Remember Bretton Woods II? In September 2003, at a time when economists were agonizing over the huge and widening current account deficit in the US, Messrs Michael Dooley, David Folkerts-Landau and Peter Garber put forward a bold theory that said the so-called global imbalances were not only rather stable, but they also closely resembled the Bretton Woods arrangement put in place at the end of World War II.
The present global economic system, according to its critics, is actually rather strange, with countries such as China producing while the US consumes.
Chinese exports to the US are paid for in dollars that are immediately invested in US government bonds, keeping interest rates low and enabling the continuation of a debt-fuelled consumption binge in the US which, of course, leads to more exports from China and so on, ad infinitum. This led to a widening current account deficit in the US and the build-up of massive foreign exchange reserves in Asian countries. Such an arrangement, said the critics, was obviously unsustainable and the world would come to grief as it unravelled.
That was when Dooley et al propounded their audacious thesis. They said the original Bretton Woods system, in which Europe had fixed and undervalued exchange rates tied to the dollar, allowed the European countries to run export surpluses to the US and thus grow rapidly. They said the current system, where developing countries, especially China, peg their currencies to the dollar and accumulate large forex reserves, is very similar. That’s why they dubbed it Bretton Woods II. They argued that the cost of accumulating the forex reserves by developing countries was outweighed by the gains in growth in countries such as China, where millions had been raised from poverty, thanks to this reincarnation of Bretton Woods. And since the system benefited both parties, it was sustainable. As French economist Jacques Reuff said decades ago, “If I had an agreement with my tailor that whatever money I pay him, he returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him.”
The result was a constant stream of dollars coming out of the US due to the huge current account deficit and the buying of these dollars by Asian central banks in an attempt to keep the value of their currencies low. That unleashed a massive amount of liquidity into the markets, boosting equity and real estate prices in emerging markets. The big rise in asset prices during 2003-07 was the direct result of Bretton Woods II.
But, with the US dollar plummeting, why should central banks in emerging markets continue to put their faith in it? In recent months, there have been several reports of central banks diversifying their forex reserves away from the dollar. Last week, the Financial Times front-paged a story on how sovereign wealth funds were cutting their exposure to the dollar.
Prof. Nouriel Roubini, one of the brave few who predicted the current crash, points to a number of similarities between the current environment and the time when the first Bretton Woods agreement unravelled. He says, “Like in the current episode—where a number of countries heavily managed their currencies relative to the US dollar by keeping them weak via aggressive, partially sterilized intervention, and thus caused excessively low interest rates and excessive growth of base money and of credit that eventually led to asset inflation and goods inflation in 2008—a similar phenomenon occurred in the period that led to the demise of Bretton Woods I in the early 1970s.”
But the growth of foreign exchange reserves by countries such as China, Russia and the oil exporters of the Persian Gulf has actually accelerated in the first quarter of 2008. What’s more, a recent study by the European Central Bank showed that, during 2007, the use of the euro in foreign exchange reserves held by countries increased by only around 1.5 percentage points, that too on account of positive valuation effects. At constant exchange rates, the share of the euro in global foreign reserves decreased by almost 1 percentage point. In spite of a depreciating dollar, central banks seem reluctant to diversify. Forex dealers point out that Europe has its own set of problems and is likely to follow the US into recession. If that happens, there will be little to choose between the dollar and the euro, and the dollar could soon rebound from its current low level.
Roubini says, however, that many Asian governments will resist the bitter medicine of raising interest rates and allowing their currencies to appreciate. At a time when growth in advanced economies is slowing down and exports are likely to be affected, they are unwilling to sharply slow domestic demand. The outcome “will be one where the real appreciation of their currencies will occur through this process of rising inflation. Thus, letting inflation remain high will effectively erode the competitiveness that the pegged or heavily managed currencies policy of Bretton Woods II had tried to maintain. Eventually, the real appreciation had to occur, and since it was not allowed to occur via a nominal appreciation, it will occur—and it is now occurring—via a rise in inflation”. Roubini believes that this will spell the end for the Bretton Woods II system. The question is: what will happen to markets if the liquidity flows generated by the Bretton Woods II system dry up?
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org