With the euro zone in deep distress, and with the euro along with the dollar comprising 90 per cent of globally allocated foreign exchange reserves, clearly there is only so much safety to be had. With the recent recourse to unconventional monetary policies in key developed country markets heaping an added dimension of complex cross-border spillover effects, PBoC’s reserve managers appear to be trapped between a rock and a hard place.

Extricating themselves from this reserve management predicament has been the driver of China’s currency internationalisation strategy. In time, as graduated steps towards internationalisation serve as veritable stepping stones to cross the perilous river of global financial integration, a fully convertible yuan, it is hoped, will assume its appointed role as one of the select few reserve currencies within the international monetary system. More long march than the quick sprint that some observers have recently posited, notably Arvind Subramanian and, more cautiously, Barry Eichengreen, the endgame is neither destined nor assured; it is a journey begun. For reasons that impinge reciprocally on the interests of Beijing and the larger international monetary system, its swift success though is deeply desirable.

At the heart of the recent dislocation in the chain of global financial intermediation is the paucity of safe, short-term and liquid instruments — be it government guaranteed or privately guaranteed — that can serve as attractive reserve assets globally. Driven by frantic considerations of safety, the secular rise of vast and footloose institutional cash pools (that is, centrally managed, short term cash balances of institutional investors and global non-financial companies) that reside outside the government-insured banking system, has made the global financial system increasingly run-prone. In time, as China graduates from net consumer to net issuer of such risk-free assets, commensurate with its heft in the global economic, trading and financial system, its ability to fill the breach in supply of such assets will lend stability to the international monetary order. Full convertibility, such that PBoC can — in the extreme — serve as a ‘market maker of last resort’ for such instruments, is a prerequisite. Along the path to convertibility, as PBoC allows its external surpluses to gradually feed into the domestic price level, a more consumption-driven domestic economy as well as a more internationally balanced monetary system is expected to emerge. Reserve management anxieties too will be consigned to the past.

At the time of the demise of the Bretton Woods gold-dollar standard, it was imagined a world of floating yet managed exchange rates operating alongside a world of convertible yet malleable capital flows would establish a ‘golden mean’, dynamically eradicating the balance of payment deficits that the United States had perforce needed to run to furnish liquidity to the global economy. The reality has proven otherwise. Capital flows have been anything but pliable, their tsunami-like effect exacting terrible punishment on exposed banking, capital and other asset markets in developing and developed countries alike over the past three decades. Terrified, meanwhile, of ceding exchange rate stability or domestic monetary policy independence, PBoC and its BRICS compatriots have largely opted to impose varyingly stringent capital control restrictions — even as they have collectively accumulated trade surpluses and/or a war-chest worth of reserve holdings. Correspondingly — and an irony that the original critic of the Bretton Woods system, Robert Triffin, would have instantly recognised — the primary issuer of the benchmark risk-free asset (the US) continues to run a persistent balance of payments deficit to furnish liquidity to the system, yet at the same time strives to preserve confidence in its currency as a store of value … a confidence eroded daily by its persistent and large external deficits.

Far from establishing a new ‘golden mean’, the current international monetary system appears to suffer from the worst of both worlds — a de facto anchor currency of increasingly uncertain worth and an adjustment mechanism that is frustrated in its means to redress imbalances within.

Going forward, an international monetary order characterised by a paucity of global reserve assets and overly dependent on an insufficiently credible dollar as its sole monetary tether will stand little chance of surviving in a world of unconstrained capital flows. Equally, a future global multicurrency order characterised by hybrid exchange rate regimes and free capital mobility, yet backed by only a weak and fragmented governance structure, will repeatedly be trumped by narrow and domestically generated protectionist compulsions. Building flexibility and capacity within the international monetary system’s regulatory mechanism to accommodate — and accelerate — the financial liberalisation trajectories of its rising stakeholders, most notably China, hence is the foremost medium-term priority of the day. In this regard, novel ideas that facilitate the acceptance and use of emerging market currency-denominated instruments as reserve assets — such as the issuance of emerging market GDP-linked bonds, other forms of pooling and securitisation of emerging market debt into composite assets, as well as a significant expansion in size and share of large, dynamic emerging market currencies within the SDR’s basket composition — each bear considering.

A comprehensive framework, further, that enables China to cope — as it liberalises its foreign exchange and financial system — with the unpredictable herding behaviour of cross-border capital flows, merits examining with an open mind too. A network of permanent currency swap lines, provision of liquidity risk insurance based on simple ex ante conditionality and orderly insolvency processes that on balance privatise the allocation of risk to the vendors of cross-border capital, are but a few examples of the elements that such a comprehensive framework could contain. Full currency convertibility, correspondingly, to avoid frustrating the monetary system’s essential adjustment mechanisms, is the reciprocal imperative for PBoC — currency internationalisation being a necessary but insufficient end. Embedding China’s capital account liberalisation program within this proposed broader institutional framework of inter-governmental liquidity and solvency risk management, rather than the current effort to erase global imbalances via a peer pressure-driven Mutual Assessment Process, ought to be high on the agenda of future G20 summits.

Sourabh Gupta is a Senior Research Associate at Samuels International Associates, Inc. in Washington DC.