Mar 30, 2011 (LBO) – India’s central bank chief has rubbished the use of the International Monetary Fund’s special drawing rights (SDR) as a global currency in a speech in Sri Lanka in sharp contrast to a position taken by China’s central bank earlier. Many Middle Eastern countries created their own currencies after the devaluation of the Indian rupee in 1966 and its credibility was lost.
“This does not seem to be a feasible option,” Reserve Bank of India Governor Duvvuri Subbarao said at an oration in Colombo to mark 60 years of Sri Lanka’s central bank.
“For the SDR to be an effective reserve currency, it has to fulfill several conditions.
“The SDR has to be accepted as a liability of the IMF, has to be automatically acceptable as a medium of payment in cross-border transactions, be freely tradeable and its price has to be determined by forces of demand and supply.
“In short, the exorbitant privilege of a reserve currency comes with an exorbitant responsibility.”
Subbarao’s comments are in sharp contrast to those of People’s Bank of China’s governor
Zhou Xiaochuan in 2009, where he advocated the increased use of the SDR through a new system of state backed rules.
“But this cannot happen by fiat,” Subbarao said. “To be a serious contender as an alternative, a currency has to fulfill some exacting criteria.
“It has to be fully convertible and its exchange rate should be determined by market fundamentals; it should acquire a significant share in world trade; the currency issuing country should have liquid, open and large financial markets and also the policy credibility to inspire the confidence of potential investors.”
The SDR is at the moment a denominator currency based on a cocktail of different floating exchange rates governed by different monetary policy priorities and backed by liabilities of their individual governments.
The SDR was created during operation of the post-World War II, Bretton Woods system of unstable or ‘soft’ pegs with the US dollar.
Under the Bretton Woods system a pegged central bank was also allowed to print its own money, (control interest rates and the exchange rate at the same time) a process that was destined to fail.
The IMF was created to help countries that failed to keep the peg by printing too much money and running deficits and ran into balance of payments troubles.
The Bretton Woods was the brainchild of Harry Dexter White, a US Treasury official who was later sacked for his alleged links with communist Russia.
Penniless Britain’s John Maynard Keynes wanted to create a completely separate currency, the ‘Bancor’ but was overruled by the US which had most of the world’s gold reserves.
At the time of its creation, helped with heavy lobbying by the State Department, the US promised to keep its own currency growth restrained by a peg to gold.
Other countries abandoned their own pegs to gold, a market based system that restrained central banks from inflating their economies through an obligation to convert to gold on demand.
Britain’s currency was losing credibility from 1914, when the Bank of England lifted gold convertibility and the UK Treasury also started to print its own notes.
A reserve currency country can ‘export’ government debt to central banks of foreign countries, reducing interest rates and run trade deficits with the cash generated as long as the issuing government does not default.
The SDR was created in the 1960s when the US printed too much money to finance the Vietnam War and gold prices started to go up rapidly, signaling a loss of confidence in the US dollar and a break from the gold peg.
In 1971 the US defaulted on the Bretton Woods, closed the gold window after printing too much money to finance the Vietnam War and fired a decade of ‘great inflation.’
The so-called ‘advanced nations’ broke the dollar pegs and floated their currencies at the same time and gave up their dependence on foreign reserves.
After messing around with a Bretton Woods-style European exchange rate mechanism (ERM), Europe created Euro, a supra national currency.
But some countries voluntarily kept pegs, and held US dollar assets as reserves. China is now the biggest holder. The 2007/8 economic collapse was mainly fired by post 2001 ultra loose US monetary policy that created a massive housing bubble in the US.
“The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits,” Zhou said in 2009.
“The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.”
The current global inflation, fired by ultra loose US policy in particular is renewing concerns about the dollar.
Subbarao said that “some measure of self-insurance will continue to be the first line of defence.”
India is already on a path to full float its currency. It has also bought gold from the IMF.
Before the nationalization of RBI and even its creation, India’s own currency was widely used in South Asia and the Middle East.