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UAE Monetary Policy, China and the SDR

Published on: July 2009​
Author:
Genre: Economics/Finance​ Category: Op eds​
We have recently heard Chinese and Russian leaders talk about moving to a monetary regime where the US dollar does not hold the dominant position it currently enjoys. In particular, the discussion has centered on creating a new global reserve currency that would take the place of the dollar.

In light of these events, the head of the UAE central bank has announced a policy of staying-the-course with the dollar peg. How should we make sense of the idea of a reserve currency and should it influence monetary policy in the UAE?

Before discussing the viability of a global reserve currency, it makes sense to trace back the origins of the current international monetary arrangement. The US dollar is not the world’s reserve currency by chance. The US trade deficit with China has contributed to the rise of the dollar. It is paid for by running a (US) capital accounts surplus which takes the form of purchases by the Chinese government of US-denominated assets, and in particular government-issued debt. These assets, of course, are purchased in US dollars. This buoys the value of the dollar and contributes to its status as a reserve currency.

Interestingly, this situation is driven as much by the willingness of Americans to buy cheap Chinese goods as it is by the Chinese government’s monetary regime: by not allowing the Yuan to float against other currencies, the Chinese government is forced to accumulate foreign-denominated assets in its reserves, thereby stemming increases in the value of its? domestic currency.

The US-China trade deficit has made the Chinese government accumulate trillions of dollars of US financial instruments. All of these assets are tied to the value of the dollar, and this has put the Chinese government in a precarious position. Had it allowed the Yuan to float, we would have observed much vaster increases in the Chinese capital accounts deficit instead of increases in its central bank reserves. This would have pushed up the value of the Yuan and stemmed the flows of Chinese goods to the US.

The dominant position of the dollar is also due to the self-fulfilling nature of currency markets. Currencies, unlike stocks or bonds do not have a “fundamental value”: if the dollar is perceived to be the reserve currency, traders hoard it and drive up its price! This explains for example increases in the value of the dollar at the peak of the crisis a month or two ago: at the time, the Obama administration passed a deficit-financed government stimulus bill while the US Federal Reserve was mopping up "toxic assets" in the mortgage market. This had caused a huge increase in US money supply that international currency traders were all-too-happy to buy.

Back to the reserve currency: what is it and will it help? The reserve currency is simply a basket of currencies, and yes: it would include the US dollar. Since all currencies in this basket are traded according to the laws of supply and demand, the value of this reserve currency would reflect market preferences.

The choice of a Special Drawing Rights-type currency as a reserve is of course the choice of individual governments. In the case of the UAE and more generally the GCC, this may not be the best choice available: if the Gulf were to adopt an SDR as a currency peg, that would drive down the value of the dollar and affect the (dollar-denominated) value of its earnings from hydrocarbon revenue. These effects, of course, are only likely to be short-term as the long-run value of oil is determined by global demand for oil. Despite this, the policy would introduce volatility for government revenues in the Gulf.

The UAE runs a capital accounts deficit to balance out its current accounts surplus: hydrocarbon revenues are invested abroad, and since these revenues are dollar-denominated, they are invested heavily in the US. It may not be advisable for the UAE central bank to adopt an SDR as a peg since dollar-denominated earnings would introduce currency risk in its fiscal policy: instead, a policy of diversification of retained earnings from oil into non-dollar assets would reduce exposure to the dollar without any increased risk in government revenue.

The fear fuelling the discussion of a supra-national currency reserve rests on the perceived notion that the US dollar may fall in value, thereby eroding the value of ?dollar-denominated assets.

Ultimately, the mass-adoption of an SDR may end up precipitating this event and hurt the UAE and other countries with heavy exposure to the dollar. In this sense, there is no panacea for the troubles these governments are facing. In the UAE, a continued policy of a dollar peg minimizes overall monetary risk but is just one facet of the solution. The other involves a diversification of assets held in its capital accounts.

Tarek Coury is an assistant professor at the Dubai School of Government.

This article was originally printed in Khaleej Times. It can be accessed here.

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