A new reserve currency
China is officially joining the exclusive club of reserve currencies. Christine Lagarde, head of the International Monetary Fund (IMF) recently gave the approval for China’s Yuan (also known as Reminbi) to join the US Dollar, Euro, Japanese Yen, Pound Sterling, and Swiss Franc as a reserve currency. Despite its troubles earlier this year, the Yuan has returned stronger – and its new status is testament to this. This is significant in two ways. Firstly, this new development paves the way for China’s further solidification of its role as an economic power. Not only this, the entrance of the Yuan as a reserve currency further erodes the dollar’s pre-eminent position as the world’s leading reserve currency. The loss of this status will have reverberating effects for the status quo. With the rise of China, this development will only further accelerate the shift of power from West to East.
How did it begin?
The reserve currency system dates back to the middle of the twentieth century. As World War II began to come to an end, the Allies convened in Bretton Woods, New Hampshire to discuss the postwar world. The intent of the meeting was to design a new international monetary system. The war had transformed the United States into an economic superpower, surpassing the dwindling British Empire. The United States emerged from the war largely unscathed and rose to become the pre-eminent commercial economy. The gathering at Bretton Woods produced a US-dominated economic structure, anchored firmly to the dollar. One by one, central banks around the world acquiesced to the system as it was based on a gold standard.
But fissures would soon emerge within the system. This led to an eventual tug of war between the national objectives of the United States, and the responsibility of being the world’s premier reserve currency. Though the gold standard was in place, the enormous currency outflow by the US resulted in an imbalance between dollars in circulation and the amount of gold in reserve that could back it up. When this was revealed to the world, a run on American banks ensued. In 1973, the United States ended the gold standard, and with it, the dollar became a fiat currency.
The same year, due to Western support for Israel during the Yom Kippur War, OPEC declared an oil embargo. In order to protect the value of the dollar, US President Nixon forged the petrodollar pact with Saudi Arabia. In exchange for the Saudi’s denominating all future oil sales in dollars, the US became the guarantor for safeguarding the House of Saud from any domestic or international threats. The remaining Gulf nations followed suit. The petrodollar global economic system was born, and the primacy of the almighty dollar secured.
The petrodollar economy
Since 1973, a major reason for the strength and resilience of the economy of the United States has been the petrodollar arrangement. This agreement has allowed the US dollar to retain its premier reserve status, due to the need of other nations to purchase dollars in order to buy oil. The petrodollar has, to an extent, allowed the US to create living standards unbeknownst to most of the world. It has also been able to maintain this living standard though its ability to export inflation. This is especially evident in the period immediately after the 2008 Global Financial Crisis.
To invigorate the economy, nations have two weapons at their disposal. They can issue bonds, or print more money. Since 2008, the United States has been doing both. The government issues bonds, and the Federal Reserve purchases them. This is a way by which the US government generates artificial demand, which it hopes will translate into actual demand. Countries around the world hold US dollars in their reserves. As the world gets engorged with dollars, other nations will have to allow their currencies to either boost in value or they can print more of their currency to offset the dollar devaluation. If they opt for the former, their economies well undergo a recession because it would cause their exports to increase in price. Higher currencies would therefore make it difficult for them to compete. Whereas printing more currency will result in direct inflation, and decrease living standards. The world reserve status therefore provides the United States economy with a unique insulation to most downturns, at the cost of other nations.
The end of an era?
[via Hellas Force]
The United States reign as the world’s reserve currency is coming to an end. A direct challenge to the current economic structure was proposed by China and Russia in their joint development of the Asian Infrastructure Investment Bank (AIIB). The bank is a direct repudiation of the World Bank and IMF, which they perceive as a propagating force behind the dollar hegemony. With the Yuan becoming part of the elite group of reserve currencies, the credibility of the AIIB will only enhance that much more. As Iran reintegrates into the world economy, it may be the first time a major oil-exporting nation uses a currency other than the dollar to facilitate transactions. Perhaps the Yuan will be used. By removing the dollar as the dominant reserve currency, China can allow global economies to be insulated from American monetary policy. These states will no longer be forced to absorb the United States’ inflation. The proliferation of the Yuan due to its reserve currency status will allow China to flex its financial muscles. China will be less restricted in how its economy is manoeuvred. What at first appears to be a typical procedure by the IMF has the potential to create a momentous outcome in global politics for decades to come.