The topic of replacing the US Dollar as the world’s reserve currency crops up more often than the debate on who’s going to manage Chelsea. So why not grab a coffee and join me in getting to grips with reserve currencies, SDRs and the future of the greenback.

Background
On 23rd March 2009 Zhou Xiaochuan, governor of the People’s Bank of China set off an enormous firework in forex land. He proposed using the SDR as an international reserve currency in place of the dollar. Russia chimed in saying that it was a splendid idea and even the US Treasury Secretary Timothy Geithner agreed (briefly).

Markets got even more excited in April when the G20 authorised the IMF to issue $250 billion in new SDRs to boost the foreign reserves of IMF members, with the aim of channelling this through to the more needy emerging economies.

This article sticks mostly to the facts; a quick history lesson, followed by an explanation of what SDRs and reserve currencies really mean. The follow-up will be more market related, considering the long-term demise of the US Dollar, but also looking at how to trade it in the near term.

A Quick History Lesson
Back in the days before aeroplanes, all currencies were backed by gold, meaning that every country had to hold in reserve enough gold for all of the currency in circulation (the Gold Standard).

In 1944 the Bretton Woods Agreement set up a modified structure of (almost) fixed exchange rates against gold. Unfortunately, Herr Hitler’s European Tour 1939-1945 had left the world with nowhere near enough gold to cope with the necessary post-war expansion.

Predictably, as politicians were involved it took until 1971 to decide that the system couldn’t cope. The US was first to break away and set the printing presses running to fund a global expansion (unfortunately all the helicopters were in Vietnam). Other countries were happy to take US Dollars instead of gold and as the world’s strongest currency, the US Dollar was used to price international commodities like gold, silver and oil.

The SDR had been created by the IMF in 1969 as a means of supporting the fixed exchange system. But when Bretton Woods was binned in favour of the US Dollar, SDRs became yesterday’s acronym.

So What Are SDRs?
From the International Monetary Fund:

“The SDR is an international reserve asset, created by the IMF in 1969 to supplement the existing official reserves of member countries. The SDR also serves as the unit of account of the IMF and some other international organizations”

Or, in plain English, an SDR (Special Drawing Right) is an artificial, not an actual, currency. SDRs were originally fixed at a rate of 1 Dollar (or 0.888671 grams of fine gold), but now they’re made up of a weighted basket of currencies, currently:

• 44% US Dollar
• 34% Euro
• 11% Japanese Yen
• 11% Sterling

SDRs are often referred to as ‘paper gold’ and are confined to computerised transactions (you can’t use them to buy a packet of fags).

What Is A Reserve Currency?
It’s a foreign currency held in large amounts by central banks and other major financial institutions as a means to pay off international debt obligations or to trade in global commodities. The reserve currency can also be exchanged for the domestic currency when intervening to influence the exchange rate.

Currently the US Dollar is deemed the world’s reserve currency. Most countries build up reserves in US Dollars to act as a cushion in case their economy/currency goes down the pan. They can then sell the Dollars in exchange for their own currency. The Dollar’s influence is boosted by the fact that most commodities, such as oil and gold, are priced in Dollars.

And The New Contenders Are…
The most recent call was for an international reserve currency, preferably backed by the IMF. China, watching the increased activity of Ben’s helicopters, started to worry about the future value of its trillion or so US Dollars. China’s proposal was borne out of a realisation that it was stuck with an investment too large to shift without self-harming; at least an SDR type currency would still have a large Dollar weighting so it wouldn’t be seen as abandoning the buck (nor would it lead to wholesale selling of the Dollar thus doing more damage than Ben’s printing presses).

There’s an interesting article today, which suggests that China has taken the first step in diversifying away from the Dollar by stockpiling copper instead of US treasury bonds. The article also picks up on Zhou Xiaochuan’s recent reference to the Keynesian ‘Bancor’ proposal; a reserve currency backed by a basket of 30 commodities.

For a long time the Euro was muted as the king-in-waiting, but with the global recession exposing the extreme difference in fortunes across Europe that one’s gone a bit quiet.

Not quite a global reserve currency, but the Gulf States have had their own petro-currency on the drawing board for years. There are plans for a single Gulf currency by 2010, but this now looks to be well wide of the mark.

An Asian reserve currency, backed predominantly by the Renminbi, has also been mulled over, but is a non-starter until the Chinese currency is fully convertible.

There’s certainly a move (if only verbal at the moment) towards a reserve basket of currencies. In the next article I’ll be looking at the pros and cons of an SDR-type reserve currency, and the effect it could have on the Dollar. I’ll also have a look at what’s driving the Dollar now.