The last few years of dominance of the USA as a world power and every countries dependance are round the corner.. or atleast it seems so with China's bold statement some weeks back. China wants the US$ to be replaced as the reserve currency with some other currency. Well, this is an odd situation which needs deep research and ratifications in the world financial policies as this will surely cause a huge shakedown of the already dim economic situation.
Before i move on.. for starters i'll explain the concept of reserve currency. A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc. This permits the issuing country(Presently USA to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. (As we do when we convert INR to USD or vice versa) It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others. The current leader in reserve currency is the USD comprising of 64% of all official foreign exchange reserves. Euro a distant second with just 26%(Mainly because of the origin of the EU. Before the Euro came USD was nearly 75%). And some negligible percent of the Pound and the Japanese Yen.
We shall look at the reasons for China's demand and its effects. China's central bank governer, Zhou Xiaochuan, had shot a letter to the IMF (International Monetary Fund) stating that it create a new reserve currency disconnected from individual nations so that it will remain stable over a long run and be free of the uncertainities caused by using credit based national currencies. The current economic crisis has led to this kind of a drastic statement. His words were "The outbreak of the [current] crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system"
The Asian countries had learnt a severe lesson during the 1997 crisis. In view of the crisis they had built up huge amounts of foreign reserves in USD to save themselves against further backdrop. The emerging economies like China and India started to build up their foreign reserves, which led to the econimic boom of these countries and henceforth higher growth(remember both had double digit growth). With China having nearly USD2000 bln of foreign assests in USD, it is the largest holder of assests in the world. This was translating into a huge advantage for the Americans, because the transaction charge incured by these assests were huge and it was an income for the Greenback(Read USD). The current econimic crisis, led the US government to place its internal debitors in higher priority than the foreign creditors. At the same time China was convert the huge USD assests to other currencies. But the move failed as it led to huge losses. Now China can neither sell those assests nor keep it for long, due to the reason the assests being stagnant leading to weaker USD and further losses.
China earlier had cleverly kept back its currency making it weaker to the USD so that it would help its export oriented economy. This paid hugely and led to its high growth over a few years. Having much confidence, it built huge reserves of assests. This move is sure to backfire if the current crisis contines further. With a eye on economic stability and gains in 2020, China is trying to woo investors to make use of its highly growing market. The government handling of the current crisis has come for praise from many quarters. It has created demand by huge public spending and thus keeping the cash registers ringing all-round. But the US is not in mood to look so further and this is a dangerous sign to China and other emerging economies.
With an view of all problems the Chinese bank governer is putting forth ideas which are being heard the world over. Ideas like expanding the role of Special Drawing Rights, Introduced by IMF in 1969 to support the Bretton Woods fixed exchange regime (But collapsed in the early 1970s to bring in an era of USD domination). Today the SDR is based on a basket of USD, Yen, Euro and Sterling. China's proposal would mean expanding the basket forming the basis of SDR valuation to all major economies and set up a settlement between SDRs and other currencies. The IMF could later manage collectively the different portions of SDR reserves and gradually replace the existing reserve curriencies. This would largely weaken the USD and would not be accepted by the US Govt.
Lets see what happens in the years to come. Are we in for a huge change. As Mr Zhou states "This proposal would require extraordinary political visoin and courage"