Although dollar concerns have retreated for the moment, given its rally against the euro, yen, and yuan, the problem of a weak and potentially weakening greenback is far from resolved.
What I found intriguing was the pessimistic underpinnings of a solid “analysis” article by Chris Giles in the Financial Times, “Adjustment or affliction? Why the dollar’s drop is failing to rebalance the world.” These stories are generally fairly lengthy, rich in detail, and point up issues without proposing solutions. Despite the momentary respite in the FX markets, Giles’ conclusion is downbeat:
Bickering and a nasty bust, though not perhaps in 2008, still seem the more likely outcome of the dollar’s unbalanced decline than a resolution of the world’s economic tensions.
However, a comment elsewhere in the Financial Times by Fred Bergsten, assistant secretary of the Treasury for international affairs in 1977-1981, offers a solution. When the dollar was depreciating rapidly in the late 1970s, the IMF created substitution accounts, which allowed members who were leery of holding depreciating dollars to deposit them and get Special Drawing Rights in exchange. SDRs are defined as a basket of currencies; the current weighting is USD 44%, EUR 34%, JPY 11%, GBP 11%.
Bergsten explains the key elements of the concept:
The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.
The fund’s members would authorise it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80bn would more than suffice.
All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 per cent dollars, 34 per cent euros, 11 per cent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimising the loss on their remaining dollar holdings as well as avoiding systemic disruption.
The US would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. Such consequences would be especially unwelcome today with the prospect of subdued US growth or even recession over the next year or so.
The main advantage of an approach like this is precedent: it was deployed in similar circumstances and was successful. It’s always easier to get participation in a program that has been road tested and whose failings (if any) are known. Greater use of SDRs may also ease the transition away from the dollar as a reserve currency, which unless there is a dramatic shift in America’s fortunes, seems inevitable.
Back to Giles’ analysis that suggests why such an extreme measure may be necessary. Note I’ve excerpted the guts of a longer and worthwhile piece; there’s an excellent section at the end on the latest approaches to forecasting currency movements.
From the Financial Times:
The economic questions are simple. Has the dollar’s decline since 2002 been a case of “beware what you wish for”? Are people making an unreasonable fuss about a necessary global adjustment? Or are there elements in the dollar’s decline that are genuinely troubling? The answer is not clear-cut, since there is evidence to back each possibility.
For example, the world has enjoyed the fastest rate of economic growth since the early 1970s over the past four years of gradual dollar declines. The International Monetary Fund sees the recent sharp decline of the dollar as reassuring because the fall has not led to a widespread loss of confidence in the dollar as a reserve currency and an associated rise in market interest rates. “The dollar’s decline has not been disorderly in that sense,” says Simon Johnson, chief economist of the IMF.
But the growing evidence that the dollar’s decline will not be followed by a narrowing of global imbalances, merely a shifting of them around the world, gives cause for real concern.
Normally cool heads in central banks and international organisations are uttering notes of alarm. Mervyn King, governor of the Bank of England, warned last month, for example, that the big upward movements in other Group of Seven leading countries’ currencies against the dollar, while many oil states and China maintained a de facto dollar peg, were causing “great currency tensions”.
“I came away from the IMF meetings in Washington recently more concerned about the implications of these tensions precisely because the unwinding of the imbalances is not just a hypothetical prospect out there, but is happening now,” he said.
Although predicting exchange rates is difficult, top officials at the Federal Reserve worry about the parochial concern that its recent interest rate reductions, alongside weak economic prospects for next year, could shake confidence in US assets, perhaps if oil exporters refused to recycle their earnings back into the American economy.
That could create a dollar crisis, pushing up both long-term interest rates and risk premiums on US assets and rendering its rate cuts much less effective than had been hoped in mitigating the economic slowdown.
The tensions that Mr King, eurozone officials and US politicians refer to when they talk about currencies all relate to the ad hoc global system of currency regimes that has developed over the past decade. In a set-up often dubbed “Bretton Woods II”, after the fixed exchange rate system that ran from the second world war to the early 1970s, advanced economies operate floating exchange rates while emerging countries manage their currencies’ value, generally against the dollar.
Trade surpluses in China and among oil producing nations are ploughed back into US assets to prevent the currencies from rising; the system, much to many economists’ surprise, has proved enduring and comfortable. The flow of savings to the US fosters low worldwide real interest rates and high US consumption.
Everyone knows it is not indefinitely sustainable. As the Organisation for Economic Co-operation and Development warned last week, foreign investors will not put up with low returns on their US holdings for ever and their willingness to fund US borrowing will wane as the country becomes a smaller part of the global economy.
The inability of the US to run ever-growing trade deficits helped to start the dollar’s decline. The trouble is that it has fallen only against the euro, sterling, other advanced economy currencies and those of certain emerging economies – namely, the more democratic developing countries that could not force their populations to forgo consumption in order to let US households spend more.
Still, the exchange rate shift is having its usual effect. US exports have become cheaper and, after quite a lag, are growing rapidly. The US current account deficit is this year projected to fall for the first time since the recession of 2001.
For the US – aside from the remote catastrophe of a sudden dollar crisis, which is causing some furrowed brows at the Fed – the outcome is not too bad. It is never comfortable for the world’s superpower to see the greenback losing its lustre, but rapidly rising exports is just what its economy needs when domestic spending may be hit by the credit squeeze and subprime crisis. For the first time in years, the US can go to international meetings saying it is playing its part in reducing imbalances, even though the spending restraint is unintentional. For the rest of the world, the durability of the Bretton Woods II system seems to suit fewer and fewer economies.
For the eurozone, which has a broadly balanced trade account, the dollar’s sharp decline threatens to create a growing trade deficit. Though perfectly manage able, European consumers and governments will probably try to avoid that outcome and are likely to get slower growth instead as exports slow. Trade tensions between Europe and China can only become worse.
In the oil exporting countries of the Gulf, dollar pegs force these overheating economies to depreciate on a trade-weighted basis when appreciation would be better. Raised import prices, a sharp rise in inflation and some internal unrest has been the outcome. The effect has recently been exacerbated as the Fed has cut interest rates to stimulate the US economy. Such a loosening of monetary conditions, which is transmitted to other countries that peg to the dollar, threatens an inflationary spiral.
China, even with its legendary efforts to offset capital inflows with purchases of dollar assets, is now caught between a rock and a hard place. If the authorities allow the renminbi to depreciate with the dollar, higher import prices and ever more demand for its exports threaten to raise inflation, requiring the state to impose ever greater administrative controls on the economy. This goes counter to the authorities’ stated objectives. But if they revalue the renminbi against the dollar, they face an immediate loss on those $1,455bn in foreign exchange reserves, at least 65 per cent of which are thought to be denominated in dollars.
Mr Johnson at the IMF says a flood of capital inflows is pushing up the currencies of emerging economies in Asia, central Europe, Latin America and Africa – creating short-run economic good times but high chances of a bust further along the road.
“Global imbalances now look nastier than before, with a very pointed stick heading in the direction of emerging markets,” he adds, advising governments in these countries to maintain a firm discipline on fiscal policy in the good times to come.
None of the problems associated with the dollar’s decline and the potential fragility of Bretton Woods II guarantees a nasty crunch this year or next, say policymakers, since the world has muddled through many such problems before. But with global imbalances unlikely to fall, even with a declining US current account deficit, the world is still vulnerable to a brutal correction. The countries most likely to be in the line of fire will be the smaller, more vulnerable emerging markets once the party from capital inflows ends.
For an imperilled world economy, the imperative is to find a route through the minefield. The economics of this are easy to describe but fiendishly difficult to achieve in practice. The US already seems likely to save more and spend less. Europe probably does not need any further appreciation of the euro but needs to keep its consumers spending to offset a weaker trade performance. Gulf states should revalue their currencies to offset domestic inflation and spend more of their windfall from high oil prices (including on imports), allowing an increase in living standards. China should let the renminbi appreciate and allow domestic consumption to become a greater driver of improved quality of life.
All of this would require an end to the Bretton Woods II system that has appeared to be so successful. But it is such uncharted territory and runs counter to so many domestic policy commitments – among oil exporters, by China and in Europe – that the political will is not there yet. Bickering and a nasty bust, though not perhaps in 2008, still seem the more likely outcome of the dollar’s unbalanced decline than a resolution of the world’s economic tensions