When Russia was invited to join the
other G7 countries in 1997, it seemed odd. Many in the West
sympathized with the political motivation to provide positive
reinforcement to President Yeltsin and his hard-pressed government.
However, the relevance of Russian membership in that exclusive Club
seemed even more tenuous shortly thereafter in the wake of the 1998
Russian financial crisis and of a number of scandals which raised
questions about governance.
The oddity stems from the basic raison
d’etre of the G7 itself whose origins were, and essence remains, a
grouping of the world’s major economic powers. Russia’s membership
10 years ago seemed like a contradiction of the group’s
principles.
How ironic then that only recently does
an objective basis seem to be emerging to justify belatedly
Russia’s membership in the economic G8 – just as some Western
critics question whether Russia should still participate in the
political G8! The fact is that, within the last year, the Russian
ruble has started to acquire the characteristics of an
international reserve currency and the Russian economy in 2007 is
overtaking two (Canada and Italy) of the G7 using GDP at purchasing
power parity.
This article seeks to recall the
origins of the G5 as an economic grouping of the major
international reserve currencies, and Russia’s seeming misfit
within that club. It then goes on to outline the characteristics of
reserve currencies and especially the primacy of the U.S. dollar –
while stressing the likely decline of the dollar which opens the
scope for other currencies like the ruble to achieve reserve
currency status. Finally it considers the changes propelling the
ruble toward an international role and the likelihood that the
ruble will indeed become a reserve currency in the years
ahead.
FROM G5 TO G7/8
The Group of Five began as a currency
club after President Nixon closed the “gold window” in America in
August 1971, effectively undermining the global monetary system. It
brought together the representatives of the five major reserve
currencies included in the basket of the SDR, a sort of
international money created by the International Monetary Fund when
the world was concerned earlier with a dollar shortage.
Following Nixon’s unilateral decision
about the dollar link to gold, there were several other major
economic events in the early 1970s that had a profound effect on
the world economic system, including the collapse of the Bretton
Woods monetary system based on fixed exchange rates; the first
enlargement of the European Community, with Britain, Denmark and
Ireland joining the original six members; the first oil crisis,
when OPEC placed an embargo on oil supplies following the October
1973 Yom Kippur war; and the 1974 economic recession in OECD
countries, in which both inflation and unemployment rates rose
sharply (i.e., stagflation).
In these circumstances, the traditional
mechanisms of international cooperation like the IMF were no longer
seen to be capable of reconciling the differences among the leading
Western powers or to give them a sense of common purpose. It was in
this evolving context that the finance ministers of the United
States, Germany, Britain and France, meeting on 25 March 1973 in
the White House library, became known as the Library Group. Later
joined by Japan, the group met periodically and came to be known as
the Group of Five finance ministers (G5), sometimes joined by
central bank governors.
Some two years after the initial
get-together of the Library Group, they began to meet formally.
France hosted the first summit meeting in 1975 at the Chateau de
Rambouillet. By that time, an aggrieved Italy inserted itself. In
their first Communiqué in November 1975, the G5 agreed to work
for greater stability to international monetary problems, involving
efforts to restore greater stability in underlying economic and
financial conditions in the world economy. They also pledged to act
to counter disorderly market conditions, or erratic fluctuations,
in exchange rates.
In the following year Canada was
invited to join, as was the European Union in 1977. Over the years,
the purview of the G8 has increased. From just economics in 1975,
they expanded not only their format and structure, but also the
number of issues on which they now take initiatives.
Russia’s participation in this group
was clearly a non-economic decision and underscored the dispersion
of focus from management of the international monetary system. With
politics in mind, the first President Bush proposed to admit Russia
as a full-fledged G7 member at the Munich summit in 1992. His
suggestion was considered premature, but Russia continued to be
invited each year using a G7+1 formula. The June 1997 meeting in
Denver was called the Summit of the Eight and Russia officially
joined in 1998 at the Birmingham summit.
Even with its membership in the G8, it
was understood that Russia, with its weak currency, low reserves,
high inflation, extensive dollarization, and the recent memory of
the 1998 default, was invited solely for the political side. It was
commonly appreciated among the G7 finance ministries and central
banks that Russia’s presence wasn’t just odd – it seemed ludicrous,
so Russia was effectively excluded from the G7 league of the major
international reserve currencies, those effectively managing the
international monetary system.
WHAT IS A RESERVE CURRENCY,
ANYWAY?
This topic warrants a whole article in
itself. Suffice it to say that, historically, there have been
around a dozen international currencies used extensively outside
the borders of the country issuing them, from the dinari and
drachma of ancient Rome and Greece, to the dinar and ducato of the
Islamic empire and Venice, through to sterling and now the
dollar.
A simple definition of an international
reserve currency would be one that is used outside its home
country. Reserve currency status is just one aspect when
considering the international use of a currency. The others can be
thought of as the equivalents of the classic three functions of
money domestically – as a store of value, medium of exchange and
unit of account. Under each function, government authorities and
private actors sometimes choose to use a major international
currency that is not their own.
With this concept in mind, let me turn
to the general characteristics that tend to denote international
reserve currencies. For any currency to serve as an international
reserve currency, three features seem especially important: 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 that the purchasing power
of that currency will remain fairly stable.
It is relatively intuitive why
countries with a large share of global trade, or with large and
active financial markets, would be more likely to have their
currency used as a global reserve asset. The larger a particular
nation’s role is in international trade, the more cost-effective it
will be for other countries to settle their international payments
in that nation’s currency.
These benefits are reinforced when
these assets can be moved efficiently from savers to businesses and
investors. This will happen when financial markets are safe,
trading volumes are high, and capital controls are kept to a
minimum. A country will make an attractive destination for global
financial activity when its rules promote transparency and high
standards of risk management. In this regard, a well-functioning
regulatory and supervisory environment is especially important in
promoting the use of a nation’s currency in international
transactions.
There are also network externalities
involved in the use of a reserve currency. An individual (exporter,
importer, borrower, lender, or currency trader) is more likely to
use a given currency if everyone else is doing so. If a currency is
widely used to invoice trade, it is more likely to be used to
invoice financial transactions as well. If it is more widely used
in financial transactions, it is more likely to be a vehicle
currency in foreign exchange trading. If it is used as a vehicle
currency, it is more likely to be used as a currency to which
smaller countries peg.
This networking power is why central
banks hold dollars in their reserves in a far greater proportion
than the proportion of trade their country conducts with the U.S.
While less than 30 percent of international trade is with the U.S.,
it is estimated that almost 70 percent of central bank reserves are
in dollars. It is why most commodities, like oil, copper and coffee
are priced in dollars, wherever they are found and
traded.
Once a currency is widely used for
official and private transactions around the world, and once it is
widely held as a reserve currency, its use is likely to continue
owing to inertia. However, 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 for the currency. One of the consequences of
globalization is that substitutes do exist for any currency if
policymakers allow its purchasing power to deteriorate.
Even then, historically, changes may
occur only with a long lag. For instance, even after the United
Kingdom ceded its position as an economic superpower early in the
20th century, the pound remained an important international
currency. In the present context, this inertial bias favors the
continued central role of the dollar. However, this may not be the
relevant precedent as the UK remained a major creditor nation,
while the U.S. is now the world’s largest debtor. Doubts about the
future soundness of the dollar could trigger a “run on the
bank.”
DECLINE OF THE DOLLAR – A ROLE FOR
OTHER CURRENCIES?
If it were not for its “reserve
currency” status, the value of the U.S. dollar would presumably
have collapsed by now. An accumulated trade deficit of $4.4
trillion since 1996, and a heavy reliance on foreign financing to
pay for its external imbalances, has severely weakened America’s
global economic leadership over the past few years. The U.S.
dollar’s strength may result from still favorable factors such as
America’s political stability and military might, its large $12.5
trillion economy (28 percent of global GDP), deep and liquid
financial markets for bonds and stocks, and not least, positive
interest differentials.
And at the end of April, the U.S.
dollar fell to an all-time low against the euro, a new milestone in
a steep decline that began more than six years ago. The euro hit a
record high of $1.3682 on April 27th, up from $1.20 a year ago and
as little as 83 cents in October 2000, when the rally against the
dollar began.
What if foreign central banks
diversified their reserves? A sale of dollar-denominated reserves
would depress the value of the dollar vis-à-vis other
currencies, resulting in large capital losses and an appreciation
of their currencies, which would make their exports less
competitive. But it is not even a question of selling existing
reserves. The U.S. economy requires net financing from the rest of
the world of over $2 billion every day, absorbing almost two-thirds
of net global savings. If central banks decide simply to withhold
new purchases of dollar assets, the results will be
similar.
The willingness of individuals and
governments to hold a particular reserve currency depends on how
they view the stability of that currency’s long-run purchasing
power. A potential loss of purchasing power can erode the economic
benefits associated with using any particular currency for
international trade. When viable alternatives exist, individuals
and governments will gravitate toward the currency with the most
stable purchasing power.
The debtor position of the U.S.
underscores a key point, which is that a central feature of the
next couple of decades could be about the unwinding of the “dollar
balances.” The inevitable decline of the dollar as the world’s
reserve currency could be a painful one. U.S. consumption and
economic activity will be so constrained by the need to repay
dollar liabilities owed to foreigners, as to lead to a build-up of
social pressures or inflation or both. The U.S. is unlikely to
pursue such a painful path willingly and we can expect some
recourse to economic, financial, political and maybe even military
options to avoid or delay the inevitable.
Over the next decade or two, the dollar
will lose its role as the key reserve currency, perhaps to Russia,
China or India. Ironically, within this group, the ruble may be
well positioned to play an important role, at least as long as it
continues to be the world’s largest energy producer.
CAN THE RUBLE BECOME A RESERVE
CURRENCY?
What a difference ten years can make
for the prospects of a currency. The “hard” ruble – dropping 000 –
was introduced on 1 January 1998, at rub. 5.9 per dollar. A year
later, it was at about rub. 20 per dollar, and inflation rose by 84
percent in 1998. It was clear that Russians minimized holding
rubles, and held their savings mostly in dollars. This aversion to
rubles was reflected in the figures for money demand at barely 13
percent of GDP in 1997.
So it’s something of a landmark that,
15 years into its market transition, Russia made the ruble fully
convertible on 1 July 2006.
The decision to lift currency
restrictions is certainly a symbol of the remarkable turnaround in
Russia’s financial fortunes since the country’s financial collapse
and dramatic ruble devaluation in 1998. Record-high oil prices are
a sign that Russia is earning tens of billions of dollars each year
in extra export revenues, fueling the demand for rubles.
At the same time, the government has
been pursuing a highly conservative fiscal policy, using a large
part of Russia’s oil windfall to pay off debts and build up
reserves. Russia’s hard currency reserves, which stood at a meager
$15 billion in 1998, recently hit $400 billion. And meanwhile,
Russia is becoming a significant creditor country and donor to poor
nations and international development institutions.
Meanwhile, ordinary Russians are
accepting rubles like never before. Recent weeks have seen Russians
heading to the exchange kiosks in droves. Ruble-denominated bank
deposits have mushroomed from 300 billion rubles in 1998 to 4.24
trillion rubles ($53 billion) today. This is reflected in the money
demand numbers with the rate expected to climb to about 37 percent
of GDP this year (a level still well below the rest of
Europe).
True, the reason for this stampede has
less to do with confidence in the ruble, and more to do with
growing concern over the fate of the dollar. In late April, the
dollar plummeted below 26 rubles for the first time since
1999.
Nevertheless, it will take more than
simply lifting the final exchange restrictions to make the ruble a
truly convertible currency – freely traded around the world in
liquid 24-hour markets. There would have to be a greater interest
in the Russian currency by markets and central banks. Indeed,
international interest in trading rubles may only take off when the
government reduces inflation (presently around 8 percent) and
replaces its current managed-float exchange rate with a free float.
Until then, the move toward ruble convertibility is unlikely to
make much real difference to ordinary Russians, who will still find
it difficult to buy rubles or open ruble accounts outside the
country.
In the meantime, initial steps have
been taken to make the ruble more attractive to the international
market. Russian capital markets have been bolstered via the
issuance of ruble bonds, which have helped to broaden the funding
base of the Russian market, establish a transparent benchmark for
Russia’s debt and provide longer-term financing for the broad
economy.
For instance, the EBRD has raised
rub.19.5 billion via bond issues, launching a two billion ruble
Eurobond in January 2007, following three domestic bonds issued
earlier in the local currency market for a total of 17.5 billion.
In addition, KfW Group, a German state agency, and the largest
issuer of corporate bonds in Europe, and the Nordic Investment Bank
have issued ruble-denominated Eurobond.
Likewise, institutional steps have
helped to pave the way for the internationalization of the ruble. A
key step was the 2003 Securities Market Law that ultimately allowed
international borrowers to raise money on the domestic market.
Another vital preparatory element prior to actually issuing ruble
bonds was the creation of the Moscow Prime Offered Rates
(MosPrime), a transparent money market index which is Russia’s
equivalent of London’s LIBOR.
Also starting this year, the ruble
began trading as an international currency when Europe’s leading
clearing system, Euroclear, started settling inter-bank accounts in
rubles. And the world’s largest London brokerage, ICAP, has started
trading rubles on its electronic trading platform, EBS, in
competition with Moscow-based MICEX. These actions by the markets
signal that the currency liberalization in Russia has achieved de
facto international recognition.
In thinking about the future role of
the ruble, a historical perspective is useful. Surely, if asked a
100 years ago about the potential role of the dollar, a London
banker may well have been incredulous retorting that the United
States did not have the institutional maturity, the air of
stability and the depth of economy to possess the world’s reserve
currency. And they would have been right, in 1907, some six years
before the Federal Reserve Board was established and just two
decades after a period in which many states defaulted on their
civil war debts. But nothing is pre-ordained. The reality is more
mundane. Institutional maturity and economic depth come with
economic growth.
AND THE FUTURE?
It is not perhaps coincidental that
almost a year ago First Deputy Prime Minister Dmitry Medvedev said
that the global economy needed a more stable financial system based
not on the single reserve currency, the dollar, but on several
currencies. “The current economic situation in the United States,
the issuer of the single reserve currency, causes concern,” he
noted. Today, he said, new leaders were coming to the foreground,
with their stable currencies, which would lead to changes in the
financial system. “There are all prerequisites for the creation of
this system,” Medvedev stressed, adding that the ruble could well
become one of the world’s reserve currencies.
Since the beginning of this year, 50 of
the world’s currencies have risen against the dollar while only
eight have declined. Behind the falling U.S. dollar is a changing
global economy. China and the U.S. are the locomotives in the
global economy, accounting for 60 percent of all the global growth
in the last five years. But now, the $12.5 trillion U.S. economy is
slowing down as a result of the slump in the housing sector, while
the $2.5 trillion Chinese economy is overheating, expanding at a
blistering 11.1 percent pace in Q1.
India, China and other dynamic
economies, such as Russia, are expected to contribute more than 50
percent of world economic growth in 2007, with China’s contribution
alone being 30 percent and India’s 10 percent. In comparison, the
U.S. contribution to world growth is expected to fall to 12
percent, after its economic output plummeted to 0.8 percent in Q1,
the smallest gain in four years.
Every time U.S. year-on-year GDP growth
has dipped below 2 percent since 1960, a full-blown recession
unfolded. In contrast, the Euro zone economy is expanding at a
2.6-percent clip, its best performance in six years, and the
European Central Bank is aiming to lift its interest rate in June,
thus making the U.S. dollar less attractive next to the euro. As
such, many foreign central banks have been reducing their exposure
from the U.S. dollar and acquiring the euro and British pound over
the past year.
The scene may be set for other
currencies to start the road toward reserve currency status.
Certainly, if current trends continue, then both China and India
will be by far the largest economic powers within 20 years. If they
begin to acquire some of the characteristics that are needed for
reserve currency status such as stability, deep financial markets,
and high legal/regulatory standards, then the yuan and the rupee
could well become dominant in the international monetary system.
However, both countries, especially China, have significant
political, social, and legislative hurdles to jump in the process
and the outcome is not guaranteed, especially within a horizon of
the next ten years.
In the meantime, perhaps over the next
5-10 years, the Russian ruble may be well placed to start being
used as an international currency. The main obstacle may well be
political. The current climate of mistrust in Russia’s foreign
relations can certainly impede the internationalization of the
ruble, just as it raises serious questions in some Western capitals
about Russia’s continued participation in the G8 itself. Whatever
the business community may prefer in pursuit of market preferences
as one of the viable alternatives to the dollar, it is hard to
imagine the widespread use of the ruble outside Russia until there
is a rapprochement between Russia and its major economic partners.
Such an improvement in good relations is of course important for
its own sake, but it is indispensable if the ruble is to play a
wider role in global finance.
It may be worth recalling some comments
by former Fed Chairman Greenspan last October on the prospects of
the ruble as a reserve currency. He said that the ruble is “still
far from being a reserve currency. A reserve currency like the
dollar and euro should be extremely liquid,” he said. Greenspan
added that for the ruble to be an “external currency” it is
important that the “rule of law” prevails. “People would want to
invest in a country where they feel their money would be safe. In
the United States, we have worked on that for over 200 years. It
doesn’t happen overnight,” Greenspan said.
Right now, the only serious threat to
the U.S. dollar’s international dominance is the euro. Even so, the
Russian ruble has come along way since the 1998 default, and it is
about time for the perceptions to catch up with the new reality. If
only politics would cooperate, both the international role of the
ruble and Russia’s rightful place in the economic G8 would be
assured.
