The Gold Standard  

If China convinces Asian nations that SDRs will evolve into a reserve currency with a yuan weighting, “then it may make sense for countries in the Asian region to start thinking right now about holding the yuan as a reserve asset,” Prasad said. “It’s a very clever way of trying to use something that everybody knows can happen only in the medium term — by that I mean 10 years — to start creating a dynamic right now for the yuan to become a sort of implicit reserve currency.”

Asian developing countries have “powerful incentives to build up yuan assets” because their trade with China is likely to increase, Prasad said.

The dollar’s dominance is secure for at least two or three years, Prasad said. Beyond then, a challenge is “very likely,” especially if the U.S. continues to have a large current-account deficit and “its public debt levels rise sharply,” he said. [More here]

Coming from Easwar Prasad who headed IMF’s China division, these are very interesting remarks. It is hard to say whether these were matter-of-fact observations or a warning. Perhaps, it does not matter. As predictions go, he has cut himself some slack.

The key conditions are in the last set of observations attributed to him. As I wrote in MINT last week, if the US government could take a leaf out of the book of the ordinary Americans, the American dollar need not lose its reserve currency status so easily. The test is the extent of fervour or demand for populist policies. If they choose to inflate their way out of trouble, then what Mr. Prasad says could become a reality. Mr. Krugman calls for another stimulus here and writes about wage deflation here.

If America does not do what Mr. Krugman writes ,there is a chance that the country enters deflation. That incidentally raises the currency’s purchasing power. Is it worth having to preserve the sole reserve currency status of the US dollar? That depends on the net present value of costs and benefits (economic and geopolitical) of ensuring dollar’s reserve currency status. Easy to say but difficult to compute.

In any case, it is unclear whether America (more specifically, American elites) has the stomach or fortitude for austerity now. The way they had dealt with banks is not reassuring. Moreover, the June non-farm employment report somehow strikes me as a game-changer. See also Krugman’s comments referred to earlier.

Interestingly, a google search for ‘Prasad yuan’ takes us to this old post of Brad Setser. I wonder whether Easwar Prasad has any thing to say on what he wrote then. That apart, these remarks attributed to Richard McGregor by Brad Setser are interesting:

Chinese leaders publicly stress the priority of employment creation, but economic incentives continue to favour capital intensive industries, not the job-generating service sector. The huge profits these industries have made in recent years have flowed back to state investors and officials, not the workforce. The other winners have been foreign multinationals, often in local joint ventures, using China as an export base [See here and here]

What would foreign or American multinationals, operating in China want? that the renminbi remains undervalued. So, how does the renminbi remain undervalued given its de facto peg to the US dollar? The dollar has to be weaker. How does the dollar weaken? If America follows inflationary (policies that cause inflation down the road, if not now) policies.

But, what if that scares countries with large foreign exchange reserves out of the US dollar? H..mm, there are wheels within wheels.

Avinash Persaud mentioned in a speech in 2004:

In the 18th century Britain was the largest economy of the western world, London was the centre of international trade and finance, the currency was convertible and so sterling became the world’s reserve currency. By the late 19^th century, the US had become the world’s largest economy, a position solidified by Europe’s repeated attempt at self-annihilation from the 1880s to the 1940s. By the 1960s, the dollar had usurped sterling and was the world’s new reserve currency with 60% of total central bank reserves being held in dollars, twice the level of sterling reserves. [See here and here]

Based on this timeline, America should not be in danger of losing the reserve currency status of the US dollar any time soon. But, what Easwar Prasad says suggests that China is in some hurry. Its flip-flops on the dollar in the last two weeks suggests that the country is finding it hard to contain its excitement.

If China were to succeed in replacing the US dollar with Special Drawing Rights (SDR) and if that happens with yuan inside the SDR basket, it somehow marks not just the end of US dollar dominance but something else and the beginning of quite something else.

The air ahead of next week’s G-8 summit suggests that the game has entered the next round.