Thursday, April 28, 2011

BRICS and the China Trap

Earlier this month the BRICS countries (Brazil, Russia, India, China, South Africa) agreed at their summit meeting in Sanya, China, to establish mutual lines of credit in local currencies. On the face of it, this is an innocuous effort by the world's fastest growing countries to strengthen their mutual relationship. However, in the context of the emerging global power relations, this is yet another important step in the Chinese initiative to end the reign of the dollar as the world's single reserve currency.

Two years ago I wrote about the Chinese campaign to dethrone the dollar. Shortly before the G20 London summit, China's central bank governor announced that the dollar should be replaced by SDRs. This was a shrewd approach. About half of China's foreign exchange reserves of $2 trillion are reportedly held as dollar denominated assets, as indeed are large chunks of the reserves of many central banks. This large exposure implies that any major depreciation of the dollar would severely erode the value of these assets. At the same time, large diversification of these reserves away from the dollar is not an option. Such a move itself would trigger a sharp depreciation of the dollar. But the exchange rate of SDR is a weighted average of a basket of convertible currencies, and a swap of dollars for SDRs at a pre-determined exchange rate would allow China, and other countries, to significantly reduce their dollar exposure without any erosion of the value of their reserves. Of course, it would also end the reign of the dollar.

At the time, most analysts dismissed the Chinese initiative as impractical and unworkable. However, China has taken several strategic steps to carry forward its agenda through alternative routes. It has established currency swap arrangements with several developing countries, which protects their trade with China against the risk of their currencies depreciating. The initial value of these arrangements was quite modest, less than $100 billion. However, during the past two years, the volume of these arrangements would have grown significantly and could eventually cover the entire trade of these countries with China. 

How should India prepare for such an outcome? India should embed itself in the currency arrangement being forged for the BRICS countries, and strive to join the embryonic Asian Monetary Fund to take full advantage of opportunities arising from these initiatives. At the same time it must remain mindful that North America and the EU will remain important trading partners in the foreseeable future.

Sudipto Mundle in The Times of India. More Here.

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