China and the Use of Special Drawing Rights

World stock markets continued their recovery this week, although in a somewhat subdued manner. Glimmers of an economic recovery along with better-than-expected (for the most part) earnings reports were the key factors driving prices higher. The S&P 500 Index gained over 9 percent in April, its strongest performance in over a year, and is now 29 percent above its March 9 low (but still well below the level it stood at last September just prior to the Lehman collapse).

In the foreign exchange markets, the US Dollar lost ground to most major currencies, except against the Japanese Yen, which lost 2 percent to the Dollar. Trading in all the currencies has seen a lack of volatility over the past month, with most currencies trading within one percent of their March 31 closes. Only the British Pound, which gained about 4 percent against the greenback in the past month, and the Canadian dollar, which is up about 6 percent, have evoked any interest.

The major factor driving currency trading during March and April has been "appetite for risk" (the favorite phrase of currency traders nowadays), with traditional economic fundamentals taking a back seat. Any time there are signs of improving economic conditions, traders demonstrate an "appetite for risk" and buy Euro, Swiss Francs and British Pounds. Whenever the global economy appears to be backsliding, traders move into safe-haven currencies: the US Dollar and the Japanese Yen. As a result, no definitive trading patterns have developed and the major currencies have generally moved sideways. This will probably continue over the near term.

On a longer-term basis, one of the issues that may turn out to affect trading is the role of the US Dollar as the world’s leading reserve currency and the prospects for its continuance in that role. In March, People’s Bank of China Governor Zhou Xiaochuan shook up the markets when he called for a new "super-sovereign currency", possibly the IMF’s Special Drawing Rights, to replace the world’s reliance on the Dollar,. Zhou’s goal is to create a currency "that is disconnected from individual nations and is able to remain stable in the long run". His remarks raised concern because of China’s massive foreign-exchange reserve position, most of which is in Dollar-denominated assets. A major shift, by China, out of those assets and into another currency (or currencies) could send the Dollar tumbling.

Initial reaction to Zhou’s remarks held that such a shift by China was unlikely because of China’s dependence on the US to buy up China’s exports, and because a shift, if it did occur, would depreciate the value of China’s Dollar holdings. US Treasury Secretary Tim Geithner appeared to dismiss concerns when he declared that he believed the Dollar should remain as the dominant reserve currency and that any shift, were it to occur, should be "evolutionary" (however, he did manage to send the Dollar plunging when, in his usual talk-first think-second manner, he first said he thought such a shift could be considered).

Since Zhou first issued his call for a new reserve currency, the market seems to have shrugged off any near-term possibility of a change and slipped back into a business-as-usual mode.

In this article, we will examine what we believe are the realistic possibilities of using a new reserve currency (in this case, Special Drawing Rights).



Background

At the end of March, China’s foreign-exchange reserves totaled either $1.95 trillion or $2.3 trillion, depending on whether you take China’s official numbers, or whether you include so-called "hidden reserves", the assets of China Investment Corporation (CIC), China’s sovereign wealth fund, as well as "other foreign assets" held by the People’s Bank of China. About three-quarters of these foreign-exchange reserves are in Dollars - about $1.5 trillion worth.
China has generally built up its reserves through massive exports to the West and by its efforts to hold down the value of the renminbi: as firms and other institutions try to buy the Chinese currency (in expectations of a currency appreciation), the Chinese central bank sells all the renminbi they want in exchange for foreign currencies, mostly Dollars.

These Dollars, acquired by the PBOC, have to be invested in Dollar-denominated assets and the PBOC has usually bought US Treasury securities (although CIC, in the past year, has been buying up US stocks and other more risky assets - and taken a bath in the process).

There are some signs that China’s appetite for American assets may be shrinking. In the first quarter, China’s official reserves only increased by $8 billion (and actually fell in January and February), compared to an increase of $154 billion in the first quarter a year ago. (Again, the actual increase may have been somewhat greater, depending on which amounts are included as reserves). In addition, China’s purchases of US Treasuries lately have mainly been concentrated in short-term Treasury bills.

China is worried about a possible decline in the Dollar and the effect that would have on the value of Chinese holdings, especially as the US attempts to spend its way out of the current economic crisis. But China has conflicting objectives regarding its reserves, which make a simple switch out of Dollar assets difficult. First, China would like to reduce its Dollar exposure but a massive move out of Dollars would cause the Dollar to plummet. And, second, China wants to continue to hold down the renminbi (or at least continue to manage its rise), which means accumulating even more Dollars.

The United States obviously doesn’t want China to either move its current reserves out of Dollars or to stop buying US Treasuries because the US needs China to finance its growing debt burden, and will especially need China when the economy turns, inflation becomes a renewed concern, and the Federal Reserve needs to dump all the securities it bought during its quantitative-easing period.

There is another reason to be concerned about China’s continued ability to buy US Treasuries. Many analysts and policymakers assume that when the global economy recovers it will be a return to the status quo, with the US and other developed nations resuming their roles as deficit nations with domestic demand again supporting the exports of the surplus nations.

Some economists have argued, however, that global rebalancing is needed - deficit nations need to increase their savings rates and reduce domestic demand accordingly, while surplus nations should take steps to develop domestic markets and reduce dependence on exports. We are starting to see this in the US as consumers de-leverage and reduce household debt.

According to economists at Goldman, Sachs, China has already announced three policy initiatives in an effort to rebalance its own economy. First, in November, China unveiled a massive stimulus package that would concentrate on infrastructure. Second, the Chinese plan to develop a full medical insurance policy for its rural community, which could spell an end to the country’s high savings rate. Third, they have begun to reverse the tightening of the credit conditions that existed before the crisis. Interest rates in the past few months have come down more than 500 basis points. The initiatives are setting the stage for what could be an acceleration of domestic demand. Goldman projects that China’s GDP will grow by 8.3 percent in 2009 and 10.9 percent in 2010, compared to previous forecasts of 6 and 9 percent, respectively. In short, China may not need to buy Dollar-denominated assets.



Special Drawing Rights

The Special Drawing Right (SDR) is a synthetic currency that was created in 1969 because of concerns that there was insufficient liquidity to support global economic activity at the time. It is not a currency per se, but rather a unit of account that is primarily used by the IMF to settle transactions between the IMF and its members. The value of the SDR is determined as a weighted average of the Dollar, Euro, Japanese Yen and British Pound. SDRs are allocated to IMF members based on their contributions to the fund.
The total amount of SDRs currently outstanding is equivalent to $32 billion, equal to only two percent of China’s foreign-exchange reserves. By comparison, there are $11 trillion worth of US Treasury securities in existence.

The recent G20 conference, held April 2, gave new importance to the IMF, tripling its resources from $250 billion to $750 billion, including a promise to create $250 billion in new SDRs.



Diversification into SDRs

Noble-prize-winning economist Paul Krugman has interpreted Zhou’s speech as an admission that China had driven itself into a Dollar trap. Because China is an export-led economy, when trade declines, as it has done in spectacular fashion, China has really been importing unemployment. By undervaluing the renminbi, China has been forced into accumulating foreign-exchange reserves. Krugman believes that China cannot diversify from the Dollar, because any attempt to diversify, or sell Dollars, would result in a Dollar collapse.

Fred Bergsten of the Petersen Institute of International Economics, and a former Carter advisor, on the other hand, thinks that swapping Dollar balances at the IMF would be of mutual benefit to the US and to any owners of substantial Dollar reserves. Dollar holders would achieve instant diversification because SDRs are based on a basket of currencies (Dollars, Euros, Yen and Pounds) while the US would avoid the risk of unwanted Dollars being dumped on the market. It may be worth considering.

At any rate, the US should certainly be considering contingency plans for the day when countries like China and Japan finally decide they don’t want all those Dollar assets.