Submitted by JC Collins  –  philosophyofmetrics

USD RMB SDRThe international monetary system is inherently unstable, and the process to shift from a unipolar to a multi-polar system is well underway.  The transition itself will take considerable time to fully implement and we are now somewhere between the first and second stages, with a third stage scheduled to be completed in the coming years.

The unipolar USD framework which forms the base of the international financial system today is built on the accumulation of USD assets in the foreign reserve accounts around the world.  One of the transition requirements for the multilateral framework is to mitigate the demand for these foreign reserves and to implement a method of diversifying the existing accounts.

We have previously discussed the purpose of the substitution accounts as a method of mitigating USD instability in the foreign reserve accounts, and moving forward with  diversifying the composition of those accounts with SDR bonds to increase global liquidity.

One of the risks associated with  mitigating demand for USD’s in the accounts and further diversifying them comes in the form of exchange rate instability.  With increased demand for SDR securities will come increased demand for SDR denominated claims.  In order for these risks to be minimized, or eliminated, the exchange of assets through the substitution accounts must be completed in the same proportion as the composition of the SDR basket itself.

This basket is currently made up of four of the major reserve currencies in the world, being proportioned at the following percentages:

USD – 44%

Euro – 34%

Japanese Yen – 11%

British Sterling – 11%

Obviously any attempt to diversify the foreign reserve accounts at this present composition will not effectively calculate for the massive amounts of USD which has accumulated in the foreign reserve accounts of countries like China, who is the second largest holder of US Treasury Bonds outside of the Federal Reserve itself.

The substitution accounts will utilize a mechanism structured around the quota amounts set for each participating country which will equally share any exposure to volatility and risk associated with a disorderly decline in the USD.  But the quota amounts are ineffective as they do not accurately reflect the reality of the emerging economies and the amount of USD held in the foreign reserve accounts of the emerging countries.

We’ve thoroughly covered the the process by which the 2010 Quota and Governance Reforms of the IMF have been delayed by the American Congress, and how the international community, lead by the IMF and the G20, are calling for the implementation of Plan B to have the reforms enacted.  See here.

Additionally, we’ve covered the internationalization of the yuan, or renminbi (RMB) and its de-facto status as a reserve currency, all in preparation for inclusion into the SDR basket in 2015.  See here.  And here.

When China exchanges the USD held in their foreign reserves for SDR bonds through the substitution accounts, that liquidity will in essence be RMB liquidity as determined and defined by the quota amounts.  Any SDR quotas can be exchanged back into the currency of the country holding those amounts, so in China’s case, the yuan.

The “cost” and risk sharing structure of the substitution accounts will only work when the exchange is arranged in the same proportion as the SDR composition.  Once the RMB is added to the SDR basket the process of diversifying the foreign reserve accounts, USD to SDR to RMB, or other currencies, can begin.

The massive QE program by the Federal Reserve has ensured that low liquidity assets held by banks were exchanged for high liquidity assets, and now those low liquidity assets which the Fed has on its balance sheet will be exchanged for SDR liquidity.

But before that can happen the IMF Quota amounts must be adjusted and the SDR composition will need to be altered so as to enable the usage of the substitution accounts.  It is extremely probable that the huge trade imbalances which America has had with China, and the large amounts of USD which has been allowed to accumulate in China’s foreign reserve accounts, were engineered specifically for the eventual inclusion of the yuan in the SDR basket.

The next stage of the transition to a multi-polar financial system was designed to utilize the RMB as the mule for USD instability.  China will only unload US debt through the substitution accounts in exchange for SDR liquidity.

It is expected that all concerned wish to avoid a disorderly decline in the USD as the foreign reserve accounts are diversified and the associated risks are mitigated.  And in fact the Plan B being implemented by the IMF and G20 will also encourage an orderly transition away from massive USD reserves, but now that the American Congress has not enacted the supporting legislation for the 2010 Quota and Governance Reforms, the success of Plan B will depend on the level of resistance by the domestic interests of the USD.

There is no doubt that the amount of USD in the foreign reserve accounts does give America a level of negotiating power, but the endgame, at least for this stage of the transition, will require American acceptance of adjustments to quotas and the governance structure of the IMF, as well as the inclusion of the RMB into the SDR basket.

Without this the substitution accounts will not work and there will be a disorderly shift away from and decline in the USD. The economic turmoil in the international economy and the volatility in the currency markets are symptomatic of this transition from unipolar to multi-polar which is taking place.   – JC