By JC Collins
The international monetary system is inherently unstable, and the process
to shift from a unipolar to a multi-polar system is well underway. The
transition itself will take considerable time to fully implement and we are now
somewhere between the first and second stages, with a third stage scheduled to
be completed in the coming years.
The unipolar USD framework which forms the base of the international
financial system today is built on the accumulation of USD assets in the
foreign reserve accounts around the world. One of the transition
requirements for the multilateral framework is to mitigate the demand for these
foreign reserves and to implement a method of diversifying the existing
accounts.
We have previously discussed the purpose of the substitution accounts as a
method of mitigating USD instability in the foreign reserve accounts, and
moving forward with diversifying the composition of those accounts with
SDR bonds to increase global liquidity.
One of the risks associated with mitigating demand for USD’s in the
accounts and further diversifying them comes in the form of exchange rate
instability. With increased demand for SDR securities will come increased
demand for SDR denominated claims. In order for these risks to be
minimized, or eliminated, the exchange of assets through the substitution
accounts must be completed in the same proportion as the composition of the SDR
basket itself.
This basket is currently made up of four of the major reserve currencies in
the world, being proportioned at the following percentages:
USD – 44%
Euro – 34%
Japanese Yen – 11%
British Sterling – 11%
Obviously any attempt to diversify the foreign reserve accounts at this
present composition will not effectively calculate for the massive amounts of
USD which has accumulated in the foreign reserve accounts of countries like
China, who is the second largest holder of US Treasury Bonds outside of the
Federal Reserve itself.
The substitution accounts will utilize a mechanism structured around the
quota amounts set for each participating country which will equally share any
exposure to volatility and risk associated with a disorderly decline in the
USD. But the quota amounts are ineffective as they do not accurately
reflect the reality of the emerging economies and the amount of USD held in the
foreign reserve accounts of the emerging countries.
We’ve thoroughly covered the the process by which the 2010 Quota and
Governance Reforms of the IMF have been delayed by the American Congress, and
how the international community, lead by the IMF and the G20, are calling for
the implementation of Plan B to have the reforms enacted. See here.
Additionally, we’ve covered the internationalization of the yuan, or
renminbi (RMB) and its de-facto status as a reserve currency, all in
preparation for inclusion into the SDR basket in 2015. See here. Andhere.
When China exchanges the USD held in their foreign reserves for SDR bonds
through the substitution accounts, that liquidity will in essence be RMB
liquidity as determined and defined by the quota amounts. Any SDR quotas
can be exchanged back into the currency of the country holding those amounts,
so in China’s case, the yuan.
The “cost” and risk sharing structure of the substitution accounts will
only work when the exchange is arranged in the same proportion as the SDR
composition. Once the RMB is added to the SDR basket the process of
diversifying the foreign reserve accounts, USD to SDR to RMB, or other
currencies, can begin.
The massive QE program by the Federal Reserve has ensured that low
liquidity assets held by banks were exchanged for high liquidity assets, and
now those low liquidity assets which the Fed has on its balance sheet will be
exchanged for SDR liquidity.
But before that can happen the IMF Quota amounts must be adjusted and the
SDR composition will need to be altered so as to enable the usage of the
substitution accounts. It is extremely probable that the huge trade
imbalances which America has had with China, and the large amounts of USD which
has been allowed to accumulate in China’s foreign reserve accounts, were
engineered specifically for the eventual inclusion of the yuan in the SDR
basket.
The next stage of the transition to a multi-polar financial system was
designed to utilize the RMB as the mule for USD instability. China will
only unload US debt through the substitution accounts in exchange for SDR
liquidity.
It is expected that all concerned wish to avoid a disorderly decline in the
USD as the foreign reserve accounts are diversified and the associated risks
are mitigated. And in fact the Plan B being implemented by the IMF and
G20 will also encourage an orderly transition away from massive USD reserves,
but now that the American Congress has not enacted the supporting legislation
for the 2010 Quota and Governance Reforms, the success of Plan B will depend on
the level of resistance by the domestic interests of the USD.
There is no doubt that the amount of USD in the foreign reserve accounts
does give America a level of negotiating power, but the endgame, at least for
this stage of the transition, will require American acceptance of adjustments
to quotas and the governance structure of the IMF, as well as the inclusion of
the RMB into the SDR basket.
Without this the substitution accounts will not work and there will be a
disorderly shift away from and decline in the USD. The economic turmoil in the
international economy and the volatility in the currency markets are
symptomatic of this transition from unipolar to multi-polar which is taking
place. – JC
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