By JC Collins
As the Special Drawing Right (SDR) rises to its position as primary reserve asset used in global trade, other countries outside of the current 4 which make up the composition, will seek to have their own domestic currencies added to the supra-sovereign asset basket. China’s yuan is the obvious inclusion on this 2015 go around, but India, and other emerging economies, will likely be internationalizing their own currencies over the next 5 years to ensure they are included in the 2020 adjustments which will be made to the SDR basket composition.
As the USD is replaced with the SDR, we are likely to see the progressive implementation of a Multilateral Effective Exchange Rate Structure (MEERS) as both high income countries and low income countries will promote the benefits of pegging their domestic currencies to the SDR.
These benefits will include a reduction of exchange rate volatility for countries who join the MEERS framework. This membership will grow and become more important as trade between higher and lower income countries continues to expand.
Other benefits include the enhancement and stability of global liquidity and a more equitable representation of the emerging economies within the International Monetary System (IMS).
As beneficial as the MEERS framework will be, it will not correct the deficiencies within the existing balance of payments system, which defines countries as having either trade surpluses or trade deficits.
David Hume (1711-1776) was an economist who made a logical argument against the existing (18th Century) model of Mercantilism. Under Mercantilism it was assumed that a country could maintain a positive balance of trade surplus, or net export. This model would always be inherently flawed because of the balance of payments surpluses and deficits, the same type of systemic deficiencies explained in the Triffin Paradox, as one domestic currency is assigned as the reserve asset used to balance global trade.
The original Hume Adjustment Mechanism was based on gold standard models and is best explained as follows:
- A positive balance of trade (surplus) would cause inflation (higher prices) leading to a decrease in exports, which in turn would cause imports to increase, eventually leading to a neutral trade balance.
- A negative balance of trade (deficit) would cause deflation (lower prices) leading to an increase in exports, which in turn would cause imports to decrease, eventually leading to a neutral trade balance.
Adjustments between both scenarios would continue until the balance of trade between all countries involved equals zero, eliminating the balance of payments deficiencies. Here is another way of looking at the mechanism.
In the MEERS framework referenced above, we can replace the function of gold in the original Hume Adjustment Mechanism with the SDR. But first let’s review some of the fundamentals surrounding how a Hume-Type Multilateral Adjustment Mechanism would be structured around the framework of the SDR and the International Monetary Fund data reporting and surveillance capabilities.
The IMF could allow countries to trade SDR to other central banks for their own currencies which have accumulated in the foreign reserve accounts of said central banks. A reversal of this transaction could also be completed as the central bank holding the foreign currency could also trade it back to the issuing central bank for SDR.
As such, any country with a balance of payments deficit could have its central bank buyback previously issued money with new allocations of SDR. (Note: The possibility of governments once again regaining control of their central banks would support the methodology described here. But these central banks, though now hypothetically under the control of governments, would still operate within the framework of the more macro globalization of central banks which is taking place. See post The Globalization of Central Banks.) This transaction of domestic reserve currency, such as the USD, to supra-sovereign SDR asset, will serve to reduce the monetary base of the country from which the currency was issued, in this case the United States.
The replacement of domestic fiat currency with international SDR reserve assets within a balance of payments framework (foreign reserve accounts) does not support the conclusions made by some analysts that the increase in the fiat monetary base can only be corrected, or accounted for, by an equal increase in the valuation of gold.
Instability during the multilateral transition process could support moderate increases in the valuation of gold, at least initially, but as the mechanism described above is implemented and gradually expanded, the valuations of gold are likely to experience decreases in the multiples of hundreds.
This same logic can also be applied to the conclusions that the USD will in fact not collapse as a domestic reserve currency. A reduction in the monetary base of the USD, and all other currencies, will eliminate many of the systemic imbalances which exist today.
Under the existing monetary framework, a central bank which issues a reserve currency, such as the USD, is not obligated to redeem that currency. Under a Hume-Type Multilateral Adjustment Mechanism, explained above, the transaction from domestic currency to SDR will be mandated to ensure a neutral trade balance is maintained.
There are two methods which SDR can be generated by a countries central bank. One is through new allocations of SDR, and the other is through the use of substitution accounts.
The large scale substitution of currency reserves for SDR would have some fundamental advantages, such as preventing sudden and sizable portfolio shifts between reserve currencies, reducing fiscal costs and limiting systemic instability, which has previously led to disagreements and a breakdown on substitution account negotiations.
A Multilateral Adjustment Mechanism would be more effective under a framework where SDR is traded directly for reserve currency amounts issued by a countries central bank. In this scenario, the SDR would have to be created through new allocations. This allocation of SDR would be facilitated by each country’s central bank, a sort of multilateral QE program meant to expand global liquidity and balance the trade system.
Considering the numerous variables and unknowns involved in the transition from a unipolar USD system to a multilateral SDR system, we are likely to see the utilization of both substitution accounts and new allocations, all of which will be based on the MEERS methodology described above.
The International Monetary Fund would be required to expand its surveillance capabilities, which include broader data reporting from member countries, and the reforming of its governance structure, as outlined in the 2010 Quota and Governance Reforms. These reforms will be implemented either as originally outlined, or through Plan B implementation, which is visible in the expansion of alternative international financial institutions, such as the Asian Infrastructure Investment Bank, AIIB. (See post IMF and G20 Moving Forward on Plan B)
At the same time as countries around the world are joining the AIIB, the multilateral transition is visible in the process by which the Chinese currency will be added to the SDR basket composition, effective January 1, 2016. The integration of eastern and western financial architecture will support the processes described here, and the intricacies of the transition itself are interwoven within the macroprudential policies and machinations of the international financial institutions, such as development banks, and central banks. – JC