Today there has been a tendency for most central banks to invest their forex reserves in dollar or euro-denominated deposits or bonds. Around 80% of global investible reserves are lodged in these two currencies with the dollar accounting for 60% and the euro 20%.
The Russia-Ukraine war may be one of its kind and there may not be similar altercations for some time. One outcome has been sanctioned being imposed by the western nations which affects almost all countries due to globalisation. But there was also the case of sanctions against Iran with certain exemptions. There are always lurking strains when it comes to geopolitical stability with suspicion increasing on how non-democratic countries could behave and the punitive actions that could follow. This has led to the question of whether central banks should diversify their foreign exchange holdings.
Today there has been a tendency for most central banks to invest their forex reserves in dollar or euro-denominated deposits or bonds. Around 80% of global investible reserves are lodged in these two currencies with the dollar accounting for 60% and the euro 20%. Another 10% is in yen or pound and the balance is distributed across other currencies including the Renminbi. Should there be more diversification?
The reason for investing in the dollar and euro is that they are considered to be strong global currencies that have also become anchors. The euro started by being a competition to the dollar but has not really succeeded as the Greek crisis exposed the shortcomings of a common currency across 19 countries that are very different. Therefore the dollar continues to reign supreme.
The problem today is that due to Russia being cut off from the SWIFT mechanism, it is hard to trade in any other currency. If other acceptable currencies were held it would be possible for central banks to provide a payments system. In a way, the USA operates a monopolistic currency system which has been furthered by the EU also following suit.
Also at a global level, there can be fear that if at some time the US decides to take a call on sanctions against any country, the dollar holdings of their central banks can be frozen, which is what has happened to Russia. In fact, China would be on guard now as any political aggression which is manifested against a neighbour country that is taken up by the US can lead to such punitive action. Therefore, countries will be in a quandary if there is a freezing of their forex reserves. Hypothetically the USA could take action against countries that do not fall in line with the sanctions that it imposes on any country by withholding funds. Therefore, there is a reason for central banks to look at alternatives that go beyond the dollar, euro, and pound.
In the earlier days, SDRs were a way out which was a basket of currencies that were globally acceptable though dominated by the dollar. Bringing back the SDR will help as the IMF remains a neutral organisation and offers help to all member countries. If all countries pitch for the SDR, then it could be the currency of last resort in case of such crises like situations. While a new basket of currencies can be constructed, the inclusion of non-democracies will always create ideological problems in times of crisis. Besides, there has to be an owner of the basket, which will be contentious. The IMF is a global institution and offers confidence and countries too should work towards moving to the SDR. The IMF will however have to work out a return that can be provided the same SDR which can be converted into currencies that can be used for on-lending purposes.
Countries also have to work out economic arrangements with countries like Russia and China which are non-democracies to create a structure for payments and settlement. The currency used for settling foreign trade must be expanded to a basket where bilateral trade is possible with domestic currencies. Hence, central banks should be stacking up currencies of important trading partners so that in case of such exigencies systems do exist for trade to continue. For this, the exchange rates have to be determined by an accepted mechanism. India for instance has friendly relations with all the West Asian countries and should be in a position to trade with these countries if they are blocked out from the global payments system.
The catch here is that this has to be a process that should be in place all through to allow for seamless trade during crunch time. Therefore countries should start having bilateral trade in their respective currencies so that there is continuity. This will automatically ensure that central banks also get to diversify their forex reserves holdings.
As we move away from globalisation and countries become more inward-looking there would be a strong case for several trading blocks to emerge. Settlement and payments have to be seamless and alternative modes have to be explored. Bilateral currency settlement makes sense provided exchange rates can be determined. It will not be surprising if cryptos become an option under these conditions. Central banks for sure must look for diversification into SDR, gold, and non-blue chip currencies to keep the basket flexible.
Today there has been a tendency for most central banks to invest their forex reserves in dollar or euro-denominated deposits or bonds. Around 80% of global investible reserves are lodged in these two currencies with the dollar accounting for 60% and the euro 20%. Another 10% is in yen or pound and the balance is distributed across other currencies including the Renminbi. Should there be more diversification?
The reason for investing in the dollar and euro is that they are considered to be strong global currencies that have also become anchors. The euro started by being a competition to the dollar but has not really succeeded as the Greek crisis exposed the shortcomings of a common currency across 19 countries that are very different. Therefore the dollar continues to reign supreme.
The problem today is that due to Russia being cut off from the SWIFT mechanism, it is hard to trade in any other currency. If other acceptable currencies were held it would be possible for central banks to provide a payments system. In a way, the USA operates a monopolistic currency system which has been furthered by the EU also following suit.
Also at a global level, there can be fear that if at some time the US decides to take a call on sanctions against any country, the dollar holdings of their central banks can be frozen, which is what has happened to Russia. In fact, China would be on guard now as any political aggression which is manifested against a neighbour country that is taken up by the US can lead to such punitive action. Therefore, countries will be in a quandary if there is a freezing of their forex reserves. Hypothetically the USA could take action against countries that do not fall in line with the sanctions that it imposes on any country by withholding funds. Therefore, there is a reason for central banks to look at alternatives that go beyond the dollar, euro, and pound.
In the earlier days, SDRs were a way out which was a basket of currencies that were globally acceptable though dominated by the dollar. Bringing back the SDR will help as the IMF remains a neutral organisation and offers help to all member countries. If all countries pitch for the SDR, then it could be the currency of last resort in case of such crises like situations. While a new basket of currencies can be constructed, the inclusion of non-democracies will always create ideological problems in times of crisis. Besides, there has to be an owner of the basket, which will be contentious. The IMF is a global institution and offers confidence and countries too should work towards moving to the SDR. The IMF will however have to work out a return that can be provided the same SDR which can be converted into currencies that can be used for on-lending purposes.
Countries also have to work out economic arrangements with countries like Russia and China which are non-democracies to create a structure for payments and settlement. The currency used for settling foreign trade must be expanded to a basket where bilateral trade is possible with domestic currencies. Hence, central banks should be stacking up currencies of important trading partners so that in case of such exigencies systems do exist for trade to continue. For this, the exchange rates have to be determined by an accepted mechanism. India for instance has friendly relations with all the West Asian countries and should be in a position to trade with these countries if they are blocked out from the global payments system.
The catch here is that this has to be a process that should be in place all through to allow for seamless trade during crunch time. Therefore countries should start having bilateral trade in their respective currencies so that there is continuity. This will automatically ensure that central banks also get to diversify their forex reserves holdings.
As we move away from globalisation and countries become more inward-looking there would be a strong case for several trading blocks to emerge. Settlement and payments have to be seamless and alternative modes have to be explored. Bilateral currency settlement makes sense provided exchange rates can be determined. It will not be surprising if cryptos become an option under these conditions. Central banks for sure must look for diversification into SDR, gold, and non-blue chip currencies to keep the basket flexible.
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