A new unit of account as a transitional mechanism

The path to a new reserve currency may involve, in a first stage, the creation of a new unit of account as a transitional arrangement. This new unit of account, we could call it NUA, can take the form of a basket of the currencies of the sponsoring countries, an SDR-like construct. The NUA would be a weighted average of the exchange rates of the currencies of the participating countries, a group of perhaps 15 to 20 Global South nations. The shares in the basket could be equivalent to shares of the countries in the group’s GDP PPP, betters suited for international comparisons than nominal GDP based on market exchange rates.
Initially, the NUA would stand on its own. In this transition, it could become known and increasingly used as a measure of value. There are at least two ways of ensuring this. First of all, the NUA could piggyback on the dollar’s unit of account function. For this, it would suffice to construct the basket in such a manner as to make it begin at a one-to-one parity with the US dollar. Parity would only be a starting point: the dollar/NUA exchange rate would fluctuate over time, in line with the average weighted fluctuations of the exchange rates of its constituent currencies with respect to the dollar, but can be expected not to depart too much from the initial parity, a point to be explained subsequently. As we will presently see, a certain stability arises from endogenous features of the NUA and could be enhanced by including some specific stabilizing criteria in its calculation.
In the second place, participating countries could actively encourage the use of the NUA to prepare for the subsequent transition to a new reserve currency. The NDB and the CRA, for example, could use the NUA in its accounts in lieu of the dollar or, alternatively, combine both units of accounts, as the IMF does by publishing accounts and other financial information in dollars and SDRs. And governments could consider denominating their own balance of payments accounts not only in dollars but also in NUA.
At one point, the NUA would be converted into the new reserve currency, maintaining the exact same distribution of weights.
A simple conversion of the NUA into a new currency is, of course, far from enough. For a currency to be successfully launched, a number of requirements need to be met. Let us now turn to this.

Would we need a new institution? A Global South Bank (GSB)?

First, a credible institution needs to be in charge of the issuance. Could it be a preexisting institution or should a new one be created?
It is possible, in theory, to encharge an existing financial institution with the issuance and management of the new currency. However, none of the institutions in place could efficiently take on the task under their current rules and legal frameworks. The New Development Bank (NDB), established by the BRICS in Shanghai, is often mentioned as a possibility. However, by its Articles of Agreement, the bank’s mandate is limited to financing infrastructure and sustainable development in emerging market and developing countries. It is a multilateral development bank, established according to the general model inaugurated by the World Bank. The Articles would therefore have to be amended extensively to establish a completely different mandate. Moreover, the NDB is a relatively new institution that began operating in 2016, and is still struggling to become an effective global lender. Adding new and totally different tasks to the NDB’s mandate is not a promising route.
Similar difficulties appear with other institutions. For instance, the BRICS Contingent Reserve Arrangement (CRA), the other institution created by the group, is even less suited. It is, by treaty, a virtual reserve pool designed to provide support to member countries in case of balance of payments difficulties. Tasking the CRA with the issuance and management of a new reserve currency also requires extensive amendments to the Treaty signed in 2014 and ratified in 2015. Furthermore, the CRA’s track record is much weaker than that of the NDB. It remains largely frozen and non-operational, having conducted no operations, only test runs.
Could any non-Western central bank take up the task? Highly unlikely. It is true that nearly all central banks are entrusted with currency issuance, among other functions. However, currencies issued by non-Western central banks are almost always national, and their legal mandates would also have to be amended in a major and unprecedented way to allow any of them to issue an international currency. A central bank that is national, in origin and essence, would struggle to fulfill this entirely new function.  
It follows that a new institution has to be established. Let us call it the Global South Bank (GSB). Who would establish the GSB? As previously indicated, it would be a plurilateral undertaking of a group of emerging market and developing countries. Would it be a BRICS initiative? Not necessarily. Not all of the 10 full members of the BRICS would be willing and prepared to join right away. India, for instance, although capable of participating,  may not desire to do so immediately. Some non-BRICS nations, however, might be suitable candidates for participation in the GSB.
For these reasons, the GSB should not carry the BRICS acronym in its name, and the new currency would not be a “BRICS currency”. We could call it, for instance, New Reserve Currency (NRC). The GSB and the NRC would, in any case, be BRICS-centric since one could not bring together a meaningful group of sponsoring countries without the participation of most of the BRICS. Given China’s size and financial strength, its participation may be seen as indispensable, the same not holding for the other BRICS.
The GSB should be  open to the accession of other BRICS and non-BRICS at a later date. Could it be open to the West? Why not? Needless to say, it is not advisable to have Western countries participate in the actual creation of the IIB since this could open the risk of distortions and undue interference in the budding institution.
Be as it may, very few, if any, Western countries can be expected to join. Their ingrained arrogance would probably impede them from taking part in an initiative originating in emerging market and developing countries. Also, many Global South nations would not be able or willing to join. The NRC could therefore not be conceived as a global currency. If it proves successful, it will be one reserve currency in a multipolar and multicurrency world, alongside the dollar, the euro, the renminbi, the yen and a few other currencies.

How to build confidence in the new reserve currency (NRC)? How would it be backed?

There is more than one way to build confidence in the new currency. For instance, in order to establish a contrast with the dollar and the euro, a clear commitment could be included in the legal structure of the GSB ruling out any weaponization of the NRC. Property rights and free flows in and out of the NRC and NRBs would be explicitly ensured under the new system. One could also specify a limit to the issuance of NRCs expressed in nominal terms and adopt rules that preserve the stability of its value.
But such guarantees are probably not sufficient. Confidence in a currency arises from what is often referred to as “backing” or “anchoring”. How could backing work in practice? It cannot be some monetary trick or symbolic assurance. In monetary theory and practice, to back a currency means, strictly speaking, to ensure its convertibility at a fixed rate into something valuable that can be trusted.
What are the alternatives for the GSB? To resort to convertibility in dollars or euros would of course defeat the whole purpose of the exercise. And other currencies (with the partial exception of the renminbi) could hardly do the job, as explained previously.
Could the new currency be backed by gold? That means going back to the long deceased gold-exchange standard. This regression to past practices, even if feasible, would not be advisable. One should keep in mind that a currency must maintain a stable relation to the asset that backs it. Now, gold is highly unstable in price, making the new currency as unstable as gold. The same holds for any other commodity or basket of commodities that might be considered as backing for the currency since price volatility is a feature of all commodities without exception. The countries participating in the initiative would, moreover, not be in a position to, even jointly, stabilize international commodity prices.  
Thus, the NRC could not be a commodity currency. It would probably have to be a fiduciary currency, as is the case of the currencies of almost all countries. As is well known, not all fiduciary currencies enjoy fiducia, only those that are backed by sound monetary and fiscal policies in the issuing country. Confidence in the NRC would depend basically on the policies of the sponsoring countries. Given the reasonable macroeconomic track record of many BRICS and non-BRICS countries that might be part of the initiative, this precondition could be largely met, provided of course that the GSB’s institutional design be well thought through.
How would the backing of the NRC be operationalized in the model envisaged in this paper? A first approximation to this issue can be formulated as follows. The new reserve currency could be backed, in the first instance, by bonds issued by the GSB, let us call them New Reserve Bonds (NRBs). NRBs would be short-term, with maturities of up to six months, and automatically renewable unless the holder demands redemption. They would take the form of a basket of bonds of sponsoring countries with weights assigned according to GDP PPP shares, as in the NUA and NRC baskets. NRC balances would be fully and immediately convertible into NRBs at a fixed price. They would in turn be convertible into the bonds issued by the Treasuries of the participating countries. More precisely, NRBs would be convertible into a basket of bonds of the sponsoring countries, with the same composition and weights as the NUA and the NRC.
In other words, the NRC would have two backstops: the bonds of the GSB and the basket of bonds provided by member countries (BoB). This mechanism would be the main vehicle through which the GSB receives support from the sponsoring countries. The solidity of the new monetary arrangement will therefore ultimately depend on the solidity of the finances of these countries, a point to which we will need to come back later.
As NRCs and NRBs enter into circulation, the proceeds from these sales, obtained in the form of currencies readily traded in foreign exchange markets, have to be entirely converted into a basket of bonds of the participating countries. The total amount of bonds and currency issued by the GSB will therefore always be 100% backed by the BoB.
The creation of a new currency would not in itself require sponsoring countries to pay-in capital. Countries would supply capital to the GSB for the sole purpose of constituting an initial precautionary reserve by transferring to the bank a certain amount of bonds issued by them. In this approach, the demands on the budgets of the countries would be limited, much lighter than the ones implied by participation in the construction of a multilateral lending bank such as the NDB or the Asian Infrastructure Investment Bank (AIIB).    
The asset side of the GSB’s balance of sheet would therefore be constituted mainly by bonds of the participating governments and the bank’s precautionary reserve invested in safe and liquid assets. On the debit side, there would be the NRCs and NRBs held by the public and the bank’s capital.
The interest rates on NRBs would be slightly lower than the weighted average of the interest rates on the bonds of the participating countries, allowing the GSB to have a net financial profit to cover operational costs. The spread would be very low, given that the GSB could and should be a lean institution. It would be fixed at a certain level and reviewed periodically.
Any excess of financial gains over operational and other costs would become a profit either to be shared with the sponsoring countries or, alternatively, retained to expand the precautionary reserve. Countries backing the GSB might well earn a profit, although profit earning would not be a goal or a major consideration for them. The objective of the GSB would be to maximize issuance, subject to preestablished constraints, and not to maximize profits.

Editor: LQQ