The case for fixed exchange rates

In an earlier article (Business Standard, March 24, 2019), the need for dispensing with the outdated relic called special drawing rights (SDRs) was discussed. This article deals with the implications of abolishing SDRs and contemplates a return to the Bretton Woods system of fixed exchange rates, where the value of a currency is determined by the US dollar and gold.     

           

SDRs, an international reserve asset created by the International Monetary Fund (IMF) in 1969 to support the Bretton Woods’ fixed exchange rate system, should have been abandoned immediately after US President Richard Nixon’s announcement in August 1971 that the US would no longer exchange dollars for gold at the fixed exchange rate of $35 per ounce. On the contrary, the SDR, redefined as a basket of 16 currencies from 1974 to 1980, was replaced in 1981 by a basket of five currencies — the US dollar, Deutsche mark, French franc, pound sterling, and the Japanese yen.    

                                     

After the introduction of the euro in January 1999, the SDR basket included only four currencies: The dollar, the euro, the pound and the yen. It was expanded in 2016 to accommodate the Chinese yuan as the fifth currency. Of these five currencies, both the euro and the pound sterling are in trouble and continuance of the SDR as an international reserve asset in its present form is no longer viable. The other two, the yen and the yuan, are well known for currency manipulation in the past to boost exports.

In 1985, the Japanese yen at 220 to a dollar had almost killed the US auto industry, until President Ronald Reagan imposed import quotas on Japanese cars, and the yen rose to 120 to a dollar. Strangely, the IMF had failed to remove the yen from the SDR basket in its 1986 review. Had this been done, the Chinese yuan, which President Donald Trump refers to as the “grand champion of currency manipulation”, would not have found its way into the SDR basket in 2016. This leaves out only the US dollar. In other words, this would signal a return to the fixed exchange rate regime.   

 The price of gold has remained remarkably stable during long periods of time. Isaac Newton, in his capacity as the Master of the UK Mint, fixed the price of gold roughly equivalent to $20 per troy ounce of gold in 1717 and it remained at this level until 1914. The official US gold price changed only four times between 1792 and the present. Starting at $19.75 per troy ounce, it rose to $20.67 in 1834 and $35 in 1934. In 1972, the price was raised to $38 and then to $42.22 in 1973. A two-tier pricing system was created in 1968, and the market price of gold has been free to fluctuate since then.

A careful appreciation of gold prices from 1833 to 1971 on the one hand and the behaviour of gold prices in the post-1971 era constitute the basis of my plea for abolition of the SDR and a return to fixed exchange rates. Gold prices have risen beyond one’s imagination in the post-1971 era (from less than $41 per ounce to over $1,500 in 2011), when the Bretton Woods system was abandoned and exchange rates were subject to the values of various currencies in the SDR basket. A comparison of gold prices before and after 1971 is striking, and provides enough justification for a return to fixed exchange rates.

        

The US holds the largest amount of gold — 8,133.5 tonnes, which accounts for 75 per cent of its reserves. In fact, its gold holdings account for 36 per cent of the total of 22,657 tonnes of gold held by the next ten countries. 

Once the US dollar replaces the SDR as the single reserve currency, the dollar could qualify to be a common currency for a select number of countries. Even after the introduction of the euro in 1999, the dollar accounts for nearly 64 per cent of global currency reserves, compared to 27 per cent held in euros, with 40-60 per cent of international financial transactions being denominated in dollars. If both the UK and the European Union were to adopt the US dollar as their currency, it could lead to substantial savings in terms of conversion and transaction costs for payments to the Gulf countries for oil, which is priced in dollars. But if a country such as France were to join the dollar zone, it will be necessary to return all the gold France exchanged for the dollar prior to August 1971.

As in the case of the Maastricht Treaty for the euro, the US Federal Reserve in close coordination with the IMF should evolve specific criteria for admission of countries into the dollar zone. Apart from the eleven countries who joined the euro zone in 1999 and Britain, the dollar zone could cover counties such as Canada, Australia and Singapore, provided they satisfy the criteria to be prescribed for the purpose. The replacement of SDRs by the US dollar could mark the culmination of President Trump’s “America First” initiative.    

The writer was formerly with the IMF