Export Increases and Currency Depreciation
By JC Collins
The future composition and weight of the SDR basket could fluctuate with the exchange rates of the domestic currencies which will use it as an anchor. To fully understand how the Special Drawing Right could work as an international monetary unit which is used to balance trade between countries, an understanding of the problems with the balance of payments under the USD regime will be required.
Most readers are now aware of the Triffin Paradox which defines the imbalances which are created when the domestic currency of one country is used as the international monetary unit of account. This is best visualized in the chart below.
The growth of America’s trade deficit is clear to see against the increase in China’s trade surplus. Both countries are on opposite extreme spectrums of the balance of payments and represent the imbalances explained in the Triffin Paradox. When China, as the world’s largest exporter, accumulates ever increasing amounts of USD in its foreign exchange reserves, the United States is forced to expand the dollar supply in order to meet the demand. This creates the large trade deficit for the US and the large trade surplus for China.
All other countries are positioned between these two in varying degrees of deficits and surpluses. The accumulation of dollars by all countries supports the valuation of the USD against the domestic currencies of those countries, which in turn affects the exchange rates of all other currencies. This adds to the systemic imbalances which are inherent in the USD based framework.
The accumulation of USD has also forced the American government into deficit spending programs which attempt to manage the debt against GDP growth. But with the increased and disproportionate valuation of the USD against other currencies, America’s production and exports have progressively decreased with the increase in the trade deficit.
American goods are too expensive for the rest of the world. This will change.
The chart below shows the rise of America’s debt-to-GDP ratio along with the growth in the trade deficit. A depreciation in the US dollar will make American exports cheaper international which will promote manufacturing growth domestically, leading to an increase in exports.
But how do you depreciate the USD when it is used as the international monetary unit of account?
The obvious answer is that an alternative to the USD is used as the international monetary unit of account. Another domestic currency will not function as this unit of account, as it will lead to the same challenges found in the Triffin Paradox.
A supra-sovereign international monetary unit of account is required.
The value, or weight, of the currencies which make up the SDR composition will be determined on a multitude of factors. The important ones will be structured around the amount of currency in use, the level of trade surplus or deficit, the debt-to-GDP ratio, and the amount of exports.
Countries with elevated debt-to-GDP ratios will experience a depreciation of domestic currency as a means of increasing exports. This will boost GDP and rebalance the debt-to-GDP ratio. Countries which have a balanced trade (minimal deficit or surplus) but have a disproportionate debt-to-GDP ratio, such as Japan, as shown in the chart below, will require more in-depth debt restructuring.
The best position for countries will be found in low debt-to-GDP ratios and high trade surpluses, or balanced trade.
Other factors which will contribute to alterations in the SDR composition will be influenced by the level of foreign exchange reserves held by each country. It is indicated that these forex reserves (of which a huge amount is denominated in USD), will be converted, or exchanged, for SDR in the coming years.
This will in essence delegate domestic currency for domestic use only. The SDR will be used to balance trade internationally, but will not be used domestically.
There has been discussions around the idea of including goods and commodities in the SDR weighting. Though gold and oil, among other benchmark commodities, could very well add stability and diversification to the SDR, it is more likely that we could see a de facto “goods” inclusion into the SDR based on the exports of member countries.
The larger the exports of a country will mean a larger weighting in the basket composition.
The combination of goods and currency weighting, defined above, will be based on the exporting of whole goods by country measured against the currency metrics which will adjust the valuation of currencies.
The amount of forex reserves exchanged into SDR (mainly USD), will add an extra dimension of re-valuation and weighting in the SDR. The US, being the debtor nation in such a formula, and China, being the creditor nation in such a formula, will find themselves locked in geopolitical negotiations over the valuation and shifting of such liabilities as the SDR becomes the international monetary unit of account.
The chart below details the largest exporters in the world measured against the size of foreign exchange reserves. It is immediately clear that China tops both categories, giving it leverage over the multilateral transition.
The US, though the second largest exporter already, has extremely low, and disproportionate foreign exchange reserves. This will change when the SDR becomes the international reserve asset and the USD is depreciated, allowing for an increase in exports. The foreign exchange reserves of countries, now denominated in SDR, will be tied to the level of exports.
The chart below gives us another way to view this, as it is based on the countries with the largest foreign exchange reserves measured against exports. Here we see that Japan has the second largest forex reserves after China. This will help them when it comes time to make adjustments to the balance of payments and correct their large debt-to-GDP ratio.
Based on the information which has been simplified above, if the SDR adjustments taking place this year were based on these metrics, the weighting would look something like the pie chart below. The multilateral transition, and subsequent adjustments to currency valuations and SDR weighting, under current conditions, works in the favor of China.
Obviously the United States will need to allow for considerable swings in the dollars valuation and a reduction in USD which has accumulated over the last 7 decades. This does create a level of leverage for the US, but also creates a precarious situation which forces it into negotiations which may not always be approached from their best interests.
The corrections to the balance of payments and the elimination of the inherent problems of the Triffin Paradox, will require the increase and decrease of exports and imports, and the appreciation and depreciation of domestic currencies.
The balance of payments chart below is a sensible guide to use when determining which currencies will depreciate and which will appreciate.
Some balancing will be required for the effective SDR can be implemented as the international monetary unit of account. The SDR composition which comes into effect this January, will only be the first step in balancing the international monetary framework.
The Chinese renminbi will be included in the SDR and its use, and accumulation internationally, will expand over the next 5 years. This will create “organic” corrections to the balance of payments in the lead up to the larger SDR adjustments, and weighting corrections, which will take place in 5 years’ time. – JC
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