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Is there a better way to organise the world s currencies?
Nov 4th 2010 | WASHINGTON, DC
WHEN the leaders of the Group of Twenty (G20) countries meet in Seoul on
November 11th and 12th, there will be plenty of backstage finger-pointing about
the world s currency tensions. American officials blame China s refusal to
allow the yuan to rise faster. The Chinese retort that the biggest source of
distortion in the global economy is America s ultra-loose monetary policy
reinforced by the Federal Reserve s decision on November 3rd to restart
quantitative easing , or printing money to buy government bonds (see article).
Other emerging economies cry that they are innocent victims, as their
currencies are forced up by foreign capital flooding into their markets and
away from low yields elsewhere.
These quarrels signify a problem that is more than superficial. The underlying
truth is that no one is happy with today s international monetary system the
set of rules, norms and institutions that govern the world s currencies and the
flow of capital across borders.
There are three broad complaints. The first concerns the dominance of the
dollar as a reserve currency and America s management of it. The bulk of
foreign-exchange transactions and reserves are in dollars, even though the
United States accounts for only 24% of global GDP (see chart 1). A
disproportionate share of world trade is conducted in dollars. To many people
the supremacy of the greenback in commerce, commodity pricing and official
reserves cannot be sensible. Not only does it fail to reflect the realities of
the world economy; it leaves others vulnerable to America s domestic monetary
policy.
The second criticism is that the system has fostered the creation of vast
foreign-exchange reserves, particularly by emerging economies. Global reserves
have risen from $1.3 trillion (5% of world GDP) in 1995 to $8.4 trillion (14%)
today. Emerging economies hold two-thirds of the total. Most of their hoard has
been accumulated in the past ten years (see chart 2).
These huge reserves offend economic logic, since they mean poor countries,
which should have abundant investment opportunities of their own, are lending
cheaply to richer ones, mainly America. Such lending helped precipitate the
financial crisis by pushing down America s long-term interest rates. Today,
with Americans saving rather than spending, they represent additional thrift at
a time when the world needs more demand.
The third complaint is about the scale and volatility of capital flows.
Financial crises have become more frequent in the past three decades. Many
politicians argue that a financial system in which emerging economies can
suffer floods of foreign capital (as now) or sudden droughts (as in 1997-98 and
2008) cannot be the best basis for long-term growth.
France, which assumes the chairmanship of the G20 after the Seoul summit,
thinks the world can do better. Nicolas Sarkozy, the country s president, wants
to put international monetary reform at the top of the group s agenda for the
next year. He wants a debate without taboos on how to improve an outdated
system.
Such a debate has in fact been going on sporadically for decades. Ever since
the post-war Bretton Woods system of fixed but adjustable exchange rates fell
apart in the 1970s, academics have offered Utopian blueprints for a new
version. The question is: what improvements are feasible?
The shape of any monetary system is constrained by what is often called the
trilemma of international economics. If capital can flow across borders,
countries must choose between fixing their currencies and controlling their
domestic monetary conditions. They cannot do both. Under the classical
19th-century gold standard, capital flows were mostly unfettered and currencies
were tied to gold. The system collapsed largely because it allowed governments
no domestic monetary flexibility. In the Bretton Woods regime currencies were
pegged to the dollar, which in turn was tied to gold. Capital mobility was
limited, so that countries had control over their own monetary conditions. The
system collapsed in 1971, mainly because America would not subordinate its
domestic policies to the gold link.
Today s system has no tie to gold or any other anchor, and contains a variety
of exchange-rate regimes and capital controls. Most rich countries currencies
float more or less freely although the creation of the euro was plainly a step
in the opposite direction. Capital controls were lifted three decades ago and
financial markets are highly integrated.
Broadly, emerging economies are also seeing a freer flow of capital, thanks to
globalisation as much as to the removal of restrictions. Net private flows to
these economies are likely to reach $340 billion this year, up from $81 billion
a decade ago. On paper, their currency regimes are also becoming more flexible.
About 40% of them officially float their currencies, up from less than 20% 15
years ago. But most of these floats are heavily managed. Countries are loth to
let their currencies move freely. When capital pours in, central banks buy
foreign exchange to stem their rise.
They do this in part because governments do not want their exchange rates to
soar suddenly, crippling exporters. Many of them are worried about level as
well as speed: they want export-led growth and an undervalued currency to
encourage it.
Just as important are the scars left by the financial crises of the late 1990s.
Foreign money fled, setting off deep recessions. Governments in many emerging
economies concluded that in an era of financial globalisation safety lay in
piling up huge reserves. That logic was reinforced in the crisis of 2008, when
countries with lots of reserves, such as China or Brazil, fared better than
those with less in hand. Even with reserves worth 25% of GDP, South Korea had
to turn to the Fed for an emergency liquidity line of dollars.
This experience is forcing a rethink of what makes a safe level of reserves.
Economists used to argue that developing countries needed foreign exchange
mainly for emergency imports and short-term debt payments. A popular rule of
thumb in the 1990s was that countries should be able to cover a year s worth of
debt obligations. Today s total far exceeds that.
Among emerging economies, China plays by far the most influential role in the
global monetary system. It is the biggest of them, and its currency is in
effect tied to the dollar. The yuan is widely held to be undervalued, though it
has risen faster in real than in nominal terms (see article). And because China
limits capital flows more extensively and successfully than others, it has been
able to keep the yuan cheap without stoking consumer-price inflation.
China alone explains a large fraction of the global build-up of reserves (see
chart 3). Its behaviour also affects others. Many other emerging economies,
especially in Asia, are reluctant to risk their competitiveness by letting
their currencies rise by much. As a result many of the world s most vibrant
economies in effect shadow the dollar, in an arrangement that has been dubbed
Bretton Woods 2 .
History lessons
The similarities between this quasi-dollar standard and the original Bretton
Woods system mean that many of today s problems have historical parallels.
Barry Eichengreen of the University of California, Berkeley, explores these in
Exorbitant Privilege , a forthcoming book about the past and future of the
international monetary system.
Consider, for instance, the tension between emerging economies demand for
reserves and their fear that the main reserve currency, the dollar, may lose
value a dilemma first noted in 1947 by Robert Triffin, a Belgian economist.
When the world relies on a single reserve currency, Triffin argued, that
currency s home country must issue lots of assets (usually government bonds) to
lubricate global commerce and meet the demand for reserves. But the more bonds
it issues, the less likely it will be to honour its debts. In the end, the
world s insatiable demand for the risk-free reserve asset will make that
asset anything but risk-free. As an illustration of the modern thirst for
dollars, the IMF reckons that at the current rate of accumulation global
reserves would rise from 60% of American GDP today to 200% in 2020 and nearly
700% in 2035.
If those reserves were, as today, held largely in Treasury bonds, America would
struggle to sustain the burden. Unless it offset its Treasury liabilities to
the rest of the world by acquiring foreign assets, it would find itself ever
deeper in debt to foreigners. Triffin s suggested solution was to create an
artificial reserve asset, tied to a basket of commodities. John Maynard Keynes
had made a similar proposal a few years before, calling his asset Bancor .
Keynes s idea was squashed by the Americans, who stood to lose from it. Triffin
s was also ignored for 20 years.
But in 1969, as the strains between America s budget deficit and the dollar s
gold peg emerged, an artificial reserve asset was created: the Special Drawing
Right (SDR), run by the IMF. An SDR s value is based on a basket of the dollar,
euro, pound and yen. The IMF s members agree on periodic allocations of SDRs,
which countries can convert into other currencies if need be. However, use of
SDRs has never really taken off. They make up less than 5% of global reserves
and there are no private securities in SDRs.
Some would like that to change. Zhou Xiaochuan, the governor of China s central
bank, caused a stir in March 2009 when he argued that the SDR should become a
true global reserve asset to replace the dollar. Mr Sarkozy seems to think
similarly, calling for a multilateral approach to the monetary system. If
commodities were priced in SDRs, the argument goes, their prices would be less
volatile. And if countries held their reserves in SDRs, they would escape the
Triffin dilemma.
For SDRs to play this role, however, they would have to be much more plentiful.
The IMF agreed on a $250 billion allocation among measures to fight the
financial crisis, but global reserves are rising by about $700 billion a year.
Even if there were lots more SDRs it is not clear why governments would want to
hold them. The appeal of the dollar is that it is supported by the most liquid
capital markets in the world. Few countries are likely to use SDRs much until
there are deep private markets in SDR-denominated assets.
Only if the IMF evolved into a global central bank able to issue them at speed
could SDRs truly become a central reserve asset. This is highly unlikely. As Mr
Eichengreen writes: No global government means no global central bank, which
means no global currency. Full stop.
Nor is it clear that the SDR is really needed as an alternative to the dollar.
The euro is a better candidate. This year s fiscal crises notwithstanding,
countries could shift more reserves into euros if America mismanaged its
finances or if they feared it would. This could happen fast. Mr Eichengreen
points out that the dollar had no international role in 1914 but had overtaken
sterling in governments reserves by 1925.
Alternatively, China could create a rival to the dollar if it let the yuan be
used in transactions abroad. China has taken some baby steps in this direction,
for instance by allowing firms to issue yuan-denominated bonds in Hong Kong.
However, an international currency would demand far bigger changes. Some
observers argue that China s championing of the SDR is a means to this end: if
the yuan, for instance, became part of the SDR basket, foreigners could have
exposure to yuan assets.
More likely, China is looking for a way to offload some of the currency risk in
its stash of dollars. As the yuan appreciates against the dollar (as it surely
will) those reserves will be worth less. If China could swap dollars for SDRs,
some exchange-rate risk would be shifted to the other members of the IMF. A
similar idea in the 1970s foundered because the IMF s members could not agree
on who would bear the currency risk. America refused then and surely would now.
Rather than try to create a global reserve asset, reformers might achieve more
by reducing the demand for reserves. This could be done by improving countries
access to funds in a crisis. Here the G20 has made a lot of progress under
South Korea s leadership. The IMF s lending facilities have been overhauled, so
that well-governed countries can get unlimited funds for two years.
Overcome your reserve
So far only a few emerging economies, such as Mexico and Poland, have signed
up, not least because of the stigma attached to any hint of a loan from the
IMF. Perhaps others could be persuaded to join (best of all, in a large group).
Reviving and institutionalising the swap arrangements between the Fed and
emerging economies set up temporarily during the financial crisis might also
reduce the demand for reserves as insurance. Also, regional efforts to pool
reserves could be strengthened.
However, even if they have access to emergency money, governments will still
want to hoard reserves if they are determined to hold their currencies down.
That is why many reformers think the international monetary system needs
sanctions, imposed by the IMF or the World Trade Organisation (WTO), against
countries that manipulate their currencies or run persistent surpluses.
This is another idea with a history. Along with Bancor, Keynes wanted countries
with excessive surpluses to be fined, not least because of what happened during
the Depression, when currency wars and gold-hoarding made the world s troubles
worse. The idea went nowhere because America, then a surplus economy, called
the shots at the Bretton Woods conference in 1944. The same forces are evident
today except that America, as a deficit country, is on the other side of the
argument. Like America in the 1940s, China would never agree to reforms that
penalised surplus countries.
Such rules would probably be unenforceable anyway. Harsh penalties in
international economic agreements are rarely effective: remember Europe s
Stability and Growth Pact? Modest co-operation has better prospects. Just as
the Plaza Accord in 1985 was designed to weaken the dollar and narrow America s
current-account deficit, so the G20 could develop a plan for rebalancing the
world economy, perhaps with target ranges for current-account balances and real
exchange rates. These would be supported by peer pressure rather than explicit
sanctions.
A rebalancing plan, which included faster real appreciation of the yuan, would
remove many of the tensions in the monetary system. But shifting the resources
of China and other surplus countries from exports to consumption will take
time.
Meanwhile, capital flows into emerging markets are likely to surge much faster.
This is partly due to America s quantitative easing: cheap money will encourage
investors to seek higher yields where they can find them. It is also partly due
to the growth gap between vibrant emerging economies and stagnant rich ones.
And it reflects the under-representation of emerging-market assets in investors
portfolios.
For the past decade emerging economies have responded to these surges largely
by amassing reserves. They need other options. One, adopted by Brazil, South
Korea, Thailand and others, and endorsed by the IMF, is to impose or increase
taxes and regulations to slow down inflows. Some academics have suggested
drawing up a list of permissible devices, much as the WTO has a list of
legitimate trade barriers.
This is a sensible plan, but it has its limits. Capital-inflow controls can
temporarily stem a flood of foreign cash. However, experience, notably Chile s
in the 1990s, suggests that controls alter the composition but not the amount
of foreign capital; and they do not work indefinitely. As trade links become
stronger, finance will surely become more integrated too.
Other tools are available. Tighter fiscal policy in emerging economies, for
instance, could lessen the chance of overheating. Stricter domestic financial
regulation would reduce the chances of a credit binge. Countries from Singapore
to Israel have been adding, or tightening, prudential rules such as maximum
loan-to-value ratios on mortgages.
But greater currency flexibility will also be needed. The trilemma of
international economics dictates it: if capital is mobile, currency rigidity
will eventually lead to asset bubbles and inflation. Unless countries are
willing to live with such booms and the busts that follow Bretton Woods 2 will
have to evolve into a system that mirrors the rich world s, with integrated
capital markets and floating currencies.
Although the direction is clear, the pace is not. The pressure of capital flows
will depend on the prospects for rich economies, particularly America s, as
well as the actions of the Fed. Emerging economies willingness to allow their
currencies to move will depend on what China does and China, because its
capital controls are more extensive and effective than others , can last with a
currency peg for longest.
If America s economy recovers and its medium-term fiscal outlook improves, the
pace at which capital shifts to the emerging world will slow. If China makes
its currency more flexible and its capital account more open in good time, the
international monetary system will be better able to cope with continued
financial globalisation and a wide growth gap between rich and emerging
markets. But if the world s biggest economy stagnates and the second-biggest
keeps its currency cheap and its capital account closed, a rigid monetary
system will eventually buckle.