More Worries About the Fragility of the Dollar

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


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  1. GeorgeNYC

    When the SDR’s were used back in the 70’s were the imbalances of the same magnitude?

    I guess I am always suspicious when big problems are able to be magically solved by the supposed stroke of a pen.

    So, if I am China and I have $1 trillion in reserves, I can go and trade them in for SDR’s and get approximately 350 billion euros, 100 billion pounds and 450 billion dollars and 100 billion yen. (I am kind of fudging here because I mean the dollar equivalent.

    So, assuming that the Chinese have all of their reserves in US Treasuries, they swap in the treasuries and are given $1 Trillion in SDR’s to use as they see fit. Why is that not “creating” another $1 Trillion in money to chase after scarce resources and/or assets? How could that not be inflationary? I guess if all China were doing was holding on to the SDR’s it is no more inflationary than the current system. But what about the false signals that the market will now be giving? It will show an exchange rate for the euro that does not reflect the true value.

    It just seems like price fixing but I am having a tough time getting my head around the analysis because it seems so seductive. Poof! All of our problems are solved. We will just call the dollars euro/pound/yen and why bother with those pesky markets.

  2. david pearson

    Giles repeats the view that China may be worried about devaluing its FX reserves.

    Its possible, but I didn’t hear such concerns when Brazil’s Real went from 3 to 1.8. Those Brazilians took a huge hit, didn’t they?

    The fact is, in a fixed exchange rate system, monetary policy determines the value of FX reserves, and not vice versa.

    China will eventually revalue because its monetary policy is now moving in the opposite direction as the U.S.. If it were to focus on the value of US$ reserves as the driver of its currency, it would be loosening monetary policy and not tightening it. Of course, this would devalue the FX reserves anyway, as its domestic inflation would reduce the purchasing power of those dollars.

  3. s

    China is desperate to halt inflation/overheating and in doing so is trying everything but the obvious. The SDR “solution” seems like nothing more than an accounting gimmick to me. In such a rich and deep fx market, not to mention derivatives market, how does this shell shift avoid being anything other than just this.

    Perhpas the US gov’t could create its own sovereign fund and make a massive leveraged bet on the revalution of alternative curencies. Unethical, no more so than the overt mercantilism that has managed to offshore US standard of living over the past few decades. it is long since time the US begin playing by the new rules.

  4. Clive

    From Dean Baker:

    “One of the areas of surprising (to me) strength in the U.S. economy thus far this year has been the improvement in the trade deficit. Strong growth in exports coupled, with sharply slower growth in imports, has offset some of the impact of the housing crash.

    For this reason, I was struck by an article in the Financial Times this morning telling readers that the declining dollar had done almost nothing to redress international trade imbalances. The FT supports its case with a chart that shows the U.S. trade deficit hovering near $800 billion since early 2005.

    The problem with the FT chart is that it is showing imbalances in nominal dollars. The U.S. trade balance has been increased by the sharp rise in oil prices over the last two years. In real terms it has fallen substantially since its peaks last year. For 2007 to date, the trade deficit in real terms is down by more than 6 percent, and a year over year comparison of the last quarter shows a drop of 11.7 percent. It is hard to believe that anyone could have expected a more rapid decline.

    The FT charts conceal large changes in trade flows because they only look at nominal flows. Since the rising price paid for oil has largely offset the change in trade flows, it appears that little has changed. (Actually, even here the FT is not really conveying the information on its chart well. The deficit had been rapidly growing until 2005, at which point it leveled off. This is an important change, with the deficit shrinking as a share of GDP over the last two years, as opposed to growing.)

    The article also asserts that China is prevented from raising the value of the yuan relative to the dollar because it would mean that they would lose money on their holdings of dollar reserves. The Chinese central bank surely knew that it would lose money on these reserve holdings when it first acquired them. It is hard to believe that this could be a major concern in their decision to set the value of the yuan.

    It is also worth mentioning that a higher-valued yuan would do much to address the major problem for China cited in the article, an overheated economy and rising inflation. Raising the value of the yuan would reduce the price of imports, thereby dampening inflation. It would also reduce China’s trade surplus, or at least slow the increase, thereby slowing economic growth.

    –Dean Baker”

  5. Yves Smith


    Dean Baker’s points well taken, but I don’t think they obviate the thrust of the story. First, in the text, it does acknowledge that trade deficit has been falling, albeit with some delay. However, the deficit has fallen relative to the countries with with the US has has a currency decline, meaning virtually not at all relative to China, and not much relative to Japan (yet),

    Moreover, the trade deficit doesn’t tell the whole story about dollar stress. Brad Setser (and this blog, not in as much detail) has been looking at the Treasury International Capital reports monthly, and there have been some alarming trends. The capital account (dramatically in August, less so in other months) has shown a large deficiency in the capital inflows needed to “fund” the trade deficit. In other months, the deficits were not funded at all (in effect) by the private sector, but completely by official flows. Dr. Setser did not see this as a good development.

    Re China, I’ve always seen the argument that they won’t let their dollar holdings fall as weak. This is a country that allows prisoners to have their organs harvested while they are still alive. Their priorities are very different than ours.

    Having said that, they are going to extraordinary measures to attempt to contain inflation rather than let the yuan rise. The Telegraph article points out that there is no ready substitute, globally, for the demand created by the chronic trade debtor nations, all of which are in not so hot shape financially and are unlikely to continue in the role of being engines of demand (at least at current levels).

    Thus if the yuan appreciates relative to the dollar in a meaningful way (as opposed to the token moves so far), the consequence would be China failing to meet its growth targets, something to which the government seems deeply committed. Yet inflation is causing domestic unrest. It isn’t clear that the Chinese will relent soon, although most believe they eventually will have to relent.

    Other observers who have strong connections in China say that China will not let the yuan appreciate unless the yen rises as well. Notice the yen has been falling in the last few weeks.

    Bottom line: even if the article depicted some particulars in ways that can be questioned, I still believe its bottom line is correct. There is risk that the “global imbalances” meaning China and other large trade surplus nations funding our chronic deficits, won’t unwind in a gradual fashion. There is still the risk of rapid, destabilizing moves.


    Actually, as I understand it, the SDR isn’t a a shell game at all. The IMF is taking FX risk by taking dollars and letting depositors take SDRs in a currency basket. I am not certain how they handled that risk in the past, whether they took it naked, hedged it a bit, or hedged it a lot. The FX markets, particularly forward markets, weren’t anywhere near deep enough in 1978-1980 for them to have hedged it, so they must have taken the risk largely naked last go-round.

  6. s

    Good point on SDR, but it seems like the complexity of derivatives market (assuming no franking privilage) obviates the ability to intervene in natural course barring cap controls. What if an Ibank created a shadow hedge mimicking the basket? It seems like it would be easy take the other side of the trade with an isolated bet against the dollar. Also if the marginal surplus dollar flowed to a different currency, it will not prevent the realignment anyway. it is not so much the eisting reserves as the future allocation? Also, what would happen if the Chinese revalued AND allowed offshore investment flows to jump? Might all the devalution expected be offset by captive capital flight?

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