Wednesday, July 01, 2009

Rethinking Reserve Currency

The recent financial crisis highlights a need for effective management of international liquidity. The use of the dollar as an international reserve currency dates back to the 1944 Bretton Woods conference, when the U.S. was the largest international creditor and by far the largest economy in the world.

Recently, Chinese leaders and other international policymakers have become increasingly interested in transitioning to an alternative reserve currency. Critics of the dollar argue that the use of national currencies to manage a global economy is troublesome; the U.S. Federal Reserve inevitably places domestic policy goals above the needs of the international economy.

While there is no clear alternative to the dollar, Chinese officials propose the expansion of IMF Special Drawing Rights (SDRs). Today's SDRs are based on a basket of four currencies - the US dollar, yen, euro and sterling - and they are used as a unit of account by the IMF and other international organizations. The Chinese proposal would involve expanding the SDR basket to include all large economies and establishing a settlement system between SDRs and other currencies, so the SDRs could be used more easily in international finance and trade.

Some argue that the IMF SDRs will never function effectively as reserve currency because of institutional limitations on their use. Many other national currencies simply lack the economic longevity and credibility of the dollar.

Should SDRs replace the U.S. dollar as the international reserve currency?

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