If time lags matter, news of the dollar’s demise as the world’s principal reserve currency is grossly exaggerated. That prediction has been periodically heard at least since the early 1970s when the United States brought the Bretton Woods arrangement to an end by breaking the link between dollar and gold. As is obvious, whatever else may be said of the role of the US in the world system, this expectation of the dollar’s displacement as the currency that is as good as gold has not materialised. This, however, is not to say that the dollar fulfils its role adequately or even satisfactorily. Not surprisingly, with the strength of the US economy once again in question, the dollar has begun to slide. Between the low of 1.2932 to the dollar it touched on 21 April 2009 and its value at the end of September 2009 the euro had appreciated by 13 per cent vis-a-vis the dollar. This (and other similar tendencies) has triggered predictions of the demise of the dollar as lead currency. Should and will a new currency replace the dollar as the paper that is treated as good as gold?

There is a noteworthy feature of the debate sparked by the revival of interest in the question of the dollar’s worthiness as a reserve currency. Most participants in the debate who argue that it is time for the dollar to go, are not basing their argument on the greater strength of an alternative currency (like the euro, the yen or the Chinese RMB) which should take the dollar’s place. Rather, the most popular alternative is the IMF’s Special Drawing Right (SDR) which is more a unit of account than a currency and whose value is itself linked to that of a weighted basket of four major currencies. There are three implications here. First, even when the weakness of the US and the dollar is accepted, the case is not that the dollar should be completely displaced, since even in the basket that constitutes the SDR the dollar commands an influential role. Second, there is no other country or currency that is at present seen as being capable of taking the place of the US and its dollar at least in the near future. And third, the search is not for a currency that can be used with confidence as a medium for international exchange, but for a derivative asset that investors can hold without fear of a substantial fall in its value when exchange rates fluctuate, because its value is defined in terms of and is stable relative to a basket of currencies.

It should be clear that in the absence of another currency that can play a similar role in the world economy, rhetoric alone will not end dollar hegemony. The question, therefore, is whether the SDR can serve as an actual currency or focus on the SDR is diverting attention from alternative ‘real’ currencies. It must be noted that early expectations of the displacement of the dollar came with the birth of the euro in January 1, 1999 and the irrevocable fixing of the exchange rates between the then member countries of the European Union. The idea that the euro was an alternative to the dollar came from the evidence that after a brief period of stability and then depreciation of the euro relative to the dollar, from the end of 2000 that currency appreciated from close to $0.8 to the euro to $1.6 to the euro in April 2008. And then, after a further period of depreciation to around $1.25 to the euro in November 2008, the euro has been on average appreciating once again to reach $1.5 in September 2009.

There are two ways in which to view this relative decline in the dollar’s value. The first is to see it as a gradual depreciation of the dollar as part of an effort to correct for the loss of export competitiveness of the US. The second is to see it as a challenge posed to the dollar’s supremacy by the new currency.

The supporting evidence to back the second of these propositions is difficult to come by. Consider for example the euro’s role in international transactions. By September 2006, 30 per cent of outstanding international securities were denominated in euros as compared with around 20 per cent in 1999. But this was not because of any significant decline of the dollar’s role in this area, since its share had fallen from just around one half to 46 per cent. In foreign exchange markets, the euro’s share had remained stable at around 20 per cent of all transactions, compared with the dollar’s 44 per cent. And, finally, the euro accounted for a stable 25 per cent of the holding of foreign exchange reserves by countries that reported the composition of their foreign exchange reserves. All in all, therefore, it appears that the euro was not being displaced by the dollar as the major reserve currency.

This is not surprising given the fact that the euro is not the currency of a single national political formation with the backing of a single powerful state. Though monetary policy in these countries is harmonised through the European Central Bank, which sets interest rates for all, there is considerable fiscal policy independence (despite the Growth and Stability Pact) of countries characterised by very different levels of development. This does not inspire confidence in the ability of the EU as a formation to be able to influence as desired the value of the euro. And no single state in this formation has the military strength or activism to assert power and stabilise the value of the currency when required.

Put simply, while there are some European nations like Germany that are economically strong, though less so than before unification, if we look at the conditions which helped sustain the dollar’s role as the reserve currency, this united formation of still legally independent sovereign states falls short of what seems to be the prerequisites for the euro to displace the dollar as reserve currency.

The SDR as reserve
Besides the euro the other contender to taking on the role of the world’s reserve currency is the SDR or Special Drawing Right created by the IMF. The debate over the SDR as an alternative currency gathered momentum when in the aftermath of the 2008 global crisis the governor of the People’s Bank of China, Zhou Xiaochuan issued a call for replacing the dollar with the SDR as reserve currency. There are, however, many hurdles between this stated desire and the actual transformation of the SDR into the world’s reserve.

Created in 1969, the SDR was initially seen as a supplemental reserve which could help meet shortages of the two then prevailing reserve assets: gold and the dollar. The IMF issues credits of SDRs to its member nations, which can be exchanged for freely usable currencies when required. The value of the SDR was initially set to be equivalent to an amount in weight of gold (0.888671 grams) that was then also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, however, the value of the SDR was reset relative to a weighted basket of currencies, which today consist of the euro, Japanese yen, pound sterling, and U.S. dollar, and quoted in dollars calculated at the existing exchange rates. The liquidity of the SDR is ensured through voluntary trading arrangements under which members and one prescribed holder have volunteered to buy or sell SDRs within limits. Further, when required the Fund can activate its “designation mechanism”, under which members with strong external positions and reserves of freely usable currencies are requested to buy SDRs with those currencies from members facing balance of payments difficulties. This arrangement helps ensure the liquidity and the reserve asset character of the SDR. So long as a country’s holdings of SDRs equal its allocation, they are a costless and barren asset. However, whenever a member’s SDR holdings exceeds its allocation, it earns interest on the excess. On the other hand, if a country holds fewer SDRs than allocated to it, it pays interest on the shortfall. The SDR interest rate is also based on a weighted average of specified interest rates in the money markets of the SDR basket currencies.

The volume of SDRs available in the system is the result of mutually agreed allocations (determined by the need for supplementary reserves) to members in proportion to their quotas. Till recently the volume of SDRs available was small. SDRs have been allocated on four occasions. The first tanche, to the tune of SDR 9.3 billion, was issued in annual installments during 1970-72, immediately after the creation of this asset in 1969. The second, for SDR 12.1 billion, occurred during 1979–81, after the second oil shock. The third, for an amount of SDR 161.2 billion, was issued on August 28, 2009. And the fourth for SDR 21.4 billion took place on September 9, 2009. As a result the total volume of SDRs in circulation has reached SDR 204.1 billion or about $317 billion. As can be noted an overwhelming proportion of the allocation has occurred in the aftermath of the 2008 financial crisis. But even now the quantum of these special reserves is well short of volumes demanded by developing countries.

Does the recent substantial increase in the amount of SDR’s allocated herald its emergence as an alternative to the dollar? There are two roles that the SDR can play, which favour its acceptance as a reserve. First, it can help reduce the exposure of countries to the dollar, the value of which has been declining in recent months because of the huge current account deficit of the US, its legacy of indebtedness and the large volume of dollars it is pumping into the system to finance its post-crisis stimulus package. Second, since its value is determined by a weighted basket of four major currencies, the command over goods and resources that its holder would have would be stable and even advantageous.

There are, however, five immediate and obvious obstacles to the SDR serving as the sole or even principal reserve. First, the $317 billion worth of SDRs currently available are distributed across countries and is a small proportion of the global reserve holdings estimated at $6.7 trillion at the end of 2008 and of the reserve holding of even a single country like China. Since all countries would if possible like to hold a part of their reserves in SDRs, the fraction of this $317 billion that would be available for trade against actual currencies would be small, implying that even with recent increases in allocations the SDR can only be a supplementary reserve. Second, expansion of the volume of SDRs in circulation requires agreement among countries that hold at least 85 per cent of IMF quotas. With the US alone having a 16.77 per cent vote share, as of now it has a veto on any such decision. Whether it will go along with the decision to deprive it of the benefits of being the home of the reserve currency is unclear. And even if it does, there could be others with a combined vote share of 15 per cent-plus who may not be willing to go along.

Third, since SDR issues are linked to quotas at the IMF and those quotas do not any more reflect the economic strength of members, the base distribution of SDRs is not in proportion to the distribution of reserve holdings across countries. Reaching SDRs to those who would like to hold them depends on the willingness of now “weaker” countries to sell. Fourth, since the value of the SDR is linked to the value of four actual currencies, the reason why a country seeking to diversify its reserve should not hold those four currencies (in proportion to their weights in the SDR’s value) rather than the SDR itself is unclear. This would also give countries flexibility in terms of the proportion in which they hold these four currencies (which is an advantage in a world of fluctuating exchange rates, since weights of currencies constituting the SDR are reviewed only with a considerable lag, currently of five years). Finally, as of now SDRs can only be exchanged in transactions between central banks and not in transactions between the government and the private sector and therefore in purely private sector transactions. This depletes its currency-like nature in the real world. It also reduces the likelihood that a significant number of economic transactions would be denominated in SDRs. While this could be corrected, such a correction can throw up a host of additional problems. But this has not prevented suggestions from some like of John Lipsky, the IMF’s First Deputy Managing Director, that the SDR can be used as the foundation to build a new currency that would be “be delinked from other currencies and issued by an international organization with equivalent authority to a central bank in order to become liquid enough to be used as a reserve.”

This presumes we have or can think of a single global state, which as of now is not a possibility. In fact, to the many difficulties associated with treating the SDR as a normal currency must be added the fact that, not being the national currency of any country, the confidence in its ability to serve as a viable reserve currency for the world and in the stability of its cannot be generated by either the economic or the military strength of a state that governs that nation. Put all of these together and while the SDR may be good as a supplementary reserve that aids diversification of the composition of reserves of individual countries, it as yet falls short of the requirements that a true reserve currency must meet.

If despite this the SDR is the focus of attention in the search for an alternative to the dollar, that can only be because there is as yet no national currency that can displace the dollar. While the dollar lacks the legitimacy to serve as the world’s reserve, it dominates because the time for its substitute is yet to come.

October 21, 2009.