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Photo: AP
Photo: AP

Prepare for economic life after the demise of Bretton Woods II

The global currency regime is about to collapse and India will have to reset its policies accordingly

Developed nations ended fixed exchange rates when the successful post-World War II Bretton Woods system was abandoned in the 70s. America began to fret about the economic success of its former enemies—Japan and Germany—although it had played a big role in their economic revival. It was worried about losing its competitive edge to them. In order to achieve competitiveness, it decided to follow an accommodative monetary policy and allow inflation to rise. Real rates in America began to decline from the mid-60s onwards.

Around the same time, America began to get deeply enmeshed in the Vietnam War. Its fiscal deficit began to widen. Inflation picked up even further. European nations began to demand gold from America in return for an overvalued dollar that they wanted to get rid of. An American recession in the 1970s accelerated the decline of the dollar. In 1971, President Richard Nixon took a unilateral decision to suspend dollar-gold convertibility. Globally, exchange rates began to float in 1973.

In the developing world, most countries pegged their currencies to the US dollar, for it helped signal their anti-inflation credibility to markets. But, fixed exchange rates frequently led to surges in capital inflows, overheating, and real exchange rate appreciation, as inflation rates spiked from time to time despite the commitment to low inflation. Or, overheating manifested itself in trade and current account deficits that needed funding. Occasionally, emerging economies found themselves at the mercy of international financial institutions or international capital markets, and that injured national pride. That played out vividly during the Asian currency crisis of 1997-98.

Therefore, very few emerging nations maintain a de jure peg to hard currencies. Most countries have floated their exchange rates. However, they wish to maintain a stable exchange rate, particularly versus the dollar. Most of them still rely on final demand from American consumers to grow their economies. In other words, although the Bretton Woods system of fixed exchange rates was dismantled in the 70s, there has been a de facto fixed exchange rate regime, with the dollar as the anchor currency. China exemplified this arrangement more than others. This is called Bretton Woods II. It synchronised global economic cycles.

When the US lowers interest rates and takes an accommodative policy stance to rejuvenate its economy, other countries follow suit, lest their own currencies appreciate too much against the dollar. But, their currencies appreciate nonetheless, as a weak dollar spurs global risk appetite and leads to capital flows into emerging economies in search of higher returns. Borrowers from emerging economies yield to the temptation to borrow in cheaper dollars and run up external debt. When the US monetary policy cycle starts to become more restrictive, risk appetite weakens and the cycle reverses. Capital flows back into America and emerging market currencies depreciate. America is about to upend Bretton Woods II. That is what Federal Reserve chairman Jerome Powell signalled on 27 August.

The US attempt is to generate inflation and keep real interest rates as low as they were in the 70s. Real rates will likely be negative for a long time. It would help America whittle down debt. At least, that is the aim. Government obligations—real and contingent—have gone up steadily in the last 40 years. But, in the last 12 years, its rate of growth has picked up momentum. Data from the Bank for International Settlements shows that America’s gross public debt-to-gross domestic product (GDP) ratio was 71% at the end of 2007. By the end of 2011, it had risen to 100.4%. It rose further to 114.6% by mid-2016. Post-pandemic, debt ratios are set to rise very sharply. In its June 2020 update to its World Economic Outlook, the International Monetary Fund projected that the debt ratio for the advanced G-20 nations would jump to 141.4% in 2020 from 113.2% in 2019.

So, left with a crushing debt burden, developed countries are looking for an encore of the 70s, when the inflation rate was in double-digits, real interest rates were persistently negative and debt ratios plunged. America’s general government debt-to-GDP ratio declined from around 55% in 1961 to around 35% by the end of the 70s. In the UK, the decline was dramatic. The net public debt-to-GDP ratio declined from 100% to 40% during the same period. The unstated objective for the 2020s is stealth inflation, thus inflating away the debt burden. Most advanced nations would be pursuing this goal. For instance, the Bank of England appeared to rule out negative interest rates as a policy tool in August, but ruled it in later in September. What had changed was the Fed’s policy framework. Competitive debasement is in.

When a system’s anchor country pursues deep and prolonged financial repression, it is near-impossible for emerging economies, including India, to expect that Bretton Woods II will sustain. It will not. India’s options include matching that repression, pursuing a strong rupee, a re-imagined monetary policy regime, and capital controls. The status quo looks infeasible.

V. Anantha Nageswaran is a member of the Economic Advisory Council to the Prime Minister. These are the author’s personal views.

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