By JC Collins
Update: With the recent move by China to move away from the dollar peg and towards an exchange rate composite index, it's worthwhile to re-visit this post from August. In that post I stated the following:
Perhaps they will end the dollar “peg” all together and move towards the composite anchor, using either the SDR or perhaps the Asian Currency Unit (ACU).
That is exactly what China just did when the China Foreign Exchange Trade System announced that the renminbi valuation would now be measured by using a composite index which includes a basket of 13 currencies, the SDR, and a BIS basket of 40 currencies.
This is another check mark for the POM analysis. - JC
Complete post follows:
With so much discussion taking place about the global monetary imbalances and ending of USD exchange rate pegs, let’s spend a few minutes to take a closer look and determine how much of the info being presented is simply dramatic headlines, and how much is factual information.
Here on POM I’ve always attempted to present information in a manner that is non-inflammatory with less-than-dramatic headlines. I’ve gotten better at this over time. It has been my contention that the information itself is extremely telling of the patterns and trends that are unfolding in the international monetary framework. Patterns and trends based on structural changes.
So far the information presented has proven to be fairly accurate.
The accuracy of the information will become more apparent in the coming months as the defined volatility associated with global imbalances becomes more manifest. The imbalances have been causing systemic and structural challenges for decades, but the rest of the global community has been willing to accept those imbalances and challenges because of a lack of other alternatives to the US dollar.
So let’s review the actual status of the USD in the monetary framework and how it is used as an exchange rate anchor.
The pegging, or exchange rate regimes, which are widely discussed throughout online communities and blogs are seldom understood, or explained, in a manner that reflects the actual status of these arrangements. The word “peg” is used widely and often out of context. I’m also guilty of this over-simplification. Understanding the complexity of such arrangements is mostly outside of the scope available to online blogs and quick snap shot analysis prepared for mass consumption.
But let’s take a few minutes to try. It will provide us a reference which we can go back to periodically to better understand the events which are, and will continue, to take place.
First, there is no doubt that the USD is at the center of the majority of exchange rate arrangements, or regimes, as they are often referenced. But that does not mean that the USD is the all-powerful exchange rate anchor which needs to be removed.
There are three major and relevant exchange rate arrangements which are of interest to us. They are:
There are many others, such as combinations of these, and other variables, but let’s stick to these three for a sense of complex-simplification.
Some currencies around the world hold exchange rate arrangements with the USD, as well as other currencies, in all three. But with each arrangement there can be different anchors used, some of which can be USD, or other currencies.
The forms of currency arrangement anchors are:
- Specific domestic currency (such as the USD, euro, and upcoming RMB)
- Composite (such as a basket of currencies, like the SDR, or other currency unit)
- Monetary Aggregate
- Inflation Targeting
- Other (includes monetary policy not committed to any specific target)
In each of the above arrangements the USD can be used as the exchange rate anchor. But not in all, as we will see blow.
To help understand the relationship between exchange rate arrangements and exchange rate anchors, let’s look at two specific currencies which are “pegged” to the USD.
The Canadian dollar would be considered an inflation targeting-floating peg against the USD. The USD goes up and the Canadian dollar goes down. The relationship between inflation and currency appreciation is outside of the scope of this single post, but the concept of the complex relationship is apparent when we consider the multi-faceted economic approach to such an arrangement.
The Chinese renminbi would be considered a monetary aggregate-managed peg against the USD. It could use any anchor, but has chosen to use the USD. The recent movements of the daily reference rate associated with this arrangement is very telling of the direction which China will be taking this managed peg. The forthcoming widening of the trading band was covered in the post China’s Rate Change is Preparation for Widening of the Trading Band.
The widening of the trading band will eventually lead to the Chinese currency using a floating arrangement. They could still use the USD as the anchor through the inflation targeting or continue with the monetary aggregate method.
Perhaps they will end the dollar “peg” all together a move towards the composite anchor, using either the SDR or perhaps the Asian Currency Unit (ACU). Further details can be found in the post When Will China End the Dollar Peg.
With all of this mind, let’s take a closer look the percentage of USD pegs, or anchors, used internationally. Our reference will be the 188 member countries of the IMF. Of those members, the following anchors are used:
- USD – 23.0%
- Euro – 14.1%
- Composite – 6.8%
- Other Currency – 4.2%
- Monetary Aggregate – 13.6%
- Inflation Targeting – 17.8%
- Other – 20.4%
It’s interesting to point out that in 2008 the percentage of countries which used the USD as an anchor was 33%. That is a 10% drop in use of USD as the anchor in exchange rate arrangements since the financial crisis.
In perspective, the recent announcement by any one country of a change to its exchange rate anchor, or changes to the arrangement type, is in and of itself not earth shattering news deserving of dramatic headlines. What is important to watch is the overall trend of both arrangement types and anchors used.
The USD will continue to be used, but the trend is strongly suggesting a declining utilization of the dollar as the anchor of choice for select and strategic currencies. The relationship between all currencies and arrangements is obviously extremely complex. But the need to watch and analysis the movements of such things are important to all macroeconomic and monetary framework matters.
The larger and more important trend for us to watch is the diversification of foreign exchange reserves. This is where the complexity of the above information can be more visibility observed. Though countries may exchange the USD in the foreign exchange reserves for SDR, or alternative composites, such as the ACU, this does not mean that they will not continue using the USD as the anchor currency.
Though it could equally mean that they will not.
The connection between foreign reserve compositions and exchange rate arrangements are obvious, but the interaction on all levels is more complex than most of us would like spending time thinking about. Regardless, the diversification of foreign exchange reserves will have to take place in order for the balance of payments deficits to be adjusted.
In the post Will China Transfer American Debt to the IMF, we explored some of the possibilities surrounding the much needed diversification of foreign exchange reserves. Too much USD has accumulated in these accounts and it needs to be reduced and exchanged for alternatives.
Yesterday’s post titled Meet the Asian Monetary Fund we introduced the framework of the AMF, the regional component East Asian institution which will complement the IMF. The Chinese RMB could be used as the anchor for this institutions, or the ACU you could play the regional role which the SDR will play internationally.
Things are in motion which now cannot be stopped. The transition is happening and the recent volatility has created the required crisis which will make the case for changes to both the foreign exchange reserves and existing USD based exchange rate arrangements. Each piece may not be dramatic, but the whole picture certainly is. - JC
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