By JC Collins
Some of the challenges which are presented with using the SDR as the international reserve asset can be minimized, and perhaps even eliminated, but staggering the structure of the multilateral financial architecture.
One of the main challenges with using the SDR is how to capture and account for, both economically and socially, the wide diversity of culture and politics which span the globe. Lumping everything and anything into one-size-fits-all composite will inevitably lead to bureaucratic bottlenecks and tense geopolitical situations which are not easily solved.
The ability of the International Monetary Fund to function as a central bank of the world with the responsibility of setting SDR reserve requirements and exchange rate arrangements is fraught with national and regional challenges for participating members.
So how does the monetary world deal with these challenges?
The implementation of the multilateral monetary framework will happen piecemeal and through staggered responses to financial crisis. Some solutions will be sovereign based. Some solutions will be regional based. And some solutions will be international and multilateral based.
There will be a multilateral component to regional solutions and mandates as well, but they will be micro machinations of the larger macro methodologies which will be established through numerous macroprudential agreements and regulations.
As an example, in the post Meet the Asian Monetary Fund, we explored the transition of the Chiang Mai Initiative Multilateralization (CMIM) into a functioning Asian Monetary Fund which would serve as a micro-region based institution which would support the marco-international mandates and framework established by the IMF.
The AMF would be more apt and able to both respond and prevent any regional East Asian financial crisis than the IMF would be. The establishment of such regional monetary funds, whether in East Asian, North America, Africa, or Eurasia, will serve to bring a deeper and broader stability to the international monetary framework.
Let’s consider that each region and monetary fund has its own currency unit which acts as a micro basket of currencies, serving the same function as the macro SDR basket of currencies. These currency units can act as the first line of defense and response to potential monetary challenges.
The euro currency itself was first established as a currency unit, called the European Currency Unit (ECU), which was a basket of weighted regional currencies. Eventually the weights and valuations were locked and the actual euro currency was born from the framework of the ECU.
Equally so, the AMF will see the implementation of the Asian Currency Unit (ACU) which will be based on the same framework of the Asian Monetary Fund itself, which we reviewed in the above post.
The ACU will also likely facilitate the monetary requirements of the AEC trade agreement which is coming into effect on January 1, 2016 in East Asia.
The incremental inclusion of the Chinese currency into the SDR composition over the next 12 months will give legitimacy and value to the ACU, as the RMB will be a functioning composite of both baskets.
As the ACU becomes more established, along with regional currency units in other parts of the world, such as Eurasia, future SDR compositions could be made up of regional currency units as opposed to domestic currencies, such as the USD, euro, and renminbi.
The transition and evolution of all currency baskets, whether macro SDR or micro ACU, will also take place piecemeal. Potentially both domestic currency and regional currency units could exist in the SDR simultaneously.
Like with the euro, each currency unit will eventually become an actual currency, which will, in turn, see the SDR itself become an actual currency in the future. As previously stated, this future macro-international currency will be called the bancor, as it was during the Bretton Woods negotiations of 1944.
The things to watch for, and trends to analyze in the coming months and years are the establishment and implementation of both regional monetary funds and currency units. The buildup of such frameworks will ultimately lead to the rise of a true world central bank.
The SDR, though able to handle short-term solutions to sovereign debt crisis and financial turmoil based on balance of payments deficits, will no doubt require further adjustments and evolution in order to facilitate and respond to the challenges a multilateral monetary framework.
Watch for the early signs of SDR recommendations as the solution to the building financial volatility which is spreading through all segments of the international monetary system, including exchange rates, foreign exchange reserves, and liquidity.
Just like it took years for the world to transition from the British pound reserve system to the USD reserve system, it will take years for this transition to the supra-sovereign SDR reserve system to complete. We are only in the early stages of this transition. Much more to come. – JC