Will special drawing rights supplant the dollar?

Original article at http://www.voxeu.org/index.php?q=node/3538

Owen F. Humpage, 8 May 2009

China recently called for SDRs to replace the dollar as the international reserve currency and diminish the US economic supremacy. This column argues that because of the huge network benefits associated with using dollars, SDRs are not likely to supplant the dollar anytime soon as an international reserve unit, especially with the euro as a more viable competitor.

China wants a new international reserve currency, one that is “disconnected from economic conditions and sovereign interests of any single country.” It recommends resurrecting Special Drawing Rights (SDRs), a composite currency issued by the IMF, as a new international reserve unit.

While China claims that credit-based national reserve currencies are inherently risky, facilitate global imbalances, and foster the spread of financial crises, the key concern may be a bit more parochial. The country holds a huge official portfolio of dollar-denominated assets that could incur valuation losses if recent US actions to limit financial turmoil and stimulate the economy generated inflation and dollar depreciation (not unrelated to the problems France faced with its 1920s “sterling trap”).
Devil in the detail

* Adopting the SDR as a reserve asset is technically feasible, but it will not reduce the dollar’s role any time soon.
* People reap substantial economies from conducting cross-board commerce in dollars, and until the SDR matches these benefits – which is a long way off – central banks will still need dollars.

If anything, the euro is likely to challenge the dollar’s pre-eminence.

In the interim, countries that want to limit their exposure to credit-based reserve currencies, like the dollar, might simply allow their own currencies to appreciate.
Something old, something new

Complaints about the dollar and a fascination with SDRs are not new. The IMF created SDRs as an international reserve currency in the late 1960s to solve problems similar to China’s concerns that rose out of the Bretton Woods fixed-exchange-rate system. After World War II, the US dollar quickly emerged as the world’s key international currency, both as an official reserve unit and for financing international commerce.

Then, as today, countries accumulated reserves when they limited the appreciation of their currencies in the face of persistent balance-of-payments surpluses. Once acquired, official reserves then provided these countries with a buffer stock that they could draw down to mitigate the disruptive economic effects of unexpected balance-of-payments reversals.

Absent such reserves, these countries would either have to allow their currencies to depreciate or quickly tighten their monetary policies, but such abrupt adjustments might not be compatible with these countries’ current goals for inflation or real economic growth.
Dollar overhang and the closing gold window

By the early 1960s, many countries began to view their official dollar holdings as excessive. They worried that the US might be forced to devalue the dollar, saddling them with foreign-exchange losses. As the situation unfolded, some countries, led by France, sought to replace the dollar with a reserve currency unrelated to any single national currency, if not solely related to gold.

The IMF – then the guardian of the Bretton Woods parity grid – came up with the SDR. The IMF initially defined the SDR in terms of a fixed amount of gold, then equal to one dollar, and allocated 9.3 billion SDRs between 1970 and 1972 in proportion to member countries’ quotas in the IMF. On 15 August 1971, however, President Nixon closed the US gold window, refusing thereafter to convert dollars into US gold. By March 1973, the large developed countries had all allowed their currencies to float against the dollar, ending their need for any dollar reserves.

Despite the widespread acceptance of floating exchange rates, no country – including the US – has completely eschewed its portfolio of foreign-exchange reserves. Still, floating doomed the SDR. The IMF redefined the SDR as a weighted average of the US dollar, the British pound, the Japanese yen, and the currencies that eventually comprised the euro and made a second allocation of 21.4 billion SDRs between 1979 and 1981. Nevertheless, the SDR quickly devolved for the most part into a unit of account, primarily on the IMF’s books.
The dollar

The dollar remains reserve currency of choice. The IMF estimates that 64% of the world’s official foreign-exchange reserves are held in dollar-denominated assets. The euro, the second most widely held international reserve currency, lags well behind, followed by the British pound and Japanese yen.

These currencies’ official reserve rankings parallel their status in international commerce more generally. This correlation should be of no surprise. Why hold a currency that no one uses? According to a 2007 BIS survey, roughly 88% of daily foreign exchange trades involve dollars. Again, the euro is a distant second, with the British pound and Japanese yen trailing.

Network externalities from dollar usage

The world reaps substantial economies from using dollars.

* Many foreign-exchange transactions, even ones not directly involving US residents, are denominated and undertaken in dollars.
* International trade in fairly standardised commodities and in products that sell in highly competitive markets is typically conducted in US dollars. Invoicing in a single currency helps producers keep their prices in line with their competitors and simplifies price comparisons across the different producers. Naturally, these invoicing gains rise with the number of producers.

In contrast, international trade in heterogeneous manufactured goods, where price competition is not as crucial, tends to be denominated in the exporters’ currencies, but even in these cases importers – or their banks – will often acquire the exporters’ currencies by first trading their home currencies for US dollars and then trading dollars for the exporters’ currencies.
Size matters

The dollar has maintained this role over the years, despite substantial fluctuations in its exchange value, because the size, sophistication, and relative stability of the US economy generally render the costs of transacting in US dollars lower than the costs of transacting in currencies that do not equally share these characteristics. In large part, the widespread use of the dollar developed and continued because the US has been the largest, most broad-based exporter and importer in the world. With a lot of Americans trading globally, a lot of dollars will naturally change hands. Because traders must finance a large portion of their business in US dollars, they maintain accounts, seek loans, and undertake myriad other financial arrangements in dollars.

A strong and open US financial system helped facilitate the dollar’s international use. While a high degree of feedback naturally exists between the dollar’s expanding role in trade and the growth of an accommodating financial structure, US financial markets have always been innovative and relatively free of cumbersome regulations. Their breadth and depth enhances the liquidity of dollar-denominated assets. Moreover, as dollar trade expands and US financial markets grow, more and more foreign financial firms – even ones not located in the US – offer dollar-denominated products. All this makes holding dollars convenient and transacting in dollars relatively easy.

As the global network for dollars expands, the benefits of using the dollar in exchange rise. The process is self-reinforcing. Moreover, once the network benefits of a particular currency become substantial, people are prone to continue using it, even if viable competitor exists. The debate on the SDR’s possible challenge to the dollar echoes many of the points made in the dollar-vs-euro debate. The euro matches many of the dollar’s qualities, and its use continues to expand. Making the jump to a new international currency, even one as widely used as the euro, requires a substantial proportion of people to make the jump in close concert. Otherwise, the network benefits are lost. For that reason, the world is not likely to shift quickly away from dollars even if the SDRs become a new international-reserve option.
What’s a country to do?

Of course, if foreigners suspected that the costs of holding dollars in terms of lost purchasing power would soon exceed the network benefits of transacting in dollars, they might quickly migrate to an alternative international currency. At its core, China’s SDR plan may reflect a fear of US inflation. As Chinn and Frankel (2008) argue, the likely candidate is the euro, not the SDR.

In the meantime, countries – like China – that worry about their expanding dollar portfolios have another option – allow their currencies to appreciate.

Between mid-1995 and mid-2005, China pegged the renminbi to the dollar and bought dollars flowing into China through trade and investments. Had China not done so, the renminbi would have appreciated against the dollar, until the dollar inflow stopped. Between mid-2005 and mid-2008, China allowed the renminbi to appreciate against the dollar, but continued to limit the renminbi’s appreciation. Recently, the renminbi has remained little changed relative to the dollar. All this is fine; many countries manage their exchange rates, particularly to avoid appreciations, but accumulating a foreign-exchange exposure is a cost of doing so.
References

Bennett T. McCallum, “China, the US Dollar, and SDRs” presentation at the Shadow Open Market Committee, 24 April 2009, Washington, D. C., Cato Institute.

Linda Goldberg and Cedric Tille, “Vehicle Currency Use in International Trade,” Journal of International Economics forthcoming

Menzie Chinn and Jeffrey Frankel. “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Currency.” 2008,

Zhou Xiaochuan “Reform the International Monetary System” People’s Bank of China, March 3, 2009

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Paul Wilmott - number cruncher who foresaw financial crash

Elena Moya, The Guardian, Friday 1 May 2009
http://www.guardian.co.uk/business/2009/may/01/paul-wilmott-interview



Photograph: Christian Sinibaldi

Paul Wilmott, one of the world's leading financial mathematicians, looks like a 30-something, although he is 49. Mathematics keeps him in shape, he says, relaxing in his jeans and trainers in his Bayswater flat.

Wilmott has made his name and fortune by applying mathematics to finance and now claims to run the biggest "quantitative analysis" website in the world. So-called "quants" combine maths and finance to produce many of the models that underlie the complex derivatives blamed for causing the credit crunch.

Wilmott had been warning for years that the models used by banks to value their assets were wrong. "Reality has vindicated me," he says. "I stood up in front of paying audiences and told them that they trusted the formulas too much and that they were also paid too much." A few people stormed out of his conferences, slamming the door, he adds.

The banking system crash has seen $1tn wiped off banks' assets worldwide after the complex formulas were proved wrong: the assets had been overpriced and the relationships between them were different from what was initially thought. If a sub-prime mortgage collapsed, millions of others followed suit.

"Following the formulas was like relying on your seatbelt to drive crazily: it's not going to save your life. People in risk management don't know a fraction of what they should; they're not sceptical, they haven't tested the data or used their imagination to find solutions."

Wilmott is also critical of the government's approach to the crisis. He claims its plan to insure more than £500bn of banks' toxic assets is based on a model and won't work as it only involves two banks (HBOS and RBS) leaving others outside the programme. Involving only a few banks won't kick-start the circular nature of inter-bank lending as all banks need to be involved.

"Governments know nothing of this subject, they spent two minutes thinking about it, without considering the consequences or getting [advice from] consultants," Wilmott says. "They're like rabbits caught in headlights. They are only talking to the bankers who got us into this mess, or lords or ladies who know nothing. They should be getting advice from people like me, who saw this coming."

According to Wilmott, the Financial Services Authority isn't much better. "They can't afford to pay the best people; we should send regulators to derivatives courses so they could ask questions to the banks."

Wilmott is angry about the amount of "idiots" who got the world into the present financial crisis. He was one of the thousands of protesters against the recent G20 summit. "Why weren't there more people there?" he wondered.

Wilmott is an evangelist for maths and its application to everyday life. His book on quantitative finance is used around the world by hordes of bankers who run the world's top trading desks.

Wilmott goes one step further than most of his peers, as he also tries to integrate into his analysis the financial world's biggest challenge to rationality: human behaviour.

"You can model electromagnetic waves: a mathematical model that shows molecules of air moving around a plane, making it fly," he says. "But in a financial model, you need more than numbers. The models in finance are not very good. In this field, it matters if you're not psychologically synchronised; people don't behave rationally. You can't rely on people following equations. It's half maths and half human."

Juggling

The son of an accountant and an entrepreneurial mother, both Paul and his brother became mathematicians. From an early age, at a grammar school in Birkenhead, Wilmott says he was always good at maths - and business.

As a child, he put together his vast collection of pets and organised a zoo that neighbours paid to visit. As an undergraduate at Oxford, he earned his pints from street performing with his juggling clubs. Ventures followed as the years went by, including a £170m hedge fund, which closed about four years ago after a fall-out between the partners.

Wilmott's two sons are also interested in maths; Zachary, 17, is preparing for his A levels in maths and Oscar, 19, is studying maths at Imperial College, London. His children may have followed his path because "I am an enthusiast, and they are intelligent," he says, adding that he didn't flood his sons with numbers from an early age.

"Mathematicians don't use numbers. Mathematics is about abstraction, all we use are symbols. If we keep educating in adding numbers, they won't go beyond a McDonald's desk." Calculus and algebra, which deal with concepts such as links between variables, are much more practical and important in life.

"Politicians say maths needs to be more practical, but you have to be more abstract. Mathematics makes your brain think in a very different way; a lot of people are afraid of it, but it's fun and intellectually satisfying."

Wilmott has focused on practical - and financial - rewards, since his days at Oxford, where he read maths and also got a PhD in fluid mechanics. At university, Wilmott designed a model that analysed the speed and efficiency of a double-razor shaving machine aimed at determining how far apart the blades should be, and which angle and speed would make the shaving most effective.

As the years went by, he also designed models on turbine plates for jet engine maker Rolls Royce, and other models for British Steel, British Telecom and for an explosives company that needed to calculate how to best blow up a mountain - "close to the edge of the mountain, but not too close," Wilmott remembers.

He travels the world lecturing bankers and regulators about quantitative finance and valuation methods. He also focuses on his teaching in 7City, a City-based professional training centre, and on his quants book, which he published in 1993 for the first time and keeps updating. His next challenge would be to develop a product that can make life more comfortable, and turn it into a business, he says.

Constants

"I'd never go and work for a bank, I am not an employee type. I don't respond well to orders. I am spoiled, I've done all my life what I wanted, my parents didn't stop me, so I've had an interesting life with lots of variety."

Business and maths are the two constants in his life - the professional one, at least. "Maths ruins your personal life," he concedes. "Some mathematicians have no connection with the real world and it's very hard to talk to them. But I am a fairly normal human being even if I am a mathematician. Others don't have any empathy, but I am in tears in half of the movies that I see."

He plugs into life by spending time with his American wife and his two children, skiing, or driving one of his three cars. Other mathematicians forget the real world, or see it in their own terms, Wilmott says. "I am talking the colours of the rainbow and they only see black and white."

Still, he admits applying maths to his personal life: while arguing with his wife, he sometimes uses the "reductio ad absurdum" principle to prove a point. In a delicate or tense conversation, bringing up extremes may not be the best way towards consensus, he acknowledges.

But the mathematical habit of challenging assumptions has always been a constant in his life, and he swears it always will be. "The natural thing for me is to think there is something wrong if everybody is agreeing."
CV: Paul Wilmott

Born 8 November 1959

Marital status Married to second wife. Two children

Education BA maths, PhD, applied maths, St Catherine's College, Oxford

Career

2002-present: Course director for certificate in quantitative finance

2002-2005: Partner in Caissa Capital Fund Management (NY and Bermuda)

1999: Academic director for Oxford University department for continuing education programmes in mathematical finance; founder of the diploma in mathematical finance

1997-1999: Group leader and founder of mathematical finance group at Oxford University

1996-present: Wilmott Associates. Clients include: Banco Santander; British Telecom; Citibank; IBM; Nationwide