Bretton Woods II: Coming Apart at the Seams

Asian Practicalities

It is also true that, rather than an exercise in rose-tinted nostalgia for the swinging sixties, Asia’s predilection for export-led growth in the current millennium had rather more practical origins. In short, it grew out of the Asian financial crisis of the late 1990s. At that time, a number of countries with external deficits and limited foreign reserves found themselves at the mercy of sudden shifts in risk appetite and financial flows, and were rapidly forced into gut-wrenching fiscal and monetary adjustments to re-establish confidence in their currencies. Reserves also had to be rebuilt from scratch and what began as an understandable effort to restore a semblance of international credibility subsequently rather developed a life of its own.

But whatever the shortcomings of the historical analysis, the fact is that much of the emerging world has been quite happy over recent years artificially to depress their exchange rates to sustain export growth, improve their current account positions and recycle much of the money earned back into the US via reserve accumulation and the purchase of dollar fixed income securities. The latest IMF Economic Outlook estimates the external surplus of the Asian NIEs in 2007 at 5.4% of GDP, that of the ASEAN 4 at 4.7%, China’s at 11.7%, the Middle East’s at 16.7% and Latin America’s at 0.8%.

Counting the Costs

However, there are now growing signs that the Bretton Woods II system is breaking down as the economic costs associated with it increasingly outweigh the benefits of stable export-led growth.

Bretton Woods II has generated a perverse constellation of capital flows and a misallocation of resources in both the US and those countries whose currencies are linked to the dollar. Capital, rather than flowing from the relatively mature and low return core to an opportunity rich periphery, as economic theory and common sense would suggest (no jokes please), has been moving in the opposite direction. Meanwhile, in the US, domestic spending, and in particular consumption, is being subsidised at the expense of exporters and those competing with importers, while there is less incentive for the US to adjust its policy-mix in an optimum manner. Interest rates are depressed and lower borrowing costs encourage the government to spend more. Outside the US, the subsidisation of exporters and import substitutes reduces current incomes. Such distortions are bound to encourage a political backlash from affected interest groups, of which US protectionism – which, it should be noted, also often enjoys a new lease of life in election years - is perhaps the most obvious manifestation.

Part and parcel of this process is that those countries adhering to the Bretton Woods II model adopt a cost of capital determined by US monetary policy rather than by their own domestic conditions. With the Fed latterly in easing mode, this has meant that monetary conditions in the periphery have loosened and that they could well get looser still, should, as seems likely, the US central bank deems it necessary to provide further support to a traumatised financial sector and domestic activity in general. In most of these economies, an independent monetary regime would have seen the domestic authorities tightening over recent months rather than loosening and, not surprisingly, we have seen a growing reluctance on the part of some, not least the Saudi Arabian Monetary Authority, to march in lockstep with Dr. Bernanke and his colleagues.

Reserve accumulation has gone well beyond the prudent. China now has more than $1.4tr in fx reserves and, as the table below illustrates, seven of the top ten holders of fx reserves are in Asia, with Russia and Brazil also on the list. Not just in these economies, but in a broader range of emerging market economies, reserves run far in excess of six months of imports and 20% of GDP, which in any context would represent extremely conservative insurance policies against an interruption of international capital flows. In the meantime, the return on these assets, which are typically short term and low risk in nature, is well below the average rate of return available on domestic assets. Former US Treasury Secretary Larry Summers estimated more than a year ago that the opportunity cost of the excessive wealth tied up in reserves was some 2% of those economies’ GDP, or the equivalent of global foreign aid or the next round of gains from global trade liberalisation! And, of course, there is also the threat of major capital losses on these assets should the dollar continue to decline.
 

The sterilisation of fx reserves is a further problem, especially in countries with relatively underdeveloped money markets. Commercial bank balance sheets can become saturated with sterilisation instruments, forcing interest rates on them higher and adding to the cost of the process. China, for example, is suffering consistent problems in controlling monetary growth and is now seeing rapid asset price inflation spill over into more elevated rates of increase in goods and service prices. An alternative mechanism to limit monetary growth is to raise the reserve requirement ratio, which China has been doing consistently of late. But while this is not costly for the central bank, it does represent a tax on the banking sector and can promote disintermediation as non-banks seek to by-pass the requirements.

The Corrosive Influence of Inflation

It was worries about inflationary policies and the fact that monetary policy in the core was too loose for the periphery that triggered the demise of Bretton Woods I. The late 60s saw first France and then Germany and Britain all start to swap their dollar reserves for gold as they questioned why they should continue to accumulate assets at depressed yields in a currency that was only going to go one way - down. We may well be witnessing a similar situation today, as spare capacity is increasingly exhausted and price pressures in the emerging world build - the greater the instability in prices, the greater the likelihood of currency realignments.

And the members of Bretton Woods II have already begun to adjust their behaviour. For some time now, they have been gradually diversifying their fx reserves away from dollars. The dollar share of global reserves was more than 71% in the late 1990s. It is now under 65%, with the euro (25.6%) and sterling (4.7%) the prime beneficiaries of the rebalancing. In addition, a number of countries have set up, or are in the throes of setting up, sovereign wealth funds in an effort to achieve a higher rate of return on their reserve assets by investing in a broader range of assets. Korea and China are just two examples of those choosing to go down this path.

Emerging Currencies on the Move

And finally, countries are proving more willing to let their currencies rise. China has widened its intervention band from 0.3-0.5% and officials have talked openly of the pressures building for a faster pace of appreciation. But attitudes to revaluation have evolved right across the emerging world, from Brazil to India, from Russia to Turkey, and from Vietnam to Kuwait.

Although not without some merits - for example, it encouraged us to consider how national balances of payments fit together as interdependent elements of a larger system - the Bretton Woods II thesis was, in truth, always a stretch. It was based on a superficial view of history and encompassed a good deal of complacency about the negative aspects of the regime. It implied the existence of a cohesive bloc of countries happy to act in their collective self-interest for a protracted period – in effect a cartel. But cartels tend to break down under strain. And just as in the late 1960s, it is in the interest of each member to exit the cartel before the dollar collapses.

If Bretton Woods II is, indeed, now unwinding, then there are some clear market implications. First, the dollar is going to fall further, perhaps substantially so, and second, a number of pegs and quasi pegs will be broken, or at the very least evolve in some way, shape or form. Of course, politics will play a part in the precise timing and nature of this evolution, especially in countries like Saudi Arabia or Hong Kong, but generally speaking, the currencies that will probably gain most will be those that have the largest current account surpluses and most dynamic economies – in this sense buying a basket of emerging Asian currencies would appear to be a sensible strategy. In the meantime, asset diversification will provide greater support to equities and remove some support from US Treasuries, although whether this rebalancing of demand will be sufficient to dominate the effects of the underlying cyclical dynamics in the world economy is open to question.

* Global Head of Fixed Income and Currency Research - Royal Bank of Canada Europe Limited