Zhou Xiaochuan, governor of China’s central bank, has suggested creating a “super-sovereign reserve currency” to replace the dollar over the long run. […] These are the first big proposals for international monetary reform from China or indeed any emerging market economy and deserve to be taken seriously for that reason alone.
Several other Asian countries, Brazil and Russia have expressed support for Mr Zhou’s ideas. The US and several other governments, however, have been quick to reject them (There’s a shock. Ed.), reaffirming their confidence in the central 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 US, European and global recovery from the crisis.
But there is a more immediate threat to financial stability […] that China and perhaps other monetary authorities, together holding more than $5,000bn in dollar reserves, will lose confidence in the dollar owing to the prospects for huge and sustained budget deficits in the US. […] We ignore at our peril the prospect that they may feel compelled to do so, especially if the US were to provoke the Chinese by taking aggressive trade policy actions against them. Big conversions by China or another large holder, or even market fears thereof, could trigger a massive run on the dollar.
Mr Zhou proposes to alleviate this problem by creating “an open-ended SDR-denominated fund” (Special Drawing Rights) at the IMF into which dollar balances could be exchanged for SDRs. This is essentially the substitution account idea negotiated in the IMF in the late 1970s and for which detailed blueprints were developed. Similar anxieties about the dollar at that time prompted its sharpest plunge in the postwar period, intensifying the double-digit inflation and soaring interest rates that brought on the deepest US slowdown since the 1930s, until now.
The substitution account would be a winning proposition for all concerned. The dollar holders would obtain instant diversification. The US would avoid the risk of a free fall of the dollar. Europe would prevent a sharp rise in the euro. The global system would eliminate a potential source of great instability.