A key topic at the G20 meeting is sure to be the future of the dollar as an international reserve currency. The global financial crisis, which started with the US subprime crisis, has eroded confidence in the dollar as an anchor for international payments. Moreover, large US fiscal deficits could add more than US$10 trillion to US government debt over the next decade - on top of trillions of dollars of implicit debt in social security and Medicare.
The US debt bomb poses a growing risk to China and other countries that hold large amounts of their foreign-exchange reserves in dollar- denominated assets, primarily US government securities. If foreign central banks are less willing to hold US debt, the Federal Reserve may be the buyer of first resort.
Running the printing press to absorb new debt would ignite inflationary expectations. If political pressure prevents the Fed from quickly withdrawing excess liquidity, the purchasing power of the dollar would fall sharply - and all those who hold dollar debt would suffer a loss of wealth.
China, with nearly US$2 trillion in foreign exchange reserves, would be the biggest loser if the US were to use inflation to reduce the real burden of its debt. That is why, for the first time, Chinese leaders are openly worrying about the future of the dollar as a reserve currency.
In a now widely cited speech released by the People's Bank of China on March 23, governor Zhou Xiaochuan raised a fundamental question: 'What kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?' Dr Zhou pointed to the 'institutional flaws' in the current global financial system and argued that reform must create 'an international reserve currency with a stable value, rule-based issuance, and manageable supply'. His specific recommendation is to expand the use of Special Drawing Rights, or SDRs, a synthetic currency created by the International Monetary Fund in 1969.
Currently, the value of an SDR is defined by a basket of key currencies (the dollar, euro, yen and pound). SDRs are not accepted for transactions, and are a tiny fraction of total reserves. Creating a global reserve currency under the direction of the IMF would not solve the underlying problem of the lack of an anchor in a pure fiat money world.