MAVERICK VIEW. Towards the end of dollar hegemony?

Ever since President Richard Nixon delinked the US dollar from gold on August 15, 1971, there has been a 44-year con job of reserve currencies linked to nothing, the system running on trust. The past four decades have been punctuated by bouts of international financial instability, the reserve currencies being thrown into periodic crises. What is surprising is not the intensity of the turbulence but the fact that the international financial system has not completely broken down.

For a country to be a major reserve currency it has to run a large balance of payments current account deficit (CAD) which gets effortlessly financed as other countries readily finance the deficit by holding their assets in the reserve currency. As there is no incentive to correct the CAD, the CAD swells to the point that holders of the reserve currency start losing trust in it. This was the experience with the sterling, and now the US dollar.

Holders of foreign currency reserves have nowhere to go and they necessarily have to hold their forex reserves in one or the other reserve currency. Periodically, one or the other reserve currency gathers strength and countries veer to investing in that currency. Over time, the predominant reserve currency becomes a victim of its own strength.

Mainstream international monetary policymakers invariably dismiss forecasts of an apocalypse as it amounts to an indictment of the obviously untenable international monetary system set up by these policymakers. It is, however, prudent for countries to take note of some studies while deciding on the currency composition of their reserves.

Steve Sjuggerud, chief strategist of Stansberry Research ( US) forecasts that an important financial announcement by the International Monetary Fund (IMF) could trigger a huge shift in international currency markets.

At the present time there are seven major reserve currencies: US dollar, euro, British pound sterling, Japanese yen, Swiss franc, Canadian dollar and Australian dollar. About 62 per cent of international currency assets are held in US dollars, around 23 per cent in euros and 4 per cent each in yen and pound sterling. The IMF’s five-yearly review of major reserve currencies is scheduled for October 2015.

The obvious candidate for inclusion in the list of reserve currencies is the Chinese yuan. At the last review of reserve currencies in 2010, it was felt that China’s exports were not high enough and world trade invoiced in the yuan was not adequately high. Since the last review there has been a dramatic increase in these parameters in favour of the yuan. Eswar Prasad, formerly of the IMF, is of the firm view that on both these criteria the Chinese yuan will, in 2015, pass the test for being ordained as a reserve currency.

The yuan is already an informal reserve currency. According to the Society for Worldwide Interbank Financial Telecommunications (SWIFT) which monitors international currency flows, the yuan is the second most used currency in global trade. It is reported that 40 central banks hold a part of their reserves in the yuan.

Stansberry Research is of the considered view that once the Chinese yuan is formally adopted by the IMF as a reserve currency, about 10-15 per cent of the global reserve currency make-up will shift and gradually, over time, 50 per cent of international currency reserves would be held in the yuan.

Nick Hodge, founder of Like Minded People, is of the view that gold, at present, is hitting the bottom. His assessment is that with the turbulence in international currency markets, gold price, over the next 10 years, could rise from the present $1,200 per fine ounce to $5,000, or even higher.

India’s present strategy on the composition of foreign exchange reserves is to allow the dollar proportion to rise up to 67 per cent of the total and that of the euro to 22 per cent of the total. It is not known whether India holds any part of its reserves in yuan and what the proportion is. The Indian authorities need to quickly focus on two aspects. Between now and October 2015, the Reserve Bank of India should endeavour to raise the yuan proportion in its forex reserves to 10 per cent of the total, and over the years still further. The Stansberry projection is that in the long run (5-10 years) the yuan proportion in international reserves will rise to 50 per cent.

The proportion of gold in the forex reserves should be raised from the present 5.5 per cent to 10 per cent by October 2015, and thereafter gradually to at least 25 per cent over the long run.

The ultimate objective of the Indian authorities should be to move the yuan proportion to 50 per cent, US dollar to 25 per cent, with 25 per cent gold. This would not be in sync with the thoughts of mainstream international monetary policymakers who continue to believe in a managed international monetary system. The warning signals of turbulence are loud and clear and we in India would do well to heed them. India should be one of the early birds to benefit from this dramatic transition.

The writer is a Mumbai-based economist

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