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One of Russia's official policy goals is for the ruble to become a leading regional reserve currency. President Dmitry Medvedev presented his vision in general terms almost a year ago at the St. Petersburg economic forum. More recently, at the Group of 20 meeting in London on April 2, Medvedev suggested against a background of financial volatility that "It would be wise to support the creation of strong regional currencies and to use them as the basis for a new reserve currency."
To many observers, such an ambition seemed derisory even before the financial crisis. With the crisis, it seems almost delusional. Not only are we in the midst of the greatest economic collapse since the Great Depression, but the flight to safety has, if anything, reinforced the central role of the U.S. dollar as the global reserve currency par excellence. The British pound and the Swiss franc have both slipped in recent months. The yen wobbles as speculators try to decide whether to pursue or ditch their carry trades. The euro still lacks political cohesion. It certainly looks like the dollar should reign supreme for years, if not decades, to come. And perhaps it will.
But maybe not. Let's be clear what we are talking about. An international reserve currency is one that is used outside its home country. The attractiveness of a reserve currency can be considered in terms of the three classic functions of money domestically: as a store of value, a medium of exchange and a unit of account. Under each function, governments and private actors sometimes choose to use a currency that is not their own. With these notions in mind, one can broadly denote the common features of reserve currencies. First, the currency must be widely used in international transactions. Second, it has to be linked to deep and open financial markets. Finally, people need to have confidence the purchasing power of that currency will remain fairly stable.
Once a currency is widely used and held as a reserve currency, its use is likely to continue owing to inertia. But that situation can change. If a central bank fails to sustain confidence in the future value of its currency, participants in the global market will eventually find substitutes. One of the consequences of globalization is that substitutes do exist for any currency if policymakers allow inflation to erode its purchasing power.
If anything, the performance of the ruble and Russian markets since late last summer would suggest that none of these conditions is fulfilled. After all, the ruble was devalued, domestic security markets collapsed and capital flight took off. There was even talk about the reimposition of capital controls that had been abolished only on July 1, 2006. To be fair, the pound fell by more against the dollar, and market dysfunctionality was not unique to Russia.
Nevertheless, it could be that the Russians are on to something.
Last week, despite the apparent appeal of the dollar in the midst of this global crisis, the U.S. bond market -- often a harbinger of future trends -- suddenly panicked, and the prices of U.S. Treasury bonds plummeted with 10-year yields jumping to over 3.3 percent. This could be ominous for the future of the dollar.
For those of us old enough to recall the 1960s, an analogy may be appropriate. In the 1950s and early 1960s, the dollar was also considered scarce. Everyone wanted dollars. It was stable, safe and totally liquid. Then, starting in the mid-1960s, prudent economic policies were loosened to pay for a foreign war (Vietnam) and President Lyndon Johnson's Great Society. This quickly led to a dollar glut. President Richard Nixon then broke the dollar's link with gold, and several years later President Jimmy Carter had to issue foreign currency-denominated bonds. Investors sought the safety, strength and liquidity of the main creditor country currencies -- the German mark and Swiss franc.
The parallel with today's dollar overhang is worrying. Zhou Xiaochuan, governor of China's central bank, following the lead of Medvedev, has suggested creating a "supersovereign reserve currency" to replace the dollar over the long run. He would sharply enhance the global role of Special Drawing Rights, or SDRs, the inter-national asset created by the Inter-national Monetary Fund in the late 1960s.
The United States and several other governments, however, have been quick to reject the Russian and Chinese proposals, reaffirming their confidence in the key global role of the dollar. They apparently fear that serious discussion of this issue could shake confidence in the dollar, driving down its value and prompting a sharp rise in the euro and other currencies. Such instability and consequent rise in global interest rates would severely complicate crisis recovery efforts in the United States, Europe and the rest of the world. But there is a more immediate threat to the dollar than that represented by pursuing these limited proposals for reserve diversification. The risk is that China, Russia and perhaps other monetary authorities -- who together hold more than $5 trillion in dollar reserves -- will lose confidence in the dollar because of excessively large budget deficits in the United States.
These worried dollar holders have thus far refrained from dumping U.S. Treasury securities only because their prices were rising and the dollar has strengthened over the past year -- both of which are almost certainly temporary -- and because of the adverse global repercussions. This situation is unlikely to be sustainable for long, and last week's disappointing auction of Treasury bonds must tempt some to book their profits before the stampede begins. Big conversions by Russia, China or another large holder, or even market fears thereof, could trigger a massive run on the dollar.
Even then, a wobbly dollar doesn't guarantee a global future for the ruble, but it does increase the likelihood that reserve currency substitutes will be in demand. It is highly unlikely that an artificial reserve asset like the SDRs will play more than a supporting role in a world still dominated by nation-states. For the foreseeable future, only national currencies can deliver the attributes sought for reserve currencies. The only issues are which ones and when?
But one thing is certain: Currencies of creditor countries, as in the past, will be preferred. In today's world, this would include China, Japan, Russia, South Korea and Saudi Arabia. Of course, the other conditions must also be realized. Medvedev's vision for the ruble may not be so far-fetched, but the crisis has exposed just how much still needs to be done to make it come true.
In the end, whether the dollar continues to play its central reserve role depends above all on U.S. economic policies, but last week's U.S. Treasury market may portend that potential new players could be thrust into leading roles sooner than they think.
Martin Gilman, a former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics.
