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What would a new global reserve currency look like?

A new reserve currency would combine those of several nations

At Wednesday’s G20 summit, Russian President Dmitry Medvedev suggested creating“a new reserve currency” to replace the dollar. In a paper published March 23, Chinese central bank governor Zhou Xiaochuan also proposed a new reserve currency, one “disconnected from individual nations.” Even Treasury Secretary Timothy Geithner has said he’s “open” to the idea. What would a new currency look like?

Lots of other currencies combined. Medvedev, the Chinese economic minister, and other would-be reformers want to create an accounting unit based on a “basket” of other currencies—a sort of hybrid. Instead of countries holding billions of U.S. dollars in their reserves—which makes them vulnerable if the dollar drops suddenly—they would hold a new unit, composed of, say, the dollar, the pound, and the Euro. The value of each component currency might fluctuate, but if one drops, the others can serve as “hedges.”

The most prominent example of such a basket is the Special Drawing Rights—or SDR—overseen by the International Monetary Fund. The value of the SDR is composed of 44 percent U.S. dollar, 34 percent euro, 11 percent yen, and 11 percent British pound. So if the U.S. dollar loses half its value, the SDR declines by 22 percent. Today, one SDR is worth 1.49 U.S. dollars. (Track the daily exchange rate here.) You can’t withdraw SDRs at the ATM, but you can use them for accounting transactions. Some countries, such as Syria, peg their currencies to the SDR. (This role earned the SDR the nickname “paper gold.”) Zhou proposes making the SDR the new reserve unit but suggests expanding it to include all other major currencies as well.

So who would oversee this new currency? Probably the IMF or another independent entity with representatives from each country. The IMF wouldn’t “produce” the new unit—let’s call them SDR2s. But you could trade, say, X U.S. dollars for Y SDR2s, which would then show up in your bank account. You could use those SDR2s to buy oil or pay down debt, or you could simply stash them in your reserve.

Instead of convincing all the G20 nations to oust the dollar, couldn’t China just start buying up other currencies? Sure. Countries aren’t required to keep their reserves in dollars—they do it because they want to. (The dollar’s “primary reserve currency” status is more de facto than official.) But if China dumped its reserve of dollars it would jeopardize its relationship with the United States, and other countries wouldn’t necessarily do the same. Any systematic overhaul would have to be done cooperatively and a switch to the SDR requires approval from the IMF, which is controlled by the United States.

The first currency to be held in foreign reserves was the British pound, during the 18th and 19th centuries. That changed after World War II, when the major economic powers met at Bretton Woods and established the exchange-rate system and the International Monetary Fund to oversee it. Under that system, the U.S. dollar became the go-to reserve currency, partly because the United States was an economic powerhouse and partly because the dollar was backed by gold. (In other words, any country could trade its dollars back to the United States in exchange for gold.) As a result, the U.S. dollar was considered extremely stable. The dollar plummeted when President Nixon unhitched it from the price of gold in 1971 but remained strong compared with other currencies. The dollar still makes up 64 percent of global reserves, trailed by the euro, which constitutes about 26 percent.

Bonus Explainer: What’s the point of a reserve currency, anyway? It serves as a standard unit for international payments, and it protects your own currency against shock. If demand for yen drops, for example, Japan can use their extra U.S. dollars to buy up the unwanted yen, thereby propping up its value. At the same time, though, the country whose currency is held in reserve—in this case, the United States—is more vulnerable to shock, since so much of its currency is in foreign accounts and therefore inaccessible to the United States. Transitioning to a hybrid reserve currency would therefore protect both weaker economies, which are usually vulnerable to another single country’s ups and downs, and stronger ones, which would have more ability to control and stabilize their own currencies.

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Explainer thanks David Beim of Columbia University and John Coleman of Duke University.