The continuing decline of the US dollar in recent months has worried countries that have huge dollar denominated reserves. The trade-weighted value of the dollar has dropped 11.5 percent from its peak in March this year.
The greenback is now only worth *89, compared with *95 a couple of months back. This means the value of dollar-denominated reserves held by other countries has depreciated as much.
The kind of responses by countries suffering huge losses in their reserves could threaten global finance stability, and if not reigned in properly, could explode into another financial crisis.
The continued fall of the US dollar has sparked debates about whether a currency that has been battered in the market and has been losing credibility should retain its status as the dominant international currency. There are at least three alternatives that have been mentioned to solve this challenge.
First, to use one or more competing currencies to serve as an international currency, equaling the status of the dollar.
Second, by extending the use of the Special Drawing Rights (SDR), the IMF quasi money, which has been used by several countries as part of their reserves.
And lastly, using gold as an international currency and reserve. But like any other radical idea, it would take years before even it is considered feasible. So we will continue to see the US dollar dominating in the world economy for some time to come.
But this does not prevent some countries from diversifying some of their reserves into non-dollar deposits. Countries such as China, Mexico and the Philippines have bought gold. The Reserve Bank of India, the Indian central bank, early this month bought 200 tons of gold from the IMF valued at US$6.7 billion. Gold now constitutes 6 percent of the Indian reserve.
This action could trigger other countries to follow suit. Oil producing countries in the Middle East and Russia have been concerned with the continuing fall in the value of their dollar reserve and have been thinking seriously about buying gold. These countries realize that with a near-zero interest rate being maintained by the US Federal Reserve and the escalating debt of the US Federal deficits, there is little hope the US dollar will rebound in the short term.
If these countries rush into buying gold at almost the same time, it could be imagined a possible scenario would emerge. Demand for gold overwhelms its supply, and gold supply would not be enough to meet demand. The IMF has been mandated to sell 2,000 tons of its gold reserve, but that must be phased out in five years.
Even with only one purchase by India, the price of gold rose steeply from less than $1,000 to more than $1,100 per troy once today. But even more serious is the gold rush of many countries could plunge the US dollar into free fall, which could push the global economy into another currency crisis. The irony of this drama is that, the more those countries want to preserve their dollar-denominated reserve, the more they have to buy US Treasury bonds and papers, accumulating more of their dollar reserve.
But these countries must be nervous as they watch US budget deficit ballooning to a historic level of $1.6 trillion, and the US Treasury issuing $112 billion worth of debt instruments in just three days last month, amounts that would usually be issued over 12 months.
So, how should Indonesia respond to this development?
The Indonesian foreign exchange reserves, after falling early this year from the impact of global financial crisis, have begun to rebound due to positive trade balance and higher-capital inflows.
Driven by high liquidity in developed countries and the desire to seek higher returns, funds have been flowing to emerging markets including Indonesia. Indonesian reserves have been rising significantly in the last two months. In October, the reserve reached $64 billion, the highest amount since the global financial crisis struck.
Gold still constitutes about 4 percent of the total Indonesian reserve, or $2.5 billion at the end of September 2009. The quantity of gold held by Bank Indonesia (BI) has not changed, and has been the same for a long time. Since gold price has increased more than 10 percent recently, the value of gold held by BI has also increased accordingly.
But, apparently BI has already started to diversify its reserve. BI statistics show that starting September this year, BI reserve had contained Special Drawing Rights (SDR), an official IMF monetary unit worth $2.7 billion, slightly higher than its gold reserve.
BI realized that prudent management of its reserves amid currency volatility required divesting part of its dollar holding.
With the dollar continuing to decline, Indonesian reserves are getting more precarious. Its value will depreciate in terms of other currencies and commodities. That's why sooner or later the government will have to deal with the issue of how to preserve the value of its reserve. One alternative to minimize risk of declining value of its reserve is to possibly diversify into several other currencies and other finance units or commodities such as gold.
To deal with these issues, there are several things that need to be considered. First, the amount of the reserve is relatively low in terms of assurance against future economic shocks and crisis. To safeguard the rupiah against sudden depreciation, BI, as it has done in the past, will have to intervene in the market.
The effectiveness of the intervention depends on the size of the reserve held by BI because market confidence and the strength of the BI reserve is closely linked. Second, if BI increases gold as its reserve, then it is important to note for the last two decades the price of gold has been volatile, with steep fluctuation over the period.
This is because the price of gold has been more influenced by trader speculation more than the underlying supply and demand. But if more countries start buying gold, the psychological impact would be so great that it would be difficult for BI to resist joining other countries in the gold rush.
The writer is an economist.
