The Hindu Business Line : China proposes to dethrone the dollar

The bulk of investments in US Treasury today comes from countries such as China, India and Japan. The US Administration can no longer ignore the Chinese suggestion to lower the almighty dollar from its position of questionable supremacy, says S. VENKITARAMANAN.

As the leaders of several nations, big and small, met recently at the G20 summit in London to discuss ways to tackle the global economic crisis, it was apparent that the Chinese had taken on an active role in suggesting solutions.

It is worth noting that the world has grown accustomed to treating the dollar as a reserve currency. All international prices are quoted in dollars and all currencies are, in effect, judged relative to the dollar.

This is a big change from pre-World War II years when the British pound played an important role together with the dollar as reserve currency. With Britain’s declining economic strength, post-War, the dollar gained supremacy.

The euro and yen tried feebly to take position alongside the dollar, but failed. The fact remains, however, that the US pays a heavy price for the privilege. It also derives the advantage of being a reserve currency.

It becomes a depository for surplus dollars from around the world, which contributes to increasing liquidity. It can issue debt in its own currency and the rest of the world will contribute to it. It can, therefore, finance its deficits in borrowing, almost effortlessly, from various countries without any foreign exchange risk.

China’s vulnerability

China has been quick to realise the dangers of a dominating dollar, especially because that country’s reserves are primarily invested in US Treasury papers.

With the dollar declining in value, the Chinese reserves have also suffered a decline. China has tried to diversify out of the dollar, but without much success. It also tried to invest in non-Treasury papers, such as equities, with disastrous results. Hence its latest effort to find an alternative reserve currency to the dollar.

A bulk of China’s reserves, estimated at over $700 billion, is held in dollar-denominated assets, namely, Treasury securities.

The Chinese head of State recently expressed concern over the prospect of these assets losing value as a result of the US’ increasing deficits.

Most recently, on March 23, 2009, China’s Central Bank Governor, Mr Zhou Xiaochuan, in an essay dealing with the international reserve currency situation, reaffirmed China’s increasingly assertive approach towards reshaping the global economy.

As the Wall Street Journal points out, Chinese officials have been increasingly frustrated at the financial dependence on the US currency.

With the Chinese proposal for replacement of the dollar by Special Drawing Rights (SDR) created by the IMF, the tables have been deftly turned on the US, which had earlier criticised China for its currency policy. This time, it is China which is on the offensive.

Call for SDRs

The Chinese proposal envisages assigning SDR to various countries in return for contributions in their respective currencies. This is China’s answer to the IMF’s proposal seeking increased contribution to its corpus.

China would prefer to have a greater role in the Fund’s management and policymaking in return for its contribution.

The Chinese proposal has likely shaken the US Administration’s easygoing approach to financing its deficits, wherein it “sells” its bonds to investors, and the bulk of investments in US Treasury today come from countries like China, India and Japan. There is no way the US Administration can ignore the Chinese suggestion to lower the almighty dollar from its current position of questionable supremacy.

China’s Central Bank chief recognises that these proposals are not a final solution.

A transition to the use of SDR as an international currency will take long.

Observers recall the psychological and political hurdles that cropped up when the euro was introduced as a common currency; the proposed use of SDR is seen to be a much more complicated affair.

Defying the dollar?

There have been attempts before to create an international reserve currency that can replace and/or supplement the dollar.

The earliest such attempt is perhaps Lord Keynes’ proposal to the IMF to create a Bancor which was resisted by the then US Treasury Secretary.

Incidentally, the sensitivity of world markets to rumours about the dollar became apparent when the US Treasury Secretary told that the Chinese that he is open to exploring the idea.

The dollar fell nearly 5 per cent, demonstrating how even a casual statement can have serious repercussions for the dollar. The US Treasury Secretary quickly clarified that the dollar would remain the international reserve currency for a long time to come.

From a position where the US lectured poorer countries on managing exchange rates, the wheel has now come full circle.

Obviously, the Chinese proposal to replace the all-powerful dollar is part of a bargaining stance aimed at wresting a share in international institutions, particularly IMF. China is no longer prepared to be at the receiving end of hectoring by richer countries like the US.

It demands and, no doubt, will get a place at the governing table of the leading nations of the world! Where does India stand on this issue?

blfeedback@thehindu.co.in

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