July 8, 2009 / 5:26 AM / 9 years ago

Q+A - Replacing the dollar as reserve currency

NEW YORK, July 8 (Reuters) - The U.S. dollar is in the line of fire as leaders from the largest developed and developing countries gather in Italy for talks, as China pushes for debate on an eventual shift to a new global reserve currency.

Sources have said the dollar’s role probably will not be included in the final communique of a G8 meeting. Even if it does rate a mention, the language used would likely be extremely general to avoid destabilizing financial markets.

Still, the symbolic importance would be immense, as it would underscore the determination of emerging economies, who will also be present in Italy for the talks, to win greater say in the global financial system and, over time, to reduce their dependence on the U.S. currency.

WHY REPLACE THE DOLLAR AS GLOBAL RESERVE CURRENCY?

China and other emerging market heavyweights such as Russia and Brazil, are among the biggest holders of dollar assets, mostly in the form of U.S. Treasury debt. Indeed, China has the biggest stock pile of foreign reserves in the world.

Yet for most of this decade, the United States has struggled to maintain the dollar’s value. Against major currencies, the dollar has lost 33 percent in value since 2002 .DXY.

And with the financial crisis prompting the United States to commit trillions of dollars to rescue the economy, these countries fear inflation will further debase the dollar. China, which is thought to hold some 70 percent of its massive $1.9 trillion FX reserves in dollars, is especially vulnerable.

Critics also say the benefits the United States enjoys as printer of the premier reserve currency promotes imbalances in the world financial system, leaving Washington to run deficits as it supplies the world with a steady supply of dollars.

The accumulation of excessively large dollar reserves can then lead to asset bubbles. Some economists contend China’s recycling of reserves into U.S. Treasury debt kept U.S. interest rates low and contributed to the housing bubble behind the global downturn.

WHAT ARE THE OTHER CURRENCIES TO WATCH?

A. Euro status grows

The euro is the world’s most actively traded currency after the dollar and so is highly liquid, making it easy to buy and sell euro-denominated bonds without disrupting the market.

As a result, the share of global foreign exchange reserves held in the euro has grown since its 1999 inception and stands at 25.9 percent from 18.1 percent. Russia’s central bank has adjusted its holdings to the point where it holds roughly equal amounts of euros and dollars, though that is partly because of Russia’s strong trade links with the 16-country euro zone.

But the European Central Bank has refrained from promoting the euro as a reserve currency, as doing so would stoke demand from central banks and push up its value against the dollar. A strong currency could hamper euro-zone growth.

B. The Mighty Yuan

China’s yuan, also known as the remnimbi, is the currency of the most populous country on earth and many believe China will in coming decades be the world’s most powerful economy.

China has already inked deals with trading partners to use the yuan as an invoicing currency, and demand from central banks to hold it as a store of value will increase as China secures its place on the top rungs of world economic power.

But there are major financial and political obstacles that will ensure this process will take years, and perhaps decades.

China would have to loosen controls over its economy and financial system to allow the currency to flow more freely and the likes of central banks and foreigners to invest freely.

Indeed, top Chinese officials seem to recognize a shift away from the dollar would take a long time. For more on what it would take for the yuan to be considered a viable reserve currency, see [ID:nL677953] and [ID:nPEK225167]

C. In commodities we trust

Demand for oil, metals and other commodities could prompt central banks to diversify some reserves into currencies from commodity exporters such as Australia, Canada and New Zealand.

A big problem is that the market for these currencies is tiny relative to the $6.5 trillion in global reserves. Even minor price moves would spark huge exchange rate volatility.

D. Super-sovereign SDR

China and Russia have suggested the International Monetary Fund’s Special Drawing Right, essentially a basket of currencies, could become a global reserve currency unit.

Greater SDR use would involve promoting it for use in trade settlement and as a monetary unit in which private international transactions — loans, bonds, deposits — are denominated.

The IMF will review the SDR’s composition in 2010, and emerging countries will likely follow China in pushing for their own currencies to be included.

Some have said it would be easier for central banks to simply shuffle reserves to reflect the SDR’s composition.

The IMF’s quarterly Currency Composition of Foreign Exchange Reserves data showed the dollar’s share of central bank reserves rose in the first quarter to 64.9 percent from 64 percent.

That was its highest share in nearly two years but was partly tied to temporary safe-haven demand for dollars during the midst of a financial crisis. It was still below the dollar’s 73 percent share in early 2001. [ID:nN30446414]

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