New international monetary system?
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Everybody loves dollars, but not anymore. Some countries are interested in replacing the US dollar with the Chinese Yuan for either economic or political reasons. They also like to promote their own national currencies for international trade. It is, however, a fact that Chinese Yuan is gaining momentum as an international currency, while some have already acknowledged and welcomed the change.
There is another development that took place last week, when the Malaysian Prime Minister Anwar Ibrahim on his state visit to China, proposed the Chinese President Xi Jing Ping to take initiatives to set up an “Asian Monetary Fund”. Anwar revealed on Tuesday at the Malaysian Parliament that Xi Jing Ping welcomed the idea. He further added “there is no reason for Malaysia to continue depending on the dollar”, according to a Bangkok Post report on April 4.
The International Monetary Fund (IMF) is so far the “lender of last resort” in the world to bailout countries in distress, but it may be now changing too. The idea of an Asian Monetary Fund (AMF) that was “dead on arrival” some 25 years ago is showing signs of life again. It was, actually proposed by Japan at the time of East Asian Financial Crisis in 1997 but ousted by the US. Perhaps, with Chinese stewardship it may be come to life in the near future.
The changes in the international monetary system are not a new thing. It has happened in the past too. It is through these changes that the US dollar itself came to be the most-traded international currency as well as the most-accepted reserve currency in the world. It still holds that position, although the emerging new international currencies have begun to challenge it.
Since I came across some related news reports on the dialogues of Russia, Brazil, and Malaysia with China, I thought of shedding some light on the changing international monetary system. In order to understand the issue in the context without taking it as a surprise, we must look at the past and the present, and then anticipate what might come in the future.
Bretton Woods system
Prior to the 20th century, world hegemonic power was concentrated in England and a few other European countries. Along with this, the British Pound and other European currencies had also gained dominance in the international monetary system. However, the most accepted international currency was gold and thus there was an international quest for accumulating gold through trade.
It was also viewed at the time that economic power of a “nation state” is determined by the country’s stock of gold. But the supply of gold in the world was insufficient against speeding trade expansion and its international distribution across different countries was uneven. As a result, it was increasingly difficult to sustain gold as a medium of exchange and as a store of value.
The answer was provided by the Bretton Woods system. The term refers to the “first negotiated international monetary system” which was established as an outcome of an agreement entered at Bretton Woods, in New Hampshire in the US in 1944. The representatives of the Western nations gathered at the Bretton Woods Conference and finally agreed on a new international monetary system which boosted the US dollar as the number one international currency in the world.
Currency convertibility at a fixed rate
By that time, anyway the world hegemonic power has transferred to the US on the one hand so that naturally the US dollar has the competitive edge over other major currencies in the international monetary system. On the other hand, the US had the largest gold stock, which was reported as large as three-fourth of the world’s entire gold stock.
The Bretton Woods system gave birth to the world’s fixed exchange rate system. As per the rules, particularly the Western European countries, Canada, Australia and Japan agreed to peg their currencies to the US dollar and guarantee their convertibility in international transactions. Secondly, it was also agreed to fix the dollar price of gold and tie up the dollar value to gold.
It was at the Bretton Woods conference that the International Monetary Fund (IMF) was born together with another multilateral organisation, the International Bank for Reconstruction and Development (IBRD), which is at present known as the World Bank. While the IMF was established in order to assist the member countries in persistent foreign exchange problems, the World Bank was to help reconstruction in war-torn Western countries and development in underdeveloped countries.
Stronger currencies against dollar
The Bretton Woods monetary system too collapsed in the early 1970s. The countries which agreed to it abandoned pegging their currencies to the US dollar. The US itself failed in maintaining the link between the US dollar and gold. While the inadequate gold supply in the world continued to be a binding constraint, the monetary policy was non-effective in addressing the rising inflation under the fixed exchange rate system.
It became clear that the Central Bank could choose only two out of the impossible trio – inflation rate, interest rate and exchange rate. And after all, it could not forget the first two. While price stability was considered to be the primary objective of the Central Bank, the interest rate was a monetary policy tool that has to be used in taming inflation.
This automatically leaves the exchange rate to be determined by market forces. Accordingly, the Western countries, after abandoning their fixed exchange rates, moved into market-determined flexible exchange rate systems. The countries which had better trade performance such as Japan and Germany experienced a long-term appreciation of their currencies against the US dollar. Later, Euro also emerged as a strong currency against the dollar.
No permanent enemies!
In the recent past China has been boosting its Yuan to be an international currency for trade as well as a reserve currency on which the other countries can accumulate their foreign assets in Yuan. Already being the second largest economy in the world after the US and the third largest trading nation in the world after the US and the EU, China is already qualified to realise this idea and to make its currency a successful contender against the US dollar.
The new currency challenge is posed by growing China as well as other “big economies” in the world which support the emerging new international monetary system. Faced with Western sanctions against the Kremlin, Chinese Yuan has replaced the US dollar – the most-traded currency in Russia. Prior to that last year Russia also made its own Ruble as an international currency for its energy trade. Already Russia’s most-traded currency is Chinese Yuan, and not the dollar.
In order to reduce transaction costs and promote trade, China and Brazil have agreed last month to trade in their own currencies, replacing the US dollar as an intermediary. In fact, many countries in the world are already using the Chinese Yuan for their payments for bilateral trade.
Promoting a “reserve currency” is not a legal process or a formal process, as it depends mostly on the level of trust among the nations. Although the Bretton Woods system has backed the US dollar at that time, the world’s economic transformation and the geopolitical dynamics have already helped the Chinese Yuan to reach its goal.
Perhaps, the landscape of geopolitics could change in the process, because there are no permanent enemies in geopolitics too. Today they may oppose each other for a different reason, but tomorrow they may join together for a common cause.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and
follow on Twitter @SirimalAshoka).
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