Efficient trade requires some monetary exchange whether that trade occurs across the street or across the globe. When no currency system is available, people resort to barter in physical commodities to establish a rate of exchange. Serving the role as an exchange currency in open markets is earned in the marketplace, not by anointing by politicians. The rise and fall of the value of the U.S. dollar in this decade and potential for it to decline more due to monetary and fiscal policies of the U.S. have created an opening to question the role of the U.S. dollar. As the largest holder of dollars as financial reserves, China has a particular interest.
The four countries issued a 16-point statement urging reform of international financial institutions to reflect changes in the world economy. Without mentioning the IMF or the World Bank, the group sought greater representation in international institutions with leaders chosen based on merit. The four leaders said, “We also believe there is a strong need for a stable, predictable and more diversified international monetary system.” Russia and Brazil had previously announced plans to buy $20 billion of IMF bonds and China has said it may buy $50 billion of bonds.
Any modern reserve currency needs to be freely traded in open markets. The Brazilian real is the only one of the BRIC four that does currently. A country’s monetary policy needs to operate in the open so that market participants have a rough idea of what may happen in the months ahead. The central bank has to build a reputation of not pursuing national interests at the expense of countries holding the currency in reserve. Most important of all, the currency needs to be part of an economy that is open to trade in imports and exports of goods, services and financials so the currency’s value truly reflects market forces.
While China has been a leading critic of the U.S. dollar as the reserve currency, it continues to take criticism in the U.S. for not allowing the Yuan to trade freely. In the summer of 2005 the Chinese Central bank allowed the Yuan to begin to slowly appreciate in a managed process by 21 percent compared to the U.S. dollar. As the worldwide economic crisis unfolded over the past year, the Chinese Central Bank more actively managed the exchange rate.
In mid-May the Currency Reform for Fair Trade Act was introduced in the U.S. House and Senate; it now has 59 sponsors in the House (218 votes are need for passage) and seven in the Senate. No further action is expected unless political or trade tensions create an opportunity to attract wider support. A currency, not just the Chinese Yuan, could be defined as “misaligned” if it is undervalued on average by 5 percent or more for 18 months, the government intervened in foreign exchange markets, the country ran a trade surplus against the world and the U.S., and the country held more reserves than necessary to pay its external debts coming due in the next twelve months. The undervaluation would be actionable as an export subsidy and offset by antidumping duties when injury is determined.
This legislation is partly the result of the Obama Administration’s decision earlier this year to not find that China manipulates its currency exchange rate to prevent effective balance of payments adjustment or to gain unfair competitive advantage in trade. This is viewed as being counter to what President Obama campaigned on last fall and what Treasury Secretary Geithner implied in his confirmation hearings. The Bush Administration had the same policy on China’s currency.
Currency valuations will continue to be major issues. Having two or three major reserve currencies would be better for the U.S. and the rest of the world than just the U.S. dollar, but that is not likely to happen in the near future. The EU euro and Japanese yen have been possibilities, but recent economic difficulties are not likely to make them alternatives to the U.S. dollar. Some analysts have promoted creating a reserve currencies based on IMF special drawing rights, but reserve currencies are chosen by market forces.
The U.S. should not take lightly the concerns raised by the BRIC countries. German Chancellor Angela Merkel recently raised similar concerns about the monetary policies of the central banks of the U.S. and England. The U.S. economy and the rest of the world are in for several years of uncertainty as financial and real assets are redeployed to match future growth opportunities. An unpredictable reserve currency would add to the challenges. Some analysts already see the recent increases in petroleum and gold prices as expectations by market participants that the U.S. dollar will move sharply lower over the next few years. The dollar measured against currencies of six major trading partners has dropped 9 percent since its mid-March three-year high. It could have dropped more except for dollar buying by other countries, including the BRIC countries.
The Obama Administration has not been tested on monetary policy because the dollar became a safe haven currency in the economic downturn. As economies start to improve in the months ahead and the Federal Reserve begins to pull back on the excess liquidity pumped into the financial system, the Obama Administration will need to pursue policies that provide the Fed flexibility to fulfill the U.S. dollars role as the default reserve and exchange currency. To do otherwise would put international trade at greater risk. Participants in international trade need to have an ongoing interest in potential exchange and reserve currencies. Market forces can sort out relative values of currencies if economies are open to trade and monetary policies are transparent.