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The future of the international monetary framework

The future of the international monetary framework

Dollar dominance here to stay
British pound seen as one of four smaller reserve currencies with renminbi and euro

by Dr. Jin Zhongxia

Thu 7 Feb 2013

For the foreseeable future, we can speak of the global currency system as a framework of ‘1+4’. The dollar will continue to be the super reserve currency, supplemented by four smaller reserve currencies: the euro and the British pound in Europe, and the Japanese yen and the Chinese renminbi in Asia.

The dollar’s global dominance will continue, reflecting US economic, financial and military power. The dollar’s superiority over the other currencies, particularly the second largest international currency, the euro, is rooted in its economic structure.

The euro area is similar to the US economy in size. But the euro area’s factors mobility, fiscal integration and, as a result, its ability to deal with any structural crisis is not comparable with that of the US.

The US economy is not merely stronger than that of the euro area by itself. In addition, the US economy also enjoys the existence of an unofficial dollar zone.
Those countries in the world that rely on the dollar for most of their international transactions and hold dollars as major international reserve asset all belong to the de facto dollar zone.

Compared to the euro area, the dollar zone has much greater resilience to shocks. This is because the exchange rate between the dollar and the other currencies are mostly not fixed and can be adjusted when necessary.

The dollar zone looks much more loosely connected, but in reality it is more coherent than the euro area, despite the official commitment of the euro member states to that currency. In most cases, the US doesn’t have any official obligation to support those de facto members in their efforts to carry out structural adjustment.

The Federal Reserve occasionally provides liquidity support to other offshore dollar centres though swap agreements. Frequently, the US can transfer its financial burdens or the cost of its own financial problems to the other unofficial members.

In addition, countries in the dollar zone use a common financial infrastructure such as the cross-border payment messaging systems dominated by the US. Even the euro and the pound rely on some of these systems.

The dollar zone looks like currency federalism, a unification based on free choice. In reality, the constraint on its members is much stronger than that which would come from federalism.
Theoretically, members of the dollar zone can freely choose their reserve currency. But, in reality, the construction of an independent international payment messaging system, other than the one supplied or dominated by the US, is too costly for ordinary countries. Therefore, for most countries in the world, there is no choice other than the US dollar.

In the medium term, the value of the dollar may tend to be stabilised and even recover, especially considering that the currency’s depreciation in the past few years has promoted American exports. Furthermore, increased domestic energy production will lead to an improvement in the US balance of payments and a strengthening of the dollar in future.

The debt crisis in the euro area has demonstrated the structural weakness of this currency. If we take into consideration that the euro partially relies on the dollar’s payments infrastructure for its cross-border transactions, we can say that the euro is basically a very large regional reserve currency. But the sheer size of the euro area economy and financial market, together with its highly-advanced science and technology, will maintain the euro as the second most important international currency, behind only the dollar, in the foreseeable future. In fact, the weakening of the euro during the crisis has benefited core countries such as Germany and France by protecting their manufacturing sectors’ competitiveness.

The British pound will continue to be an important player with very special vitality and unique importance. The British empire no longer exists. But London, being located in the middle of the east and west time zones, is still the most important international financial centre, comparable to New York in many aspects.

London has advantages in financial freedom and openness, in foreign exchange trading, international bond issuance and financial derivatives. London is the world’s most important offshore financial centre. Notably, the benchmark interest rate of the dollar is determined in London rather than New York. We have Libor, not Nibor.

Although many people believe that Japan has been not very successful in promoting the yen’s internationalisation, the yen is still the most internationalised currency in Asia. It is very likely to continue as such in coming years. Yen settlement accounts for 30-40% of Japan’s total foreign trade, a level that China will take years to catch up.

Several factors are likely to help the yen keep its leading role in Asia in the next decade. These are its full convertibility on capital account, its higher degree of openness in financial markets compared with most of its neighbours, its persistent low interest rates and the promotion of official Japanese overseas development assistance, credit and investment.

The internationalisation of the renminbi has been a hot topic in recent years. In fact, the renminbi has lagged behind the yen in Asia for many years, not to mention the other major currencies.
But the Chinese currency has great potential. The degree of China’s domestic market integration and factor mobility is comparable with that of the euro area, although it is lower than that in the US. China’s fiscal integration is not only higher than in the euro area, but also higher than in the US.

The size of the Chinese economy will catch up with the US and the euro area in one or two decades. To some extent, the process of renminbi internationalisation is determined not by how much we export the renminbi to the offshore market, but rather by the size, openness and competitiveness of the Chinese economy.

An international currency system that is properly tiered among multi-polar segments can benefit global economic stability. But we must bear in mind that the cross-border usage of the renminbi is aimed, mainly, at dealing with some problems in the Chinese economy.

Internationalisation of the renminbi can reduce the country’s currency mismatch, so that a more flexible exchange rate adjustment will not generate unexpected shocks to the real economy, and any external imbalances can be corrected in a timely and effective manner.

From the viewpoint of developed countries, the cross-border usage of the renminbi can satisfy three sets of requirements. It can meet demand for liquidity in China-related international transactions, diversify currency risk, and help reduce the burden on other central banks to provide liquidity to the international financial market. That will in turn enable the stimulative monetary policy in these countries to boost their domestic economies, rather than creating bubbles in the rest of the world. Therefore, the internationalisation of the renminbi, based on market choice, will contribute to the stability of the international monetary system.

Dr. Jin Zhongxia is Head of the Research Institute at the People’s Bank of China. This article is his personal view and may not represent the opinion of PBOC.

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