U.S. DOLLAR HOLDERS MAY BE FORCED TO ACCEPT IMF RESERVE ASSETS IF THEY WANT TO DIVERSIFY; FLOOD OF DOLLARS THREATENS GLOBAL ECONOMY

December 12th, 2007

WARNING: This is not a recommendation to buy, sell or hold any financial instrument.

“This is the warning I’ve been repeating for years: You do not want to try to reach the exit as millions of other people attempt to do the same thing. Waiting for clarity is not often rewarded.

Cryptogon: Waiting for Clarity on the Brink of Oblivion

This is easily the most dire financial story in a generation.

I almost tagged the title with EMERGENCY, but I didn’t because the plan outlined below hasn’t been implemented yet. This is, however, almost certainly a warning of major dislocations ahead.

In my portfolio ideas post, I discussed the strategy that I have employed with our meager savings. That strategy called for 65% of our portfolio to be held in currencies other than the U.S. Dollar.

That strategy has worked well for us and sophisticated investors who have been a few steps ahead of the curve.

The problem, however, is that the herd now smells danger and the people who run the show want to block the exits. They want to try to contain the problem; keep it from spilling out into the rest of the world.

That problem is the U.S. Dollar.

Writing in the Financial Times, former Council on Foreign Relations economist, C. Fred Bergsten, lays out a global financial crisis management scenario that calls on the International Monetary Fund to absorb the flood of dollars that are looking for safety outside of the United States. Depositors would be issued instruments called SDRs (Special Drawing Rights), which the IMF defines as, “an an international reserve asset,” comprised of a, “basket of currencies, today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar.”

I’m not going to try to speculate as to what this plan would mean, because I don’t think there’s any way to comprehend how serious the implications would be.

States are considering controls to prevent U.S. Dollars from moving into their currencies, bloating them up and making their exports too expensive. There’s just too many dollars and not enough places for them to go. This is a global problem, and the IMF appears to be stepping into the vacuum that the collapse of the dollar is creating.

In summary: Ordo ab chao…

Via: Financial Times:

How to solve the problem of the dollar

By Fred Bergsten

Published: December 10 2007 19:24 | Last updated: December 10 2007 19:24

The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000bn, even a modest realisation of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy. Fears of such an outcome have risen sharply in both official circles and the markets.

However, none of the countries into whose currencies the diversification would take place want to receive these inflows. The eurozone, the UK, Canada and Australia among others believe that their exchange rates are already substantially overvalued. But China and most of the other Asian countries continue to intervene heavily to keep their currencies from rising significantly. Hence, further large shifts out of the dollar could indeed push the floating currencies far above their equilibrium levels, generating new imbalances and a possibly severe slowdown in global growth.

There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund through which unwanted dollars could be converted into special drawing rights, the international money created initially by the fund in 1969 and of which $34bn-worth now exists. Such an account was worked out in great detail in 1978-1980 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today’s circumstances.

There was widespread agreement, including from influential private sector groups and congressional leaders as well as the IMF’s governing body, that the initiative would enhance global monetary stability. It failed only because the sharp rise in the dollar that followed the Federal Reserve’s monetary tightening of 1979-1980 obviated much of its rationale, and over disagreement between Europe and the US on how to make up for any nominal losses that the account might suffer as a result of further depreciation of dollars that had been consolidated.

The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.

The fund’s members would authorise it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80bn would more than suffice.

All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 per cent dollars, 34 per cent euros, 11 per cent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimising the loss on their remaining dollar holdings as well as avoiding systemic disruption.

The US would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. Such consequences would be especially unwelcome today with the prospect of subdued US growth or even recession over the next year or so.

The international financial architecture would be greatly strengthened by a substitution account. In the wake of the dollar crises of the early postwar period, the IMF membership adopted SDR as the centrepiece of a strategy to build an international monetary system that would no longer rely on a single currency.

The move to floating exchange rates by most major countries in the 1970s postponed the need to pursue that strategy to its conclusion but also generated the extreme currency instability that triggered official consideration of an account. The global imbalances and large currency swings in recent years, and the accelerated accumulation of official dollar holdings by countries that have essentially reverted to fixed exchange rates, replicate the conditions that led to both the creation of SDR and the negotiations on an account.

A substitution account would not solve all international monetary problems nor would it suffice to restore a stable global financial system.

The dollar needs to decline further to restore equilibrium in the US external position. China, many other Asian countries and most oil exporters will have to accept substantial increases in their currencies now and much more flexible exchange rates for the long run. But early adoption of a substitution account would minimise the risks of adjustment of the present imbalances and the inevitable structural shift to a bipolar monetary system based on the euro as well as the dollar.

The writer is director of the Peterson Institute for International Economics. He was assistant secretary of the Treasury for international affairs in 1977-1981 and led the substitution account negotiations for the US in 1980

Related: Council on Foreign Relations on U.S. Dollar: “An Absurdity… Supported Only by Faith”

Related: Lessons for Today’s Market in 1907 Panic

Research Credit: PR (Special Thanks)

One Response to “U.S. DOLLAR HOLDERS MAY BE FORCED TO ACCEPT IMF RESERVE ASSETS IF THEY WANT TO DIVERSIFY; FLOOD OF DOLLARS THREATENS GLOBAL ECONOMY”

  1. dale says:

    “…unwanted dollars could be converted into special drawing rights…”
    Is this just before unwanted dollars are converted to heat?

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