What would it take for new int'l reserve currencies to emerge?
CHI - New international reserve currencies may emerge in the future, but for this, a number of developments will be required, says IMF document.
The International Monetary Fund in its recent report titled The Debate on the International Monetary System, released by Strategy, Policy &Review Department stated that in the near term, given the dominance of the US dollar in private transactions and financial markets, few candidates could replace it. The euro, the yen, the renminbi, and possibly other currencies may take on a greater global role in the future, as the following reconditions are increasingly met: (a) deep and liquid financial and foreign exchange markets that remain resilient during crises (b) macroeconomic stability to ensure confidence in a currencys long-term purchasing power (c) wide use in private sector transactions.
According to report, prerequisites for developed financial markets include an open capital account and currency convertibility. A financial market infrastructure is also important for this purpose, as a number of convertible currencies (e.g., Swiss franc, Australian dollar, and Swedish krona) are eligible reserve assets, but is not used globally.
Report further said that the US financial markets are the deepest and liquid, followed by the euro area; the United Kingdom and Japan are less so. These differences were especially evident when, at the height of the recent crisis, liquidity evaporated in all markets except the United States.
Lower depth and liquidity reflects structural issues as well as restrictions. For example, fragmentation and lower credit quality in sovereign offerings is believed to hamper financial market development in the euro area. Similarly, a withholding tax on interest is believed to hinder foreign participation and deepening of government securities markets in Japan. Lacks of convertibility and capital account restrictions have led to relatively underdeveloped financial markets in China, report said.
Policy-making institutions with credibility and a track record of maintaining price stability are a critical ingredient. Whether this would also entail moving to a market determined exchange rate regime remains an open question, report added.
Report mentioned that while current reserve currency issuers (Euro area, Japan, the United Kingdom, and the United States) have had track records of broadly comparable strength, the crisis has raised fiscal sustainability concerns, requiring credible exit strategies to avoid undermining their reserve issuer status. Chinas adoption of conservative fiscal and monetary policies in the context of a pegged exchange rate and capital controls has so far helped maintain a relatively low inflation environment and resilience to external shocks, and key would be to preserve macroeconomic stability over the medium term even as the economy undergoes fundamental structural changes.
As per the findings of the report, a currency with a large share in world GDP, trade, and finance attracts more users as other countries use it for trade, as a monetary anchor, as well as to conduct financial transactions. This attracts network externalities through a self-reinforcing cycle of lower transaction costs and higher liquidity.
Report disclosed that the US dollar was involved in about 90 percent, and the euro in almost 40 percent, of all foreign exchange transactions. Other currencies were less prominent.
Going forward, regional reserve currencies that meet the other conditions and dominate regional trade could provide a substantial domestic store of value and diversification benefits, report predicted.
Report indicated that the emergence of a new international reserve currency might also require overcoming reluctance on the part of reserve issuers. Reserve currency status presents challenges in macroeconomic management for the issuer.
These challenges include the inability of the issuer to actively use exchange rates as a macroeconomic adjustment tool, volatility of short-term capital flows, and the implications for fiscal policy of the need to achieve greater depth in government securities markets.
Report found that a radical redesign of the international monetary system would be to introduce a new currency-outside money-that could be used in international transactions and would float alongside national currencies.3 The currency would be issued by an international monetary institution with a governance structure quite different from todays IMF and geared towards ensuring a stable value. Disconnected from the economic problems of any individual country and with a balance sheet backed by the membership of the institution, this currency could serve as the global risk free asset. Scale economies in its use could deliver efficiency in international transactions, and the exorbitant privilege enjoyed by other major reserve issuers would be transferred to the institutions membership.
Report projected that adjustment would become less asymmetric, as surplus countries that peg their exchange rates to this currency would see their currencies appreciate relative to deficit countries that float, enhancing systemic stability. Such an institution could also serve as a true global lender of last resort that could attenuate deflationary bias and resolve funding issues associated with multilateral bailouts or lines of credit.