, Zhou's plan would include: an increase in SDR allocations; a settlement system between SDRs and other currencies; greater use of SDRs in international trade; new financial assets denominated in SDRs; and SDR valuation based on a basket of currencies of all major economies, not just the four currencies used today. In the longer run, centralised management of the reserves of IMF member countries could mean that SDR allocations would eventually replace existing reserve currencies.
The dollar briefly fell 1.3% against the euro yesterday after Tim Geithner, U.S. Treasury Secretary, said that the U.S. was 'quite open to that' idea. He cautioned, however, that greater use of SDRs would be an 'evolutionary step', not a move towards 'global monetary union'. The U.S. insists that the dollar is still the world's dominant currency.
Given China's losses on investments in other currencies, at least in the near future China will still hold much of its reserves in dollars. And despite the proposal, calls for China to raise domestic consumption and stop artifically holding the renmimbi down to boost its exports are not going to get drowned out any time soon.