How Have Multiple Reserve Currencies Functioned in the Past? Why were the Rules-Based Adjustment Indicator and the Substitution Account abandoned in the past?
Catherine R. Schenk
Prepared for ‘The International Monetary System: old and new debates’, sponsored by the Reinventing Bretton Woods Committee
Paris, December 2010
• Sterling operated as an important secondary reserve currency during the Bretton Woods period, comprising over half of the reserves of 35 economies as late as the 1970s. The competition between sterling, the US dollar and gold was considered destabilising, with portfolio shifts threatening exchange rate stability and international liquidity. This threat prompted collective action to support the role of both the dollar and sterling in the international monetary system while an alternative international reserve asset was debated from 1959-67.
• The effort to replace national currencies as international reserve assets was a failure. The SDR did not achieve this goal, nor did it prolong the pegged exchange rate system as it was intended to do. Instead, both gold and sterling gradually receded in importance as international reserve assets, leaving the dollar dominant by the early 1970s.
• The diversification of reserves by many countries from sterling to the US dollar did not take place naturally in response to market forces. The process was carefully managed by G10 central banks in cooperation with holders of sterling. Three Group Arrangements were signed providing overlapping lines of credit amounting to the equivalent of c. £120 billion today.
• The G10 Group Arrangements to manage the diversification of sterling reserves were agreed in 1966, 1968 and 1977 – they thus persisted despite the devaluation of sterling in 1967, the advent of a supposedly floating exchange rate regime in the early 1970s and a sharp fall in the share of global reserves denominated in sterling.
• During the end of the Bretton Woods period, from 1968-1974, currency competition was eliminated since the UK offered a US dollar value guarantee to countries holding sterling so long as they did not further diversify their reserves. Given high nominal interest rates in London, this guarantee allowed these economies to reap premium real returns on their sterling assets. The credibility of the guarantee was underpinned by the 2nd Group Arrangement from G10 central banks.
• The Group Arrangements provided the UK with a ‘safety net’ of credit from G10 central banks that could be activated if countries began to diversify their reserves away from sterling. They aimed to reduce first mover advantage for diversification and to delay a damaging run on the pound that would prompt a run on the dollar.
• The failure of the SDR to resolve apparent problems in the IMS led to consideration in the early 1970s by the C20 and IMF of a Substitution Account to promote the SDR as a replacement reserve asset for the US dollar. This plan was finally abandoned in 1981. Key obstacles were: burden of risk, use of IMF gold and governance.
• Rather than replacing the US dollar with the SDR, the US Fed and Treasury sought to improve the symmetry of the adjustment process through a rules based system to force countries in persistent surplus to adjust through currency appreciation. These plans were ultimately unsuccessful in the 1970s because of a lack of consensus over governance and implementation but they echo US proposals at the G20 Seoul Meeting in November 2010..."