Paola Subacchi
Research Director, International Economics

The international monetary system - and therefore the dollar - is once again in the spotlight. China's central bank governor recently suggested that the status of the dollar as the key reserve currency should be halted, as the costs of the current system may have exceeded its benefits. 'The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.' The implication of Governor Zhou's comment is that overall reform of the international monetary system is now due, and China is keen to engage in the debate.

The exchange rate regime was the missing piece from the London Summit's agenda - the ghost waiting in the shadows. The international monetary system featured briefly on the G20 agenda in October when President Sarkozy called for reform of 'the Bretton Woods system'. But the lack of a concrete reform plans and the dramatic unfolding of the crisis have pushed aside issues related to exchange rate arrangements.

In a Chatham House report published last month, we argued that the London Summit should address the arrangements underpinning the international monetary system as a significant structural realignment in the world's external imbalances is unfolding. We suggested setting an appropriate framework for further multilateral discussions within the G20 remit if the G20 want to make a significant contribution to crisis resolution in the short term and reform of the international financial and monetary architecture.

The exchange rate, like trade, is both cause and effect of tensions between domestic agendas and global issues. Such tensions have become particularly acute as a result of the current economic and financial hardship, pushing countries into protecting their domestic markets as well as supporting their exports. In this respect, competitive devaluations can be as effective as trade barriers. Thus, if fighting protectionism is seen as a natural remit for a multilateral forum such as the G20, then international policy cooperation should also be directed towards dealing with the negative spillovers resulting from exchange rate misalignments.

With a number of countries seeing huge contractions in exports, the risk of competitive devaluations is all too real. Switzerland was the first developed economy to opt for explicit depreciation of its currency. Through intervention in the currency markets, the Swiss national bank curbed the rise of the franc against the euro and, at the same time, tried to discourage the use of the franc as a haven currency. But unilateral devaluation is a zero-sum game and, given the limited number of currencies that qualify for safe haven status, the scope for unilateral exchange rate policy is very narrow. The burden cannot be shifted without limit in the hope that somebody else will take the strain, rather it should be fairly shared.

This is a pressing issue in the current crisis. With US expansionary monetary policies putting downward pressure on the dollar, the Eurozone countries may be forced to share the burden of the US stimulus indirectly through the exchange rate. In the Chatham House report, we acknowledge this point and suggest that fiscal stimulus packages are not the only policy response to the crisis. The G20 leaders should be vigilant to avoid the emergence of competitive devaluations. Not only should they eschew protectionism but also seek to pursue economic policies that do not generate 'beggar your neighbour' effects through currency devaluations.

As the euro is absorbing some of the pressure in the currency market, will a two-pillar monetary system emerge? Should this be central to the debate on the future of the international monetary system? A two-pillar system based on the dollar and the euro in a complementary rather than rivalry role is highly desirable. If properly developed it would ensure that pressure is defused and appropriately shifted from one currency to the other in time of crisis without triggering huge instability in the currency market. Such a system, however, will take a long time to develop.

Monetary authorities and political leaders could prepare the ground for this, but cannot change the system by mandate. The current system is underpinned by a formidable combination of confidence, efficiency and inertia. This is a critical point, which Governor Zhou's analysis missed.

Read New Ideas for the London Summit: Recommendations to the G20 Leaders >>