The Debts of the Lenders: Another Look at China's SDR Proposal

China stunned markets earlier last week when it openly challenged dollar hegemony by calling for an alternate reserve currency. The markets have since recovered and have basically called China's bluff as nothing more than political posturing ahead of the G20 meeting later this week.

Today both Chinese and US officials refused to comment on any currency negotiation except to say that it is off the table . . . . for now.

However, that does not change China's displeasure w/American fiscal profligacy. So, w/that in mind let us take a closer look at the SDR or special drawing rights.

SDRs are a form of "currency" that is composed of a basket of currencies. In the past that basket has traditionally been composed of major G7 currencies such as the Dollar, the British Pound, the Euro (the German Mark and French Franc before the Eurozone's integration) and the Japanese Yen. SDRs are not true currencies in the sense that they can be freely traded at the retail level.

Instead SDRs are an INSTITUTIONAL form of "currency" which acts more like a claim or ticket w/a supra-national body such as the IMF and other international organizations. In other words the SDR is an INTERNAL accounting unit. The value is more political than economic as you will be unable to find any commercial banks that trade in such things.

Goldbugs will perk up b/c the SDR has a history of being tied to paper gold and silver. But that is a tangent which I will not explore further here.

China created an immense buzz by suggesting - through both words and actions - that it would move to circumvent dollar hegemony by inserting its currency, the Yuan, as a 5th possible component of the SDR currency basket.

Will it happen?

Slowly but steadily. But any substantive change is unlikely to happen w/in the next 2 weeks.

Instead, I encourage readers to focus on the fundamentals - The Debts of the Spenders (G7 countries) and the Debts of the Lenders (emerging markets like China and the Arab oil states).

Dollar imbalances generated from a generation of cheap labor and commodity sales have contributed significantly to the current deflationary environment. The search is on to find a new "safe haven" (translation - a new borrower nation or group of nations) away from the dollar.

In the immediate forefront is the Eurozone's desperate attempt to fuel further bond offerings. Unlike Washington, London, and Tokyo, Asian lenders are less familiar w/(e.g. fewer trade ties) w/the EU. While China may have critical ties to INDIVIDUAL Eurozone nations like Germany they have fewer stakes w/the peripheral members such as Spain or Greece.

Therefore there is LESS of an incentive for China, Japan, or any savings rich nation to buy the sovereign bonds of the Eurozone. While they MIGHT buy German or French bonds the underlying structural flaw of the Maastricht Treaty prevents Spain and Greece from debasing their currency as they have in the past. This amounts to further pain for the stronger members like Germany which are pressured to bailout the periphery. That is something few German taxpayers would want.

So, the Chinese solution has been to form some sort of peripheral "body w/in a body" that has supervisory authority over debtor nations like the USA and can dictate spending terms. While this is par for the course in the corporate lending world such notions brush against political complications in the sovereign legal realm.