What's in BRICS' Basket? Redefining Global Trade with an Alternative Reserve Currency

(This article is partially organized and written by GPT-o1-preview)

Introduction

Recent discussions at the BRICS (Brazil, Russia, India, China, and South Africa) summit have brought renewed attention to the concept of a BRICS currency. The idea is to create an alternative reserve currency or settlement mechanism to reduce reliance on the U.S. dollar and other major international currencies like the euro, pound sterling, and yen. This proposed common currency would be backed by a basket of BRICS currencies and possibly commodities. The initiative aims to mitigate risks associated with sanctions and enhance economic cooperation among member countries.

Exactly what is a basket of currencies for international settlements, and how does it work, at least in theory? This article explores how such a system might function, its historical context-including the Triffin Dilemma—potential impacts on global economics, technological considerations, and factors involved in its implementation.

Brief History

Understanding the historical context provides insight into why a basket of currencies is considered a viable alternative today.

1. The Gold Standard Era (Pre-1914)

• Fixed Exchange Rates: Currencies were pegged to gold, providing stability in international trade.
• Limitations: The gold standard restricted monetary policy flexibility, leading to economic rigidity. Inflation was rare, but deflation and credit crunches were common.

2. Interwar Period and Bretton Woods System (1914-1971)

• ?Abandonment of Gold Standard: World War I disrupted the gold standard, leading to floating exchange rates.
• Bretton Woods Agreement (1944): Established a new system where currencies were pegged to the U.S. dollar (USD), which was convertible to gold at $35 per ounce. The U.S. held a significant portion of the world's gold reserves, partly due to gold inflows during and after World War II.
• Dominance of USD: The USD became the central currency in international trade and finance.

3. The Triffin Dilemma

• Concept Introduction: Economist Robert Triffin identified a fundamental problem with the Bretton Woods system.
• Explanation: The country issuing the global reserve currency (the U.S.) must supply the world with sufficient liquidity (USD) to meet global demand, requiring persistent trade deficits financed by debt. However, excessive deficits undermine confidence in the currency's value.
• Impact: This highlighted the inherent instability in the Bretton Woods system, contributing to its eventual collapse.

4. Collapse of Bretton Woods and Shift to Fiat Currencies (1971 Onwards)

• End of Gold Convertibility: In 1971, President Nixon ended the dollar's convertibility to gold, leading to floating exchange rates.
• Increased Volatility: Currencies fluctuated based on market forces, introducing exchange rate risks in international trade.
• Continued USD Dominance: Despite the collapse of Bretton Woods, the USD remained the primary global reserve currency.
• Impacts: The abundance of USD facilitated global trade, but inflationary pressures mounted, and U.S. trade deficits and debt soared in the following decades.

5. Emergence of Currency Baskets

Special Drawing Rights (SDR) by the IMF (1969)

• Creation: Introduced to support the Bretton Woods fixed exchange rate system.
• Allocation to Members: SDRs are allocated to IMF member countries in proportion to their IMF quotas, reflecting their relative size in the global economy.
• Purpose: Serve as an international reserve asset to supplement member countries' official reserves.
• Usage: While SDRs are actively used by the IMF and its member countries, they have not evolved into a global currency used in international trade.

European Currency Unit (ECU) (1979-1998)

• Introduction: A basket of EU member currencies used as a unit of account before the euro.
• Transition to Euro: The ECU paved the way for the adoption of the euro in 1999.

Asian Currency Unit Proposals:

• ?Motivation: In response to the Asian Financial Crisis (1997), proposals emerged for an Asian currency unit to promote regional financial stability.
• Challenges: Diverse economic conditions and lack of political consensus hindered progress.

Global Financial Crisis (2008)

• ?Reevaluation of USD Dominance: The crisis prompted discussions on reducing reliance on the USD.
• ?Calls for a New Reserve Currency: China and other nations suggested expanding the use of SDRs or creating new basket currencies.

?BRICS Currency Initiatives

• Proposal: Brazil, Russia, India, China, and South Africa explored creating a reserve currency based on a basket of their currencies.
• Objective: Reduce dependence on the USD and enhance financial cooperation.

Digital Currency Baskets:

• Innovation: The rise of cryptocurrencies and blockchain technology led to proposals for digital currencies backed by baskets of assets or currencies.
• Examples: Facebook's initial Libra project aimed to create a stablecoin backed by a basket of currencies.

How Does a Basket of Currencies Work?

A basket of currencies is a collection of selected national currencies, each assigned specific weightings based on criteria like GDP, trade volume, and economic stability. The value of the basket is determined by the combined value of these currencies according to their assigned weights.

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Implementation Steps:

1. Creation of the Basket: Selection of currencies and assignment of weights.

2. Valuation: Calculating the basket's value using current exchange rates.

3. Pricing Goods and Services: Denominating international contracts in basket units.

4. Settlement of Transactions: Converting basket units into local currencies at the time of payment.

5. Risk Management: Utilizing financial instruments to hedge against currency fluctuations.

In theory, a basket of currencies is more stable than relying on a single global reserve currency. Because it doesn't need to be backed by gold, it avoids the credit crunches associated with deflation crises. However, implementing such a system presents significant challenges.?

The Market Sets the Price

Prices are set by market participants—sellers and buyers—based on:

• Negotiations: Between exporters and importers.
• Market Forces: Supply and demand dynamics.
• Currency Conversions: Using current exchange rates provided by financial institutions.

Central banks influence the economic environment and currency values through monetary policies but do not directly set prices for goods and services.

Who Sets the Weights?

?The weights assigned to each currency in a basket determine each currency's influence on the basket's value. They are typically determined by the governing body or institution that creates and manages the basket currency.

Determining the Weights:

1. Institutional Decision-Making:

• ?International Organizations: For example, the International Monetary Fund (IMF) sets the weights for its Special Drawing Rights (SDR) basket.
• ?Multilateral Agreements: Collaborating countries negotiate and agree upon the weights, considering economic size and trade relationships.?

2. Criteria for Weight Assignment:

• Economic Indicators: Factors such as GDP, total trade volume, financial market depth, and currency stability.
• Global Financial Role: The extent to which a currency is used in global trade, finance, and as a reserve currency.
• Liquidity and Convertibility: Currencies that are more freely convertible and liquid in international markets may receive higher weights.?

3. Periodic Reviews and Adjustments:

• Regular Assessments: Periodic reviews adjust weights to reflect changes in the global economy.
• Transparent Methodology: A clear process enhances credibility and acceptance among market participants.

Negotiating these weights requires significant effort and cooperation among participating nations.

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Role of Central Banks and Governments

• Participation in Negotiations: Central banks and government representatives play key roles in discussions about weight assignments, advocating for their national interests.
• Data Provision: They provide economic data and forecasts that inform weighting decisions, often leading statistical agencies in this effort.

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Impact on Market Participants

• Predictability and Stability: Knowing how weights are determined helps businesses and investors understand the basket currency's behavior and plan accordingly.
• Risk Management: Awareness of weight assignments assists in developing effective hedging strategies and financial planning.

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Role of Intermediaries—Commercial Banks

Intermediaries like commercial banks will play a crucial role:

• Holding Basket Currencies: Maintaining reserves of constituent currencies to provide liquidity.
• Facilitating Transactions: Converting between basket units and local currencies.
• Managing Risks: Offering financial products to hedge against currency fluctuations.

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Impacts

Impact on Foreign Exchange (FX) Exchange Rates

?Adopting a basket of currencies could significantly impact FX exchange rates:

• Altered Currency Demand: Reduced demand for dominant currencies like the USD may lead to their depreciation, while increased demand for currencies included in the basket could cause appreciation.
• Exchange Rate Volatility: Diversification may reduce overall volatility, but transitional periods could see increased fluctuations.
• Monetary Policies: Large central banks might adjust interest rates or intervene in FX markets, influencing exchange rates. The U.S. Federal Reserve's dominance may reduce, while the influence of the European Central Bank (ECB), People's Bank of China (PBoC), Bank of Japan (BoJ), and others may grow.

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Which Economies Benefit More?

The impact varies among different types of economies:

1. Manufacturing Economies: Likely to benefit due to reduced currency risk in importing inputs and exporting goods.
2. Services Economies: Gain from decreased transaction costs and exchange rate risks, enhancing international competitiveness.
3. Resource Economies: May benefit from stabilized commodity pricing but are also influenced by global demand and non-currency factors. Commodity-exporting countries may gain more.

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Will It Expand Global Trade?

?Potentially yes. A basket of currencies could:

• Reduce Currency Risk: Making international transactions more predictable.
• Lower Transaction Costs: Simplifying currency exchanges.
• Promote Fairer Trade Practices: Encouraging inclusivity and balanced economic representation.
• Mitigate Geopolitical Risks: Reducing reliance on any single country's currency.

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Central Banks' Power

Adopting a basket currency could grant central banks more power, especially those of large non-U.S. economies:

• Policy Coordination: Increased collaboration among central banks.
• Exchange Rate Control: Greater influence over currency values.
• Regulatory Oversight: Expanded roles in managing financial systems.

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Impact on Sovereign Debt and the U.S. Dollar

• Large Economies' Debt: May face challenges in raising sovereign debt due to reduced demand for their currency-denominated assets, potentially leading to higher borrowing costs.
• USD Depreciation: Reduced global demand for the USD could lead to its depreciation, affecting exchange rates, capital flows, and the U.S. economy.
• Addressing the Triffin Dilemma: Moving away from reliance on a single reserve currency like the USD may help mitigate the contradictions identified in the Triffin Dilemma, balancing domestic and international monetary needs.

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Impact on U.S. Manufacturing

Positive Effects:

• Export Competitiveness: A weaker USD makes U.S. goods more affordable abroad.
• Domestic Advantages: Reduced competition from imports due to higher prices of foreign goods.
• Potential Re-shoring: May lead to more manufacturing returning to the U.S., benefiting manufacturing-focused states.

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Challenges:

• Higher Input Costs: Imported materials become more expensive.
• Inflationary Pressures: Increased production costs may lead to higher consumer prices.

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Impact on Global Credit Creation

The adoption could both tighten and loosen global credit creation.

Potential Tightening:

• Transitional Uncertainties: Banks may adopt cautious lending practices initially.
• Regulatory Changes: New compliance requirements may restrain lending capacities.

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Potential Loosening:

• Exchange Rate Stability: Reduced currency risk may encourage cross-border lending.
• Policy Measures: Central banks might implement accommodative policies to promote credit expansion.

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Technological Considerations

Implementing a basket currency system would require significant technological adaptations in the financial sector.

Core Banking Software Upgrades

• Multi-Currency Handling: Processing composite currency transactions.
• Real-Time Data Integration: Managing live exchange rates for multiple currencies.
• Accounting Adjustments: Updating financial reporting systems.
• Compliance and Risk Management: Adhering to new regulations and managing exposures.

Crypto and Blockchain Technologies

The rise of cryptocurrencies and blockchain technology offers innovative solutions for implementing a basket of currencies:

• Digital Currency Platforms: Blockchain can facilitate the creation of digital basket currencies, enabling secure, transparent, and efficient transactions.
• Smart Contracts: Automating the execution of contracts based on predefined conditions, reducing the need for intermediaries.
• Stablecoins Backed by Baskets: Cryptocurrencies pegged to a basket of currencies or assets can provide stability and reduce volatility common in traditional cryptocurrencies.

Examples:

• Libra (now Diem) Project: Initially proposed by Facebook as a stablecoin backed by a basket of currencies and assets.
• IMF's SDR in Digital Form: Discussions on leveraging blockchain to create a digital version of SDRs.

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Challenges with Crypto and Blockchain:

While offering potential solutions, there are challenges:

• Regulatory Uncertainty: Varying regulations across countries can hinder adoption.
• Technical Complexity: Implementing and maintaining blockchain systems requires expertise and resources.
• Security Concerns: Vulnerabilities can arise at endpoints or through smart contract bugs.
• Adoption Hurdles: Achieving widespread acceptance among financial institutions and users is a significant challenge.

Conclusion

Adopting a basket of currencies for international trade presents a complex array of potential impacts. Such a system could distribute responsibilities and pressures across multiple economies, potentially addressing issues highlighted by the Triffin Dilemma. From the U.S. perspective, having the global reserve currencies poses an inherent contradiction between the benefits of economic dominance and the challenges of long-term trade deficits and hallowing out its industries.

However, implementing a basket currency system also poses challenges like infrastructural changes, shifts in economic power, and transitional uncertainties. The overall effect would depend on careful implementation, international cooperation/compromises, technological readiness, and adaptive strategies by businesses, financial institutions, and governments.

Key Takeaways:

• Economic Shifts: Manufacturing and services-exporting economies might benefit (i.e., China, India), while resource economies could face mixed outcomes.
• Financial Systems: Significant upgrades and adaptations are required in banking and financial infrastructure.
• Global Dynamics: Central banks may gain more influence, and the USD's dominance could be challenged.
• Technological Innovation: Blockchain and cryptocurrencies offer new possibilities for implementing basket currencies but require careful consideration.
• Addressing the Triffin Dilemma: A basket currency system may alleviate the contradictions faced by a single reserve currency issuer.
• Strategic Responses: Stakeholders must proactively manage risks and leverage opportunities presented by the new system.

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