28 April 2009
Ousmène Mandeng, Ashmore Investment Management
The global financial crisis has caused significant interest and exchange rate volatility. Both can be deemed failures to manage global liquidity. This risks causing commercial and trade disruptions, lead to competitive devaluations and fuel protectionism thus undermining prospects of a sustained recovery. Many commentators have attributed those market dislocations to a failure of the international monetary system, the set of rules that govern cross-border monetary transactions. Recent proposals to foster a diversification of reserve currencies by China and Russia, the G20 commitment of an SDR allocation and Brazil’s International Monetary and Financial Committee statement of April 2009 “to make […] international liquidity gradually less dependent on the monetary policies of a few countries that issue reserve currencies” have been fuelling calls for a system reform. For international investors those efforts may well be one of the most important outcomes of the global financial crisis.
An international monetary system normally aims at providing sufficient exchange rate stability and limiting the build-up of payment imbalances to foster international trade and global expansion. It is the exchange rate frameworks and the currencies used that provide the foundations of a monetary system. On the former, today’s monetary arrangements are many: From floating to pegged exchange rate regimes. On the latter, the dollar has remained by far the dominant international currency. This seems to represent the biggest problem for the international monetary system.
The international monetary system is not a system. It is the remains of the Bretton Woods system established after World War II as the outcome above all of U.S. and British interests. Bretton Woods created a system of fixed exchange rates where all currencies were pegged to the dollar, at fixed but adjustable rates, and the dollar was fixed to gold. The motivation for the system rested above all in the aim of the U.S. to promote the dollar and restore a system close to the gold standard of the 1880s-1914 that had been associated with vigorous globalisation and prosperity. The U.S., the largest creditor and holder of gold at the time, also wanted a system that would put the burden of payment adjustment onto the debtor. In contrast, Britain the biggest debtor at the time and facing severe balance of payment problems wanted to preserve monetary autonomy and payment adjustments to be undertaken largely by creditors. The U.S. won the argument and the system was in place effectively through 1973.
The Bretton Woods system of course enshrined the dominance of the dollar. The dollar represents about 65 percent, or an estimated70-75 percent if including non-reporting countries, of US$7 trillion in international reserves. The reliance on the dollar by the official sector to manage international liquidity has provided the U.S. with a significant advantage to finance its external payment deficits. If leading economic powers were to meet today, interests would differ significantly from those prevailing after WWII. Today the U.S. is the largest debtor and China effectively the largest creditor. Yet China is not as dominant a power as the U.S. was after WWII nor does its currency come close to rival the dollar. As at Bretton Woods, it is improbable that a debtor nation would dominate the outcome; furthermore, it is extremely unlikely they would reach consensus on something close to the Bretton Woods system.
There are therefore at least two immediate questions about inter- national monetary reform: Why does reliance on the dollar pose a problem and what would be a reasonable alternative? Other key issues in relation to international monetary reform in particular the concern of increasing international liquidity and inflation, institutional change and implication of the co-existence of multiple exchange rate policy frameworks are omitted here. Other factors that normally convey reserve currency status such as store of value and unit of account are also skipped.
The dominance of the dollar has been controversial for some time. Former French president Charles de Gaulle famously complained about the U.S.’ exorbitant privilege (finance without discipline) and, France as a large creditor to the U.S., threatened to liquidate its dollar balances. This is closely related to a problem that has been associated with the so-called Triffin dilemma in the 1960s: Rising international transactions require an increasing amount of dollars; yet an increasing supply of dollars undermines confidence in the value of the dollar. More importantly, the U.S. is unlikely to subordinate its domestic policy objectives to the needs of the international economy.
The concentration of central bank reserves has led them to hold at least about half of U.S. treasury notes and bonds. This has made the U.S. dependent on the foreign official sector, above all on China, and the international economy exposed unusually to U.S. domestic policy priorities. The predominance of official sector institutions in the U.S. treasury market has also probably led to distortions in price formation and severely rationed the supply of high quality assets. The latter may also have prolonged the liquidity crisis by leaving the private sector short liquidity management assets. Similarly, the official sector holds so many U.S. treasuries that any significant liquidation of their holdings would lead to a collapse of the treasury market. The problem therefore seems to be that there are simply not enough dollar assets to satisfy the demand for managing dollar liquidity.
While the dollar has remained the dominant international currency, it is a fact that the international economy relies on multiple reserve currencies encompassing at least the euro and in significantly smaller quantities the British pound, Swiss franc and Japanese yen. A departure from a multiple currency system seems unlikely. Recent proposals by China and Russia suggest that more currencies should be added. There will naturally have to be a trade-off between the marginal benefit of using a common currency (externality effect) and the marginal benefit of holding multiple currencies (diversification effect). Diversification can include adopting more national currencies or SDRs. Either is likely to produce demand for a greater variety of currencies.
The key is whether the effect of reserve currency diversification is stabilising or destabilising. By conjecture, China’s continuous purchasing of U.S. treasury securities is most likely to have had a stabilising impact on treasury prices and the dollar. By the same token, any significant divestment by China could cause substantial instability. The net effect of currency diversification will depend on whether central bank allocations will be gradual or abrupt.
The dollar represents as much as three quarters of central banks international reserves yet the U.S. represents only one quarter of world output. This signifies a fundamental asymmetry an international monetary reform would need to address amid the limitations of using national currencies. According to the IMF, the world in 2014 will have emerging markets among the 10 largest economies in terms of GDP. Given that the international economy is becoming more multipolar, adopting a multi-polar system to balance the limitations of individual currencies seems sensible. So far, the official sector has not taken up international monetary reform in earnest but is most likely to do so shortly. For investors any reform move will signal a fundamental transformation in the perception of and desire to hold emerging markets as an asset class.