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This isn’t kung-fu fighting, but it could get a little bit frightening – for the US dollar in the least. China seems to be indulging in another kind of kung-fu fighting in a new cold war style, while trying to assert, its new found economic dominance, into the world order. China seems to be getting support from Russia as well, where both the nations have issued statements that the US dollar needs to be replaced by a new world reserve currency. This sent alarm bells ringing in Washington and forced Obama and his aides to issue a hurried statement that the US dollar will continue to remain the world’s reserve currency as the strength and size of the US economy is unmatched.

But it is a well known fact that the pound sterling was a reserve currency for the world in the 18th and 19th centuries. As England lost its economic dominance, the pound gradually got replace by the US dollar as the reserve currency. Is history repeating itself and has the death knell for the US dollar as a reserve currency been sounded?

If some of the recent moves by China are factored in, the US dollar most certainly appears to be loosing its sheen. China has begun to replace the Yuan as a trading currency with some of its large trading partners, spread as far as Latin America. China’s latest $ 10 billion dollar currency swap deal with Argentina, allows the latter to trade with China in the Yuan instead of the US dollar. This is China’s sixth such agreement since late 2008. China has moreover started to offer Yuan denominated aid instead of the US dollar, so that the benefit of the aid comes back to China. While, this seems to be miniscule, it definitely has alarmed the US government and obviously, reduce the need for the US dollar in international trade, even though marginally for now. However, an extension of this trend can definitely start exerting a downward pressure on the US dollar.

But, China also has huge US dollar reserves and any move by it to dethrone the dollar would also impact the value of its dollar holdings. This seems to provide some cushioning for the dollar, but China, could gradually move towards ending the dollar’s primary dominance as a reserve currency. This is virtually like a cold war, being fought on economic frontiers.

It however, debatable as to what can replace the dollar as a reserve currency. A reserve currency needs to be backed by a nation that has a sound economy, transparent economic and financial markets, free and well regulated markets, a sound and just jurisprudence, political stability and a government of the people. China clearly is not ready in many senses, as it is not a democracy and lacks transparency. Its judicial system is also questionable.

Realizing its weaknesses, China seems to have proposed the IMF’s SDRs as a reserve currency as an alternative to the US dollar. In reality the SDR is nothing but a representative basket of currencies including that of the US, Europe, UK and Japan. If China’s idea were to be accepted, it could well bring an end to the dollar’s predominance as the world reserve currency and transfer that responsibility to the IMF basket of currencies. As a next step, China could try to arm twist its way into the IMF and hope to get the Yuan included in the IMF basket of currencies forming the SDR. A review of the IMF currency basket is due in 2010.

The lesson to be learnt is that reserve currencies can lose their status over time as did the pound sterling and if a gradual transference of economic dominance from the West to Asia takes place, then a new world currency order would be the most logical outcome.  This would definitely have an impact on the US dollar in the long run.