The Short, Wondrous Life of the International Reserve Currency

We posted a couple times last week on the kerfuffle surrounding remarks by China's central bank governor, Zhou Xiaochuan, that advocated "creat[ing] an international reserve currency that is disconnected from individual nations." To many, this sounded like an attempt to displace the dollar from the top of the currency heap, and a sign of China's growing ambitions.

Brad Setser, a macroeconomist at the Council on Foreign Relations, who I quoted in my earlier post, took the weekend to read Zhou's comments more closely and came up with a different interpretation: "In some ways Zhou's call is a sign of weakness as much as a sign of strength," he wrote on his blog yesterday.

Zhou stopped short of calling for a new global currency like a Bancor. What he actually advocated is a larger role for some arcane device called "special drawing rights." SDRs were created by the International Monetary Fund in 1969 because the Fund didn't want its loans to be denominated in a single national currency. After all, if I'm Thailand circa 1997, and I have to take an emergency loan from the IMF, I don't necessarily want to pay it back all in dollars. What if the dollar-baht exchange rate fluctuates too much? The value of my debt would be constantly changing. SDRs, instead, are based on a basket of four currencies -- the dollar, the pound, the yen, and the euro. If the value of one of those currencies changes dramatically it will impact the value of a loan made out in SDRs, but much less so than if the loan were just made out in dollars.

But as the IMF itself likes to point out, "the SDR is neither a currency, nor a claim on the IMF." You can't pay for a shipment of oil with SDRs, and there's no such thing as an SDR coin or an SDR bill with a picture of Kofi Annan on it. Rather, holding an SDR gives you the right to a certain amount of dollars, yen, pounds, and euros. So even if everything in the world were denominated in SDRs -- and if it were possible to assign negative probabilities to an event, I would assign one here -- there would still be plenty of need for dollar reserves. Last week's talk of a "supranational reserve currency" misunderstood the immediate and practical implications of Zhou's white paper.

So where does Chinese weakness come in? As I noted last week, China holds about $1 trillion in Treasury bills, which represents about 25 percent of Chinese GDP. If the dollar declines, so too does the value of that hoard. As Arvind Subramanian of the Peterson Institue puts it, the "threat of dollar decline has suddenly become more immediate because of the dramatically increased vulnerability of the US government's balance sheet." China would love to be able to hand over some of those Treasury bills to the IMF in exchange for SDRs, which aren't as exposed to the dollar.

Perhaps it's useful to paraphrase an old saying here: "If you owe China a billion dollars, China owns you. If you owe China a trillion dollars, you own China."