Could there be Purchasing Power Parity between the Major Reserve Currencies?

Economics, Premium POM

By JC Collins

The point of diversifying the large accumulation of US dollars in the foreign exchange reserve accounts of central banks around the world is to reduce the risk associated with the dollar itself.   With so many countries holding large amounts of these dollars, the risk of all nations holding such large volumes of one nation’s currency is problematic.

When the geopolitical world was dominated by the United States and its partners in Europe, the case for using one sole asset as the international reserve currency was easy to make.  Though there were many economists who spoke out against the systemic imbalances which would develop from such a unipolar framework, the political support was not there to make the necessary changes.

There are many reasons for this.  The most obvious of which is the reluctance of American monetary and military strategists to relinquish control of such an influential tool.  The other reason is that there simply was not another reliable asset which could carry the burden with the dollar.

The yen, though a major reserve currency, has proven to be volatile and massive deflation has stricken Japan for many decades now.

But with the creation of the euro the opportunity to begin diversifying dollar denominated reserves became a real possibility.

Being that the euro would in essence only switch places with the British pound, there needed to be a third viable currency which could complete the triangle of stability with the euro and the dollar.

Economic activity in Asia has increased dramatically in the last few decades.  There are numerous reasons for that, some of which has to do with the China carrying large amounts of US debt and having to increase its own credit markets in order to absorb that capital inflow.

The growth in China has overshadowed Japan and the need for the yen to rise in stature as an equal to the dollar.  Though this may still happen as a component of a larger western strategy in the region, it is the Chinese renminbi which has shifted upward and is quickly becoming internationalized.

The rise of the renminbi is one of the great monetary stories of our time.  It’s inclusion into the SDR composition this year is a major victory for the monetary authorities in Beijing.  It will facilitate the much needed diversification of USD denominated reserves around the world, with the largest adjustments taking place in Asia.

Pending the more complex adjustments to the international monetary framework, including a broader use of the SDR, a multicurrency reserve system will serve as the most viable path forward in the interim.  China, and the Asian region as a whole, will not risk maintaining the typical dollar standard and reserve levels without major changes to how the monetary system functions taking place.

This supports the implementation of a multicurrency reserve system on a temporary basis. Such a system will enhance stability as the monetary health of the international economy will not be based on the health of one nation’s currency or domestic financial system.

One of the problematic areas of concern in such a multicurrency framework is exchange rate fluctuations. These fluctuations could become more frequent and enhanced as official reserves are diversified further.  The direct effect which these fluctuations would have on capital flows could be extremely harmful to the stability of the international monetary system.

One of the possible solutions which could address this potential problem is to move all the major reserve currencies to an exchange rate regime structured around purchasing power parity.  PPP would level the playing field and not give one nation and its domestic currency advantage over another by keeping the value of its currency lower than that of the other nations.

China has long been labeled as a currency manipulator from politicians in the west.  Perhaps it is not understood that by maintaining a lower value for the renminbi China has allowed the west to run large fiscal deficits.

The main issue with a PPP exchange rate regime would be the effect it has on the massive capital flows which define the international monetary system today.  Without currency value differentials between nations there would be a reduced need for capital mobility, outside of regular trade channels at least.  This would make a PPP regime much less desirable than a pegging framework which takes into account other metrics, such as trade volume and GDP.

Though in this crazy world, we can never be certain.  An agreed upon PPP exchange rate regime between the major reserves currencies could very well be a strategy rolled out by the G20 in order to prevent trade and currency wars from escalating into the real wars between now and the time broader reforms can be made to the international monetary framework.  – JC