Dollar Slams Up Against a (Great) Wall

The People's Bank of China flexes its muscle in call for a new reserve currency.

Move over Ben Bernanke. Step aside Tim Geithner. There's a new power in international finance: Zhou Xiaochuan, governor of the People's Bank of China, the $2 trillion central bank of China. It has the tools and the financial interests to be the new power player on the global financial stage.

Zhou Xiaochuan--better learn how to spell it and pronounce it--threw down the gauntlet this week at the Obama-Geithner-Bernanke financial regime. His remarks can only be interpreted as a slap in the face of U.S. policy during the severe financial crisis that has swept the world. His prescriptions are bound to be debated in London next week at the G-20 parley and for years to come.

Boldly stated, Zhou--backed by Russia, Brazil and India--wants to break the dollar's hegemony in global finance. In a paper grandly called "Reform the International Monetary System," Zhou has called for the creation of an international currency unit that he admits will require "extraordinary political vision and courage." He suggests that we start with a blend of the dollar, pound, yen and euro--the so-called Special Drawing Rights (SDR) created by the IMF in 1969 that borrowed a concept first recommended by famed economist John Maynard Keynes.

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Zhou's provocative remarks come only days after Premier Wen Jiabao demanded U.S. action to safeguard China's holdings of U.S. bonds--some $740 billion of Treasuries and $600 billion of other debt.

"We have lent huge amounts of money to the U.S. [and] we are concerned about the safety of our assets," said Wen. Indeed, China has bought $200 billion of Treasuries while selling agency securities over the past six months. But it also lost about a third of its equity holdings, including $5 billion in the Lehman bankruptcy.

Zhou's rationale appears reasonable to Croesus. "A super-sovereign reserve currency not only eliminates the inherent risks of credit-based sovereign currency, but also makes it possible to manage global liquidity," writes Zhou. "This will significantly reduce the risks of a future crisis and enhance crisis management capability."

By the way, don't dismiss Zhou as just a voice in the wilderness. His plan for a global reserve currency is backed by multibillionaire trader and economic wiseman George Soros, as well as Martin Wolf, an influential columnist for the Financial Times. Geithner, queried at the Council on Foreign Relations on Wednesday, said he hadn't read Zhou's proposal, but praised his counterpart as "a very thoughtful, very careful, distinguished central banker." Geithner added that he was "quite open" to the suggestion of expanding the SDR's role.

Zhou has surprised the experts by suggesting that international financial institutions such as the International Monetary Fund should manage some nations' currency reserves. The IMF uses its funds to prop up nations in financial crisis. Expanding the SDR would give the IMF the potential to "act as a super-sovereign reserve currency" and to increase the IMF's resources, Zhou emphasized. "The scope of using the SDR should be broadened so as to enable it to fully satisfy the member countries' demand for a reserve currency," adds Zhou.

This would be a shocking change in a system where central banks maintain control over their reserves and many keep their operations entirely secret and non-transparent. Zhou makes a telling point when he insists that "the centralized management of part of the global reserve by a trustworthy international institution will be more effective in deterring speculation and stabilizing financial markets." In other words, Zhou is saying that the recent vicious meltdown might have been avoided if the world's financial system was not tied solely to the American dollar, the currency at the focal point of the global economy.

"For a country like China that prizes its sovereignty and to date hasn't even been willing to report the currency composition of its reserves to the IMF [something most other countries do], this would be a big step," says Brad Setser, a fellow of the Council on Foreign Relations and former Treasury official in the Clinton administration.

In a second address Thursday, Zhou took an even tougher whack at some American institutions and financial concepts. He blasted the way "the global financial system relies heavily on the external credit ratings for investment decisions and risk management." Having three U.S. ratings agencies dominate the world results in "a massive herd behavior at the institutional level. Moreover, the rating models for mortgage-related structured products are fundamentally flawed." All true. The massive write-downs across the globe were the result of these flaws in the American way of doing things.

Then, Zhou goes on to blame the American fair-value accounting system and especially the mark-to-market model for the intense market fluctuations and disorderly trading. Take that America. China described the "negative feedback loop" as the most toxic American export ever. Zhou also crowed about how China's "macroeconomic measures," including a massive stimulus program, have produced "some leading indicators pointing to recovery of economic growth, indicating that rapid decline in growth had been curbed."

Then, Zhou really stuck it to Obama-Geithner-Bernanke, as well as to Europe and Japan. "Facts speak volumes and demonstrate that compared with other major economies, the Chinese government has taken prompt, decisive and effective policy measures, demonstrating its superior system advantage when it comes to making vital policy decisions." Talk about gauntlet dropping.