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Saturday, 15 October 2011

Changing the international monetary system

2007 $1 Washington coin reverse.


ON Oct 5, 2011, the Triffin International Conference celebrated the 100th year of birth of Robert Triffin, a Belgian economist who was trained in Harvard, worked in the US Fed, taught in Yale and then returned to Europe to help work on European monetary integration.

He was of course famous for the Triffin Dilemma, defined as the inconsistency between the domestic needs of the reserve currency country and the external needs of the world that uses the reserve currency. Put in another way, Triffin identified that the reserve currency country would have to run a current account deficit in order to provide the world with greater liquidity.

Over the long term, running cumulative current account deficits becomes a large debt overhang that is called the Global Imbalance.

Triffin wrote about the Dilemma in the late 1960s, when the United States was struggling whether to maintain its peg to gold, which it abandoned in 1971. This removed the anchor of the Bretton Woods system of fixed exchange rates, which had been in existence since 1947.

The succeeding Bretton Woods II, or non-system as some critics call it, has become a system of flexible exchange rates, plagued by financial crises every decade in the 1980s (Latin America), 1990s (Mexico and East Asia), 2007-9 (US subprime) and today, the European debt crisis.

Today, there is sufficient awareness that the shift from a unipolar world to a multipolar global financial system carries with it great risks and unknowns. The unipolar world of dominance by the US dollar had a lot of advantages, as long as the US remained the unchallenged hegemonic power. The US dollar became not only the standard unit of account for global trade, but also the deepest and most liquid market and an important store of value.

The price of oil, gold and other important commodities are all measured in US dollars. The US Treasuries market is the most liquid and efficient clearing system, which is one fundamental reason why the dollar remains superior to the euro, which does not have a single eurobond market, being divided into different national (German, French, etc) bond markets.

According to the BIS (Bank for International Settlements) April 2010 survey data, the US dollar today still accounts for 85% of global foreign exchange trading, compared with 39% for the euro, 19% for yen and 13% for sterling (because FX transactions are paired, total turnover sums up to 200%). By contrast, the Hong Kong dollar accounts for only 2.4% and the yuan 0.9% of turnover.

Because of its dominance in international trade and payments, the US dollar still accounts for nearly two thirds of total foreign exchange reserves. China alone reputedly holds roughly US$2 trillion in US dollar assets in the foreign exchange reserves and holdings by Chinese banks and state-owned enterprises.

In 2009, People's Bank of China Governor Zhou Xiaochuan called for the use of the SDRs (International Monetary Fund's Special Drawing Rights) as a possible global reserve currency. The logic for a globally issued reserve currency as opposed to a nationally issued reserve currency is impeccable. Nationally issued reserve currencies are subject to the Triffin Dilemma, because countries, however strong, will sooner or later go into deficit.

In other words, the whole global financial system is stable when the national reserve currency country is strong, but it will go into crisis, when the national reserve currency country goes into crisis. This is the current state of affairs.

The four reserve currency countries (US, euro area, Britain and Japan) accounting for just under 60% of world GDP are all in deep trouble. The US is running a current account deficit in excess of 3% of GDP and a fiscal deficit over 9% of GDP in 2011. At the end of 2010, the US had a gross foreign liability of US$22.8 trillion or 157% of GDP. Thank goodness that most of the debt is in US dollars, so that it can devalue its way out of debt.

The euro area as a whole has a smaller current account deficit of 0.5% of GDP, but if you look deeper, there are deep imbalances within the eurozone. Germany, the Netherlands and a few are in surplus, whereas the smaller countries like Greece, Portugal, Ireland and Spain all have net foreign liabilities exceeding 50% of GDP, an indicator of crisis using the Asian crisis experience as rule of thumb.

Britain has a fiscal deficit of 8.8% of GDP and gross debt of 81% of GDP. Its one advantage relative to the Euro is that it can devalue its way out of debt.

Japan, on the other hand, has a net foreign surplus of 50% of GDP, being a major net lender to the rest of world, since it runs a current account surplus of 2.3% of GDP. Its vulnerability is, however, its large domestic gross debt of 220% of GDP, growing larger every year with fiscal current account deficit of 8.3% of GDP in 2011. This means that the domestic debt is vulnerable to bubble implosion, because if interest rate rises, the debt becomes unsustainable.

In sum, the reserve currency countries are in a double trap. They have to run loose monetary policy to keep interest rates low, so that their fiscal debt will not run out of control. But their central banks also know that exceptionally low interest rates are distorting not only global financial markets, they also have very distortive impact on their domestic resource allocation.

This is the liquidity debt trap that Japan got into in 1990 when its asset market bubble burst following the sharp rise in the yen exchange rate. Japanese GDP growth never fully recovered after that. Reserve country status has not been a privilege, but a curse.

The emerging markets are struggling because the present international monetary system has become unstable and unsustainable. How should this essentially unipolar system be reformed to a multi-polar system where yuan plays a role will be the subject of the next column.

l Tan Sri Andrew Sheng is president of the Fung Global Institute.