Ethos Perspectives

In Reserve

In March this year, in the run-up to the G20 summit in London, Zhou Xiaochuan, the Governor of the People’s Bank of China, surprised the international financial community by calling for the creation of a "super-sovereign reserve currency" as a way of achieving greater stability to the international monetary system. The Special Drawing Rights (SDRs) issued by the International Monetary Fund (IMF) were put forward as a candidate for the new reserve currency. ¹

China’s desire to reduce its dependence on the US dollar as the reserve currency is echoed elsewhere in the world. In June this year, at the Shanghai Cooperation Organisation summit, Russian President Dmitry Medvedev called for the establishment of a "supranational currency" to replace the US dollar in global economic transactions. ² The BRIC nations, at their first formal meeting, stressed the "strong need for a stable, predictable and more diversified international monetary system". ³

The concerns of China and the other BRIC nations over the US dollar are not surprising — the dollar alone accounts for about 65% of the world’s official foreign exchange reserves. (The euro comes in second at 26%.) Three-quarters of all reserves are held by emerging economies. Some 65% of China’s foreign exchange reserves are denominated in US dollars. ⁴

This issue of Ethos Perspectives looks at the recent history of reserve currencies and SDRs.

Reserve Currency Competition
In 2004, Avinash Persaud, a former currency trader and now a professor at Gresham College in London, predicted that the yuan would overtake the dollar as the world’s reserve currency by 2050. ⁵ Persaud echoed the conventional wisdom that there was only space for one dominant reserve currency at a time. Reserve currencies fulfil several roles: as a settlement currency for trade transactions, as a vehicle currency for foreign-exchange transactions, and as a store of value, including official foreign exchange reserves held by central banks and government agencies. The more entrenched a particular currency is as a reserve currency, the stronger the incentives for other government and private sector actors to use this currency in their transactions. Network effects ensure that there would be very few reserve currencies at any point in time. The benefits that accrue to the reserve currency country are not trivial: the current financial crisis has demonstrated the "exorbitant privilege" of the US in being able to borrow and spend well above its income without a catastrophic collapse of confidence or a sizeable fall in the value of the dollar.

The US dollar had not always enjoyed that position. In the eighteenth century, Britain was the pre-eminent trading nation, London the centre of international trade and finance, and sterling the world reserve currency. The US overtook the UK as the world’s largest economy by the end of the nineteenth century, and as the world’s largest exporter 1915. Before World War I, the UK was the largest net creditor in the world; by 1914, the US was. The process of losing reserve-currency status took place over a longer time frame, in part because of network effects (which conferred advantages to the incumbent), and in part because of currency controls such as the formation of the sterling bloc that encompassed Britain and her imperial colonies.

By the end of the World War II, however, the US dollar was unquestionably dominant; and by the 1960s, 60% of central bank reserves were held in dollars, twice the level of sterling reserves. Persaud drew on that story to extrapolate the overtaking of the dollar by the yuan. By the mid-21st century, China and India would have overtaken the US. ⁶

Barry Eichengreen challenged the conventional wisdom with his work on reserve currencies in the interwar period. Eichengreen argued that network effects applied to the use of reserve currencies as settlement and vehicle currencies, but were less clear when applied to reserves held by central banks and governments. At the eve of World War I, about half the world’s official foreign reserves were in sterling, a third in French francs, and a sixth in German marks. Within Europe itself, sterling came in third after the franc and the mark. There was arguably a three-way oligopoly of reserve currencies before the First World War, giving way to a sterling and dollar duopoly in the 1920s and 1930s.

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