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Dollar will remain the pivot

by Takehiko Nakao, Asian Development Bank

Dollar will remain the pivot

The dollar is the key currency in the international monetary system. It is backed by trust, as well as by US economic, political, cultural and military might. It is supported by the liquidity and depth of US financial and
capital markets and the settlement infrastructure maintained by the US monetary authorities.

Some argue that, with declining US political and economic power, challenges are growing to the dollar’s position. However, the US economy seems to have the flexibility and diversity to undergo needed dynamic transformation.

Some would argue that changing to a system of multiple key currencies would enhance stability. Competition between currencies would, it is said, enforce macroeconomic discipline. Others maintain that such a system would be less stable as differences in economic performances and interest rates among reserve-issuing countries would increase volatility of capital flows and exchange rates.

Supporters of a multiple currency system often cite the 1920s, when the pound, dollar and French franc co-existed as key currencies. That system, however, was based on the gold standard, when the value of each currency ultimately depended on the value of gold. It is doubtful whether that framework was a genuine system of multiple key currencies.

During the 1980s and into the 1990s policy-makers espoused a vision of a tripolar currency system based on the dollar, yen, and D-mark, but such an idea has now receded.

When one considers the possibility of another currency becoming parallel to or replacing the dollar, the euro is usually seen as the most promising candidate.

However, a key currency requires deep and liquid financial markets. In the case of the euro, each member country has a separate market for its government bonds. Market depth and liquidity are lower compared with the dollar. Some intrinsically difficult issues about the euro system have been brought to the fore by the euro crisis.

Internationalisation of the renminbi

Some people have suggested that the renminbi will become a key currency alongside the dollar in the future. There have been many reports on the ‘internationalisation of the renminbi’.

However, promoting the usage of renminbi, even only for trade settlements, requires the liberalisation of capital accounts. Exporters to China want to manage their proceeds and importers want to finance their bills in renminbi. But convertibility in capital account transactions, which should be preceded by deregulation of domestic financial markets – including the liberalisation of interest rates – still requires a great deal of time in China.

Comparing China’s economic development model with Japan’s past high economic growth, China’s model is more open to mobilising international capital, reflecting the changed international economic environment, and the Asian network of overseas Chinese. China may be able to internationalise its currency more quickly than Japan did, but this is not a simple matter.

The status of the yen

How should we view the status of the yen? Since the time of the US-Japan yen dollar committee in the early 1980s, the Japanese government has pursued yen internationalisation. Important objectives have been promoting the yen’s international use, especially in Asia, and upgrading the conditions for the yen to be freely selected to meet the needs of those engaged in transactions.

The ultimate vision was to make the international monetary system ‘tripolar’. The 1960 adoption of free yen accounts, allowing the yen to be used in trade, marked the beginning. This was followed by liberalisation of current transactions in 1964 and capital transactions in 1980. Institutional reforms were finalised by complete liberalisation of capital transactions in 1998.

Enthusiasm about the tripolar system was highest at the pinnacle of Japan’s economy, described as ‘Japan as No 1’ in the 1980s. Unfortunately, however, following sluggish growth and low returns on yen-denominated assets, it is difficult to conceive of the yen becoming a global currency.

Synthetic special drawing right

The International Monetary Fund’s synthetic special drawing right is another area of attention. The London G20 summit in April 2009 agreed on a new SDR250bn allocation, a roughly tenfold increase.

With this allocation, emerging market countries and developing countries were able to attain foreign currency reserves at a lower cost than on the market as a buffer against sudden reversals of capital flow.

Even after the new allocation, SDRs accounted for only 3% of the world’s foreign currency reserves. Moreover, an SDR is a mere synthetic currency composed of the dollar, euro, yen, and pound. There are no SDR banknotes or coins that can be used for transactions in the private sector.

It would be difficult to conceive of currencies such as the euro, the yen and the renminbi becoming global reserve currencies and means of payment on par with the dollar in the foreseeable future, even though their usage might expand in neighbouring countries and regions. Similarly, it is difficult to imagine SDRs playing such a role.

Policy-makers should focus on efforts by countries and regions to strengthen the current system’s stability, based on the premise that the dollar will remain the key currency.

First and foremost, it is important that the US pursues appropriate macroeconomic policies including responsible fiscal management. Other major economies including the euro area, Japan and China should manage their economies responsibly with due regard to the international impact of their economic policies. They should draw on peer review frameworks such as IMF surveillance (monitoring of economic policy) and G20 mutual assessment.

Takehiko Nakao is President of the Asian Development Bank. This paper, underlining the relatively static nature of issues affecting the world monetary system, is an abbreviated version, without any updating, of the author’s speech of March 2010 at the Institute of International Monetary Affairs, Tokyo, made in his capacity as director general of the international department of the Japanese ministry of finance. Nakao served as vice minister for international affairs from 2011 to 2013. For the full version, see www.iima.or.jp/Docs/symposium/20100318/Mr_Nakao_Speech_text_e.pdf