Dollar's days as the world's only reserve currency could be numbered

OVER the next two days, world leaders gathered at the G20 summit in Pittsburgh will attempt to address the issue of the persistent global imbalances that have been cited as a long-term cause of the recent economic downturn. Integral to this debate has been the long-standing issue of the US dollar&rsquo;s hegemonic status as the world&rsquo;s reserve currency &ndash; IMF data shows that nearly 65 per cent of allocated foreign exchange reserves were held in dollars in the first quarter of 2009. <br /><br />The dollar&rsquo;s reserve currency status allowed the US government to build up its current account deficit from just $11bn back in 1998 to as much as $60bn a decade later without being under the same compulsion as other countries to undertake the necessary macroeconomic or exchange-rate adjustments to bring their deficit back under control.<br /><br />The dollar&rsquo;s hegemony has come under fire from a number of quarters over the past year, most notably from the Chinese &ndash; themselves holding $2 trillion in FX reserves as of June 2009. Ahead of the G20 summit held in London last spring, Zhou Xiaochuan, China&rsquo;s central bank governor, said the desirable goal of the international monetary system is to &ldquo;create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies&rdquo;.<br /><br />The Chinese have pointed towards using the International Monetary Fund (IMF) Special Drawing Rights (SDRs) as an alternative world reserve currency to the US dollar. SDRs were created back in 1969 as a means of supporting the Bretton Woods fixed exchange rate system. <br /><br />The value of an SDR is based on a basket of four key international currencies &ndash; the dollar, the euro, the yen and the pound &ndash; which can be exchanged for freely usable currencies. The third ever allocation of SDRs was approved on 7 August for SDR 161.2bn &ndash; currently equivalent to about $317bn &ndash; and which took place on 28 August to pump more liquidity into the global monetary system. <br /><br />Furthermore, the United Nations Conference on Trade and Development (UNCTAD) called earlier this month for a new currency to be established to protect emerging markets from the &ldquo;confidence game&rdquo; of financial speculation.<br /><br />But while China might be calling for a greater use of SDRs, Nouriel Roubini, professor of economics at the Stern School of Business at New York University (and the man named Doctor Death for his gloomy pronouncements before the financial crisis), says that the Chinese government is paving the way for the yuan&rsquo;s ascendance. He goes further, arguing that China is in fact better placed than the US to provide a reserve currency for the 21st century thanks to its large current account surplus, focused government and the fact that it lacks many of the economic worries that have plagued the US. <br /><br />Even the US Treasury&rsquo;s economic and financial emissary to China, David Dollar, has argued in the past month that it makes sense for China to diversify its huge stockpile of foreign exchange reserves, saying that it is healthy to have a wide and different type of reserve currencies.<br /><br />While some diversification into euros and sterling has occurred over the past 10 years, the US dollar has lost very little ground. Back in 1999, countries held 71 per cent of their allocated foreign exchange reserves in dollars, and just 18 per cent of reserves in euros. Today, 26 per cent of allocated FX reserves are in euros. <br /><br />But while many are calling for an end to the dollar&rsquo;s supremacy and for countries, especially in emerging markets, how likely is it that the dollar will be replaced a global reserve currency?<br /><br /><strong>REPLACEMENT</strong><br />Mark O&rsquo;Sullivan, director at Currencies Direct, says that while it would be ideal to find a replacement for the US dollar, he can&rsquo;t see what it would be. &ldquo;At the end of the day 65 per cent of the world&rsquo;s commodities are still priced in dollars and until you change that dynamic, you won&rsquo;t see an end to the US dollar&rsquo;s reserve status,&rdquo; he says. Furthermore, the vast majority of international contracts and invoices between multinational companies are priced and accounted in dollars. A change to the dollar&rsquo;s status would require an eventual change to this practice. <br /><br />O&rsquo;Sullivan says that in order to see a shift in the dollar&rsquo;s status, the Chinese need to come to the table and make the yuan fully convertible. The Chinese might have been complaining that the dollar is too powerful, but they need to allow central banks to hold the yuan in reserves. <br /><br />But while the Chinese might be hoping to diversify their foreign exchange reserves, it is going to have to be done very slowly indeed. As Richard Turner, FX sales dealer at spread betting firm IG Index points out, given that the Chinese have a trillion dollars worth of US dollars, they aren&rsquo;t going to want to drive down the value of their reserves by selling large amounts of dollar-denominated assets. <br /><br />Even if the yuan could not become a world reserve currency, it is sometimes suggested that it could take that role in Asia, especially among countries which trade with China. Other regions could also follow suit: the Economic Community of West African States plans a common currency, although plans were recently put back until 2015. <br /><br />The euro is the obvious choice for EU countries, while the rouble could do the same job for Eastern Europe. In a world with many economic powerhouses, it might make sense for there to be a number of different reserve currencies. For now, the dollar is still top dog, but radical changes could be afoot.