Saturday, 4 June 2011

US dollar cracking at the seams


MY last columns dealt with the international monetary system (IMS), specifically why the world monetary order is in disorder, and why free movement of capital underpinning the IMS is increasingly being challenged.

Today's column concerns the basic anchor of the IMS the reserve currency role of the US dollar and why it will give way to rapidly rising pressures towards multipolarity, that is, the concurrent pulling of forces emanating from more than two growth centres.

In 20 years, the World Bank expects the newly emerging BRIIKs (Brazil, Russia, India, Indonesia and Korea) to join China as new drivers of growth towards a multipolar world. Today, none of their currencies is used for reserve accumulation, invoicing or exchange rate anchor. The status quo remains centred on the US dollar. But change is in the air.

In 1991, the G3 (US, euro-zone and Japan) accounted for 49% of world trade, and the BRIICKs (BRIIKs plus China) only 9%. By 2010, the G3's share had fallen to 29%, while the BRIICKs' share rose beyond 30%. Without doubt, the post-war structure dominated by advanced nations is in the midst of fundamental change. Globalisation and the rapid growth of the emerging market economies (EMEs) are bound to translate into greater global economic power. It's just a matter of time.


We are witnessing the cracking of the global institutions created in 1945. They are still unadjusted to the growing weight of the EMEs, reflecting reluctance by the United States and euro-zone to come to terms with a world they no longer dominate. It is also a manifestation of uneasiness in China, India and Brazil that the management of their domestic economy, long the jurisdiction of internal prerogative, now matters to the rest of the world.

This is understandable. The founding of the Bretton Woods institutions (IMF and World Bank) after the devastation of the Great Depression and WWII set in motion an era of stability at a time when the US was unchallenged in the global economy. In international finance, this post-war order began to fall apart in the 1970s as the US economy floundered, the dollar tanked, Europe was rebuilt and Japan asserted itself.

The move towards multipolarism was, however, interrupted in the 1980s and 1990s by the Soviet Union's collapse, the euro-zone's indigestion after swallowing a re-united Germany, and the Asian currency crisis. The US was thrust into the forefront to lead. But, the home-made US financial crisis in the 2000s in the face of rapidly rising EMEs, brought the era of US dominance to an end.

Yet, neither the US, euro-zone nor China has the capacity and clout to manage global problems. Happily, the G-20 came along to replace the G7, stumbling on to a mutually beneficial co-operation. Prof Barry Eichengreen's reference in history of another scenario is scary: “The decades following WWI were marked by the inability of rising or declining powers to stabilise the world economy or create functioning global institutions; the result was the Great Depression & WWII.”

A definite shift is taking place, driven by the rising power of the emerging BRIICKs, together representing more than one-half of global growth in 14 years. According to the World Bank report, Multipolarity: The New Global Economy, the EMEs will grow at 4.7% per annum up until 2025, which is double the rate of the advanced nations (2.3%). The implications are far-reaching:
  • the balance of global growth and investment will shift to the EMEs;
  • this shift will lead to boosts in investment flows to nations driving global growth, with a significant rise in cross-border M&As, and a changing corporate landscape where established multinationals will largely be absent;
  •  a new IMS will gradually evolve, displacing the US$ as the world's main reserve currency by 2025;
  •  the euro and the RMB (renmimbi, China's currency) will establish themselves on an equal footing in a new “multi-currency” monetary system;
  • the euro is the most credible rival to the US$; “its status is poised to expand provided the euro can successfully overcome sovereign debt crisis currently faced by some member countries and can avoid moral hazard problems associated with bailouts within the European Union;”
  •  the rising role (and internationalising) of the RMB should “resolve the disparity between China's growing economic strength on the global stage and its heavy reliance on foreign currencies;” and
  • the transition will happen gradually.
At no time in modern history have so many EMEs been at the forefront of an evolving multipolar economic system.

A strong US dollar a delusion

The US dollar is the reserve currency. This refers to its use by foreign central banks and governments as part of their international reserves. This role, combined with its widespread use as a medium of exchange (transactions and settlement vehicle), a standard of measurement (unit of account) and a store of value (method of holding wealth), has given rise to the key currency status of the US dollar. For these reasons, the US serves as world banker.

This was not planned. It just evolved since it met various needs of foreign official institutions and foreign private parties more effectively than any alternative could. Many of the reasons for the use of US dollar by official and private parties are the same. However, the aims of the two users need not always coincide. If the US dollar's role as reserve currency was terminated, its use by private traders and institutions would most likely remain, perhaps even stronger. The wheels of commerce keep turning. The role of the US dollar as world banker remains relevant.

It is a long-standing tradition for the US Treasury to favour a strong US dollar. The US Fed has no say since it is outside its purview of fighting inflation and unemployment.

The exchange rate is just another price. The price of the US dollar relative to other currencies is determined in the market, and not under the control of anyone. An increase in demand for US dollar or a reduction in its supply strengthens the US dollar. Lower demand and increased supply will weaken the US dollar.

A strong US dollar is not always good. It depends on what causes it to strengthen; if the cause is rising productivity or innovation, that's good. But in an economy struggling to grow and to create more jobs, a strong US dollar is not so desirable. A weak dollar means goods are cheaper relative to foreign goods; it stimulates exports and reduces imports. Foreign goods get more expansive but more US jobs are created.

At this time, US is better off with a weak dollar. Strangely, most politicians thinks it's desirable for the US dollar to weaken only against one currency, the renminbi. The US Congress routinely bashes China for not weakening the US dollar enough. Indeed, a fall in the value of the US dollar against all currencies would help the US even more. Yet, in the next breath, the same Congress wants the US dollar to be strong. This delusion just won't go away. They are like failed dieters who talk earnestly about healthy living while eating a chocolate doughnut.

The US dollar isn't going anywhere. It is not about to be replaced anytime soon. The only dangers are (i) reckless US mismanagement giving rise to chronic inflation (or deflation if the exit of QE2, the second round of quantitative easing, is not well handled), which is implausible; and (ii) US budget deficits run out of control; outright debt default is far-fetched. Mark Twain once responded to accounts of his ill health by saying “reports of my death are greatly exaggerated”. He might well have referred to the US dollar. For the moment, the patient is stable, external symptoms notwithstanding. But there will be grounds for worry if he doesn't commit to a healthier lifestyle.

The euro and renminbi

Today, the US dollar faces growing competition in the global currency space. The serious contender is the euro, which has gained ground as a currency goods are invoiced and as official reserves held. Nevertheless, share of reserves held in US dollar remains well over double the share held in euros; US$ share did fall from 71% in 2000 to 67% in 2005 and 62% in 2009, while euro's share rose from 24% in 2005 to more than 27% in 2009. In terms of global forex, the US$ market turns over US$3.5 trillion daily, more than double that in euros. But the US dollar share of the market fell from 45% in 2001 to 42% in 2010. Euro capital markets are of comparable depth and liquidity as the US dollar's, and the euro-zone and US economies are roughly the same size.

Events since 2008 have shaken faith in the US financial markets. But the banking crisis and its economic fallout are a trans-Atlantic affair. Continuing euro bailouts is a sign the old continent is not much safer than the US. Worried savers may still sleep better with US$ under their pillow. So for the euro, it's going to be a long haul.

The sheer dynamism of China and the globalisation of its corporations and banks will propel the renminbi to a greater international role. It can become a global settlement currency this year. China has made good progress, signing currency swaps with more central banks. The issuance of renminbi-denominated bonds is actively promoted. Renminbi offshore deposits in Hong Kong (to top 1 trillion renminbi by year-end) are rising rapidly, and offshore renminbi trading will expand beyond Hong Kong.

But with the undervalued exchange rate, an asymmetry in settlement has arisen. Foreign importers are reluctant to settle in renminbi, while foreign exporters are glad to do so. In the end, success at internationalising the renminbi depends on the pace China liberalises the capital account.

The problem lies in speculative capital flows aimed at profiting from arbitrage. Capital controls remain as China's last line of defence against hot' money inflows. Its policy continues to encourage non-residents to hold more renminbi and renminbi-denominated assets. The sequencing of policy adjustments remains critical as China moves forward. The road ahead is going to be bumpy.

Policies co-ordination

By 2025, the World Bank's best bet is the emergence of a multipolar world centered around the US dollar, euro and renminbi. A world supported by the likelihood US, euro-zone & China will constitute the three major “growth poles” by then. They would provide stimulus to other nations through expanding trade, finance and technology transfers, which in turn creates international demand for their currencies. Already, private investment inflows into EMEs are expected at US$1.04 trillion this year (mainly to China) against US$990bil in 2010 and US$640bil in 2009.

Inherent in this shift is rising competition among them, which is real. This is bound to create situations of potential conflict, which can exact a heavy toll on global financial markets and growth. This calls for workable mechanisms to strengthen policy co-ordination across the major growth poles in particular. This is critical in reducing risks of political and economic instability.

In the recent crisis, the G-20 was able to pick low-hanging fruits by managing the re-alignment of macro-economic policies aimed at generally common objectives to get out of recession and to rebuild financial systems. In today's world, shifts in policy co-ordination will be increasingly towards more politically sensitive domestic fiscal and monetary and exchange rate policies. Also, the interests of the least developed countries (LDCs) have to be safeguarded against pressures accompanying the transition to a multipolar order.

Against the backdrop of the tragic earthquakes and tsunami that hit Japan, the political turmoil of the Arab spring' gripping much of Middle East and North Africa (MENA), and growing uncertainties emanating from euro-zone sovereign debt crisis, global growth remains at sub-par this year with high unemployment, and rising inflation in the EMEs and LDCs. This calls for building confidence and promoting investments to boost productivity and create jobs to absorb the large pool of youth in MENA in particular. The LDCs and MENA nations are heavily dependent on external demand for growth. Aid and technical assistance have the ability to cushion adjustments as they adapt in the transition process.

According to the World Bank: “It is also critical that major developed economies and EMEs simultaneously craft policies that are mindful of the growing interdependency associated with the increasing presence of developing economies on the global stage and leverage such interdependency to derive closer international cooperation and prosperity worldwide.”

A former banker, Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome at