[Translated from Le Figaro (Paris)]
BUSH ANNOUNCES AN INTERNATIONAL FINANCIAL SUMMIT
** The American president said he would host "in the near future" the summit in the U.S. For Nicolas Sarkozy, the conference, which would be the occasion for reviewing financial policies, could be held before the end of November. **
Le Figaro (Paris)
October 18, 2008
Faced with stock-market storms that are shaking the planet, Europeans and Americans have agreed in principle to hold an international financial conference on the financial crisis, an idea proposed by French President Nicolas Sarkozy.
The American president, George W. Bush, offered on Saturday to host the conference in the United States "in the near future," without specifying either the date or the location. "I look forward to hosting this meeting in the near future, so we can help ensure that this crisis doesn't happen again," he said at a joint press conference with Nicolas Sarkozy, his French counterpart, and José Manuel Barroso, the president of the European Commission, at the Camp David presidential compound.
The French head of state, for his part, said he thought the meeting could be held before the end of November. He insisted that the crisis was an opportunity to review financial policies.
Nicolas Sarkozy and José Manuel Barroso went to the presidential residence in Maryland to exhort George Bush in the name of the Europeans to accept a recasting of the global financial system, on the model of the "Bretton Woods" agreements. The objective of the Europeans, who are leading the charge against the crisis: to convene a summit to decide the rules of the game for a new international financial order, as was the case in the American town of Bretton Woods in July 1944.
G-8, GREAT EMERGING COUNTRIES, AND ARAB WORLD?
The Europeans had already rallied to their cause the secretary general of the United Nations, Ban Ki-Moon, who said Saturday the holding of an international summit should be "at the latest at the beginning of December." He proposed it take place at the U.N. in New York.
"I confirm my strong support for your initiative as president of the E.U. to hold an emergency summit" of an enlarged G-8 on this subject. "I am pleased to offer the facilities of the U.N. secretariat in New York," Ban Ki-Moon wrote in a letter made public by the office of the French president after a meeting between Ban Ki-Moon and the current president of the European Union on the sidelines of the Francophone summit.
The configuration of the summit is still to decided. In addition to the G-8 countries, Nicolas Sarkozy wants the great emerging countries to participate (China, India, Brazil, South Africa) and if possible a representative of the Arab world.
The Camp David meeing comes after a week of ups and downs in financial markets that are totally "manic-depressive," in the words of the 2008 Nobel Prize economist Paul Krugman.
Despite the roller coaster, the main European stock exchanges rose this week: Paris regained 4.8%, London 3.3%, and Frankfurt 5.2%. And they ended Friday's session on a positive note, with clear gains. The picture is more mixed for the New York Stock Exchange: unable to confirm its rebound of the day before, the Dow Jones dropped 1.4% in a very volatile market. For the week, the index gained 4.7%, however.
Translated by Mark K. Jensen
Associate Professor of French
Department of Languages and Literatures
Pacific Lutheran University
Tacoma, WA 98447-0003
Web page: http://www.plu.edu/~jensenmk/
Comment & analysis
GRAND CLAIMS BUT ONLY TIRED IDEAS
Financial Times (London)
October 16, 2008
The biggest financial crisis since the Great Depression deserves a comprehensive, measured response, and a lot of painstaking thought about how the global economy should be run. But what the world risks hearing is an exercise in grandstanding, with tired old ideas pulled off the shelf and unconvincingly repackaged as bold new initiatives. That, at least, is the initial impression from the chorus of calls for a “new Bretton Woods” that has emanated from European leaders this week, particularly Gordon Brown, the U.K. prime minister.
Mr. Brown is in danger of getting ahead of himself. Flushed with success from the international praise he has rightly garnered for acting decisively to stave off the U.K.’s banking crisis, he has dusted off an idea that he has been touting for years -- a global “early warning system” to combat financial crises -- and called for the International Monetary Fund to take a leading role in regulating global finance.
Lest we forget, Mr. Brown himself was in charge of the IMF’s ministerial steering committee for a large part of the past decade and yet signally failed to implement the ideas he is parading. During this time, it was repeatedly explained to him that every early warning system devised by the finest minds in international economics, including those at the fund, either predicts crises that never arrive or misses those that do. If Mr. Brown has any econometric modelling tips or has spotted any new indicators for the IMF’s economists, they would be delighted to hear them.
IMF staff might also point out that, despite repeated attempts by Mr. Brown’s Treasury to influence their public pronouncements on the U.K. economy, they did repeatedly warn him about the threats from the build-up of credit and the housing boom -- and were ignored. Transparency begins at home.
As for the idea of a new global regulator, anything that improves information flow and taking of decisions at the appropriate level is welcome. Yet the current crisis, while undoubtedly global in nature, did not arise from a failure of co-ordination. It arose because regulators and policymakers in a variety of countries -- including the U.K. -- made similar mistakes. They allowed credit growth and housing booms to spin out of hand and they failed to understand the risk from toxic derivatives.
Globalizing regulation would not by and of itself have stopped the Northern Rock fiasco, saved Lehman Brothers, nor prevented banking systems across the world from needing wholesale government interventions.
Although the crisis is still with us, it is still important to plan for what will come next. The world needs a thorough look at how global finance is managed. But there is little point in rushing. Any credible plan will need U.S. support, which means a new administration must be in place. It must include the developing world both as a subject and as a participant. This is a topic to which we and others shall return. It is an important discussion that will require deep thought and prolonged preparation, not easy slogans and old ideas.
[Translated from Le Figaro (Paris)]
PREPARING FOR AFTER THE CRISIS
By Gaëtan de Capèle
Le Figaro (Paris)
October 18, 2008 (posted Oct. 17)
And now what do we do? How do we organize to be able in the future to equip ourselves for a similar crisis to the one that is now bringing the world economy to its knees? What systems, what straitjackets do we dream up to channel and control the thousands of billions that are circulating in the pipes of international finance? Such is the copious menu inscribed on the agenda of today's meeting between Nicolas Sarkozy and George W. Bush, with a view toward a great international summit that has never seemed as indispensable.
The program is already sufficiently vast for us to beware of settling for words alone. More than a "refounding of capitalism" or the elaboration of a "new world order," it's a matter of prosaically seeking truly efficient regulations to frame better the financial actors and their practices, without excessively constraining their activities. Which, need we recall, play an essential role in the development of modern economies. Today we are bitterly aware of this: when the banking system seizes up, the entire machine stops. In brief, the question is not to destroy finance and capitalism, but to correct their excesses.
This way of looking at things is important: we'll never drag the United States -- fortunately -- into even a adventurous questioning of free-market policies, even if the examination is "lite." On the other hand, the shipwreck of the American financial sector followed by the damage caused in Europe and the world forces them profoundly to reconsider things, which George W. Bush accepts and which his successor will doubtless not be able to avoid. How could it be acceptable to change nothing after the mind-boggling rescue plans fixed upon for banks on both sides of the Atlantic?
Prodded by a public opinion that is aghast at what it is discovering, Europeans and Americans have no choice to but to go forward together. And it's hard to imagine that the other great powers, beginning with China or Russia, being held at arms' length from their reflections. For on a financial planet which is now completely interconnected, characterized by phenomena of instant contagion, there cannot be national or even continental responses. Having made this obvious observation, for all that we cannot expect a revolutionary break in the history of global finance. Doctrines, special cases, and, in a word, well-understood interests on all sides make this an illusory goal. The suppression of off-shore centers and other tax havens, those famous "black holes" of finance, is, for example, far from being a foregone conclusion.
On the other hand, there are subjects on which consensus can probably be found. We can thus imagine, among other things, a platform of common principles of regulation and banking supervision as well as the the establishment of close cooperation among the various authorities; a deep reform of rating agencies; a redefinition of the role and missions of the IMF, which has been impotent during this crisis. The list is not an exhaustive one. After having castigated finance run amok, at the cost of exonerating themselves of their own responsibility, politicians now have their backs to the wall.
Translated by Mark K. Jensen
Associate Professor of French
Department of Languages and Literatures
Pacific Lutheran University
Tacoma, WA 98447-0003
Web page: http://www.plu.edu/~jensenmk/
BW2: ARE WE BACK TO A NEW STABLE BRETTON WOODS REGIME OF GLOBAL FIXED EXCHANGE RATES?
By Nouriel Roubini
October 8, 2004
What is the hottest current policy debate among academic geeks, policy wonks, and market gurus? The Bretton Woods 2 hypothesis: i.e. the view that the world is effectively back to a regime of global fixed exchange rates pegged to the U.S. dollar like the original Bretton Woods regime that lasted from 1945 to 1973. Global fixed exchange rates? This BW2 hypothesis has been forcefully advanced by three economists affiliated with Deutsche Bank, namely David Folkerts-Landau (Global Head of Research at DB), Peter Garber (Global Strategist at DB) and Michael Dooley (formerly head of EM research at DB and now back to academia at UC Santa Cruz). David, Peter, and Mike are three extremely smart folks and when they speak and write, people listen to them. They have recently written four papers ("An Essay on the Revived Bretton Woods System"; "The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates & Exchange Rates in Center Countries"; "Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery"; and "The U.S. Current Account Deficit and Economic Development: Collateral for a Total Return Swap") where they argue that the international financial system is experiencing today the reemergence of a new Bretton Woods regime of global fixed exchange rates (Bretton Woods 2 or BW2). In this view, this new BW2 regime will allow the U.S. to finance its large current account deficit at a low cost for a long time; consequently, the United States's growing external indebtedness poses few immediate concerns. So, while everyone else is worrying about the U.S. current account deficits and the global imbalances, the three DB gurus tell us not to worry about them and enjoy the U.S. current account deficit.
In my recent paper with Brad Setser on the U.S. current account deficit, I discuss in detail this BW2 hypothesis and provide a critique of it. In summary, the BW2 is not a real global fixed-rate regime and this semi-fixed-rate regime for some regions is neither stable nor sustainable. The main substance of our critique -- pulled from our paper with some additions -- is reported below in the continuation of this blog item.
THE BW2 HYPOTHESIS
The BW2 argument goes as follows. The U.S. is currently running a large current account deficit while most of Asia is running a large current account surplus. After the Asian crisis, most Asian economies decided that a growth model based on financing investment via external capital (i.e. running current account deficits, as they had done in the early 1990s) was not desirable, given their vulnerability to a sudden reversal of capital flows. Immediately after the crisis, they needed to run current account surpluses to rebuild their reserves, but they then maintained large current account surpluses and continued to rely on export-led growth. In a world of floating exchange rates large current account surpluses (and in China’s case, large capital inflows, including large FDI inflows) would naturally tend to lead to currency appreciation. To avoid appreciation, many Asian economies, including those whose currencies are formally floating, started to intervene aggressively in the foreign exchange market. Some Asian currencies are formally pegged to the U.S. dollar, mostly notably the Chinese renminbi (also the Hong Kong dollar and the Malaysian ringitt). But many other countries intervene heavily, and thus are to effectively pegged to the U.S. dollar (and more importantly, to the Chinese renminbi) (India, Korea, Taiwan, Thailand, Indonesia, and even Japan). This aggressive intervention manifest itself in the huge accumulation of foreign exchange reserves by Asian central banks.
According to the BW2 argument then, at least along the U.S.-East Asia axis, the heavy intervention of the “periphery” to prevent appreciation of their currencies against the core (the U.S.) effectively has created a new Bretton Woods system of fixed exchange rates. The Bretton Woods gold-dollar fixed exchange rate regime has been replaced by a new dollar-renminbi fixed exchange rate regime. This new regime is based on structural current account deficits in the U.S. and structural current account surpluses in Asia, with the Asian current account surpluses recycled to provide cheap financing for the U.S. current account deficits. The U.S. gets to consume more than it produces and finance budget deficits cheaply, while strong export growth drives East Asian growth rates and rapid industrialization absorbs the labor surplus created by China’s underemployed rural population.
China is at the center of this arrangement, as an undervalued renminbi propels spectacular growth in China’s exports, and particularly its exports to the United States. But, so long as China maintains its current peg and resists letting its currency appreciate, other Asian countries have to intervene to avoid an appreciation that would cause a loss of competitiveness relative to China in Asian and global markets.
Large-scale intervention is not costless. Weak currencies mean that the terms of trade of these countries are worse than they could be. This, however, is not necessarily viewed as a problem in East Asia: expensive imports are part of the reason why domestic consumption in China and other Asian economies is low and national savings are high. A depreciated exchange rate thus supports an economic model based on export-led growth financed largely by domestic savings. The currency intervention needed to appreciation also has its costs. Asian central banks are accumulating huge stocks of low-yielding foreign reserves (essentially low yielding T-bills and other U.S. government debt). To prevent reserve accumulation from leading to an increase in the domestic money supply, East Asian central banks must issue local currency debt, sterilizing their intervention in the foreign exchange market. However, difference between the interest rate Asian central banks pay on their local currency debt and the interest rate they receive on their reserve assets creates an ongoing fiscal cost. In addition to the ongoing flow costs created by the interest rate differential, Asian central banks are exposed to the risk of large capital losses by, in effect, financing the purchase of low-yielding dollar debt with the issuance of high-yielding local currency debt. If Asian currencies were to eventually appreciate relative to the U.S. dollar, the local currency value of their dollar denominated reserve assets would fall sharply, while the value of their local currency debt would stay constant. Finally, the scale of local debt issuance needed to sterilize the current pace of reserve accumulation poses many technical difficulties. Particularly in countries like China, difficulties with sterilization are leading to potentially inflationary growth in monetary aggregates.
To proponents of the Bretton Woods two hypothesis though, these costs are trumped by the benefits of export-led growth and a weak currency. The capital loss that countries with large dollar reserves would experience the day their currencies appreciate against the dollar is a worthwhile price to pay for the benefits of high economic growth today. Particularly in China, the explosive growth of the export sector is supporting the massive transfer of millions of underemployed labor from rural areas and loss-making state-owned enterprises. Consequently, it is in the interest of China and all the other exporting countries in Asia to continue to resist currency appreciate, to accumulate large reserves and to lend these reserves back to the U.S. at a low rate (rather than say invest their reserves in assets that offer protection against dollar depreciation, such as euros).
Proponents of the Bretton Woods hypothesis also argue that this system is in the short-run interest of the U.S. -- in spite of the squeeze that it puts on the tradable and import-competing labor-intensive manufacturing sector -- since cheap financing from Asian central banks keeps U.S. asset values high and supports a consumption-led expansion. Without Asian central bank financing, U.S. interest rates would spike upwards, risking a severe recession. Thus, it is in the interest of both the United States and Asia to maintain the new BW2 regime, a regime based on an overvalued U.S. dollar, high U.S. consumption, continued spending growth above income growth and a structural current account deficit in the U.S. financed by the reserve accumulation that stems from undervalued Asian currencies, with Asian consumption and spending growth squeezed by unfavorable terms of trade and high import prices to generate structural current account surpluses.
So far, this new Bretton Woods 2 regime is not global. Europe allows its currency to float relative to the U.S. dollar and some emerging market economies, unlike those in Asia, are still capital-importing (i.e. running current account deficits) rather than capital-exporting (i.e. running current account surpluses). But soon enough, Europe and Latin America may be forced to join the pegged-regime bandwagon. Many Latin American economies, especially countries that experienced a recent a recent crisis and thus have undervalued currencies, are either running current account surpluses or are close to balance (Argentina, Venezuela, Brazil). Fixed exchange rates in Asia transfer the pressure for dollar depreciation to Europe. But the trend of euro appreciation against the dollar that started in 2002 is not sustainable. If the euro were to keep on appreciating, it would lose competitiveness relative to both the dollar and the Asian currencies. The loss of European competitiveness and the increase in import penetration of Asian goods in Europe would sap European growth (until recently, driven largely by exports) and lead to severe protectionist pressures in Europe. Europe would either respond by slapping major protectionist tariffs on Asian exporters or, as more likely, when the ECB would start to intervene aggressively to prevent further Euro appreciation. In that latter case Europe would also join the Bretton Woods 2 regime of fixed exchange rates.
In the view of its supporters, the Bretton Woods regime is stable and sustainable for at least a generation (about 20 years or so), until China’s agricultural labor surplus is transferred to the tradable sector. The pressures created by the current, partial system of fixed exchanges are more likely to be solved by expanding the current Asian dollar peg fixed exchange rate regime to include Europe and Latin America than by the collapse of the Asian dollar peg. Since it is in the short-term interest of both sides to maintain the imbalance created by the new Bretton Woods dollar-renminbi exchange rate system, the new regime is stable for a long time in the view of Bretton Woods 2 apologists. Of course, eventually the system will unravel as the accumulation of U.S. external debt will become at some point unsustainable. But since this accumulation is financed by the official sector of Asia (their central banks) and not private agents, it can be maintained as long as it is in the interest of Chinese and Asian authorities to maintain this export-led growth model.
ARE WE IN BW2 AND IS IT SUSTAINABLE? A CRITIQUE
How strong are the arguments that a new system of fixed rates has emerged, and that this new regime is stable and sustainable over time?
The first part of the argument -- that a new system of fixed exchange rates has emerged -- is the strongest, but even this argument needs to be qualified in two ways. First, a managed float is not quite the same thing as a pegged exchange rate, and far more Asian economies have managed floats than pure pegs. Second, the new Bretton Woods system of managed floats is providing far larger financial flows than the initial Bretton Woods system of fixed exchange rates.
Japan, of course, is the most important example of a country that intervenes in currency markets to manage a float, rather than to maintain a pegged exchange rate. No one doubts that Japan intervenes aggressively in market: aggressive intervention during calendar 2003 and Q1 2004 led the Bank of Japan to accumulate $347 billion in reserves. While this intervention no doubt has kept the yen from appreciating further, the yen still moved from 132-134 yen to the dollar in early 2002 to around 109 to the dollar now -- a 20% nominal and real depreciation. Aggressive intervention when the yen gets close to 100 is very different from a peg. The same argument holds for many other Asian currencies: Korea, Thailand, and Indonesia have allowed some appreciation of their currencies relative to the U.S. dollar (around 10% in Korea, Thailand, and Indonesia relative to the beginning of 2001-2002 level) even as they intervene to avoid too much appreciation. Other Asian economies (Taiwan, India, and to a degree Singapore) have been more aggressive in preventing -- via massive intervention -- major changes of their currency values relative to the U.S. dollar.
The overall picture is mixed: Asian currencies do not float freely but they have not returned to totally fixed exchange rates. Most countries allow some exchange rate flexibility but intervene aggressively to prevent appreciation they judge to be excessive. In some sense, though, U.S. sustainability -- at least in its current form -- hinges on the scale of the intervention, not whether the intervention comes in the context of a peg or a heavily managed float. Both forms of intervention have contributed to the build-up of foreign exchange reserves in Asia and provided steady, and cheap financing of the U.S. twin deficits.
The scale of reserve accumulation and the associated financing of the U.S. current account deficit is another difference between Bretton Woods one and Bretton Woods two. As Barry Eichengreen (2004) has emphasized, Bretton Woods one never financed U.S. current account deficits on a comparable scale to the current U.S. current account deficit. The U.S. actually ran trade and current account surpluses throughout the1960s. On one level, the postulated new Bretton Woods system is based on a weaker commitment to exchange rate stability than the initial Bretton Woods system. On another level, the financial flows required to sustain the new Bretton Woods system are far larger than those associated with the initial Bretton Woods system.
This inconsistency is at the core of the system’s weaknesses. The scale of the financial flows required to sustain it are likely to exceed the financial flows that arise naturally from East Asia’s limited commitment to exchange rate stability.
In our view, there are five reasons why this new regime will not prove to be stable.
1. Internal dislocations in the United States. Bretton Woods two keeps U.S. interest rates below what they otherwise would be (particularly given large U.S. fiscal deficits), helping interest-sensitive sectors of the U.S. economy. However, the financing comes at the expense of import-competing sectors of U.S. economy, since Asian current account surpluses are needed to generate the cheap reserve financing the U.S. needs. If Bretton Woods two is sustained, those sectors in the U.S. that compete with Asian exports would be increasingly crowded out and the associated job losses and related economic dislocation risk leading to intense protectionism. Indeed, the jobless recovery and weakness of employment in the U.S. manufacturing sector is already leading to protectionist pressure. The U.S. politically cannot allow its manufacturing base to decline as sharply as a sustained Bretton Woods two system would imply. Nor is it entirely clear that it is in the long-run economic interest of the U.S. for its tradeables sector to contract to the extent likely implied by the new Bretton Woods system. After all, in long-run, the U.S. needs its tradeables sector to grow to pay for its current borrowing. While resources are currently flowing out of the tradeables sector into sectors that benefit from low interest rates, in the long run, resources will have to flow back into the tradeables sector and out of the non-tradeables sector.
2. The strains placed on Europe. If the Asians keep on pegging their currencies, most of the downward pressure on the U.S. dollar will be channeled towards the Euro. This is not a politically sustainable disequilibria. Europe cannot allow its tradable sector (both export and import competing) to be crowed out by Asian competition. Europe could respond by joining Asia in pegging against the dollar, expanding the Bretton Woods two system. The ECB, the Bank of England and the Swiss national bank would join the Bank of Japan and the Bank of China in providing large-scale financing to the United States. But it more likely that Europe will join with the United States to put political pressure on the Asian economies to allow their currencies to appreciate (alternatively, there could be an upsurge in European protectionism).
3. The strains placed on China’s domestic financial system. Particularly in China, the sterilization of the foreign exchange intervention required to prevent upward appreciation against the dollar is becoming increasingly difficult. The stock of domestic financial assets is not large enough to allow the easily sterilization of an annual reserve buildup of $100 billion a year (roughly 10% of China’s GDP). If sterilization is incomplete, the ensuing monetary growth will lead to higher inflation, and higher inflation in turn will lead to a real appreciation via inflation. Real appreciation through inflation is slow -- and will be even slower if distortionary steps like internal price controls are partially successful at limiting the pace of inflation. But such real appreciation still will tend to reduce the current account surplus over time. China’s inflation rate is rising (even though it is partly repressed by official policy actions) and China’s 2004 current account surplus looks to be... though it is likely that the shrinking surplus is more the product of increased imports of higher-priced oil and other commodities (price rises that stem in part from rising Chinese demand for these commodities), not of any incipient real appreciation through inflation (since the renminbi has remained stable v. the dollar, it has depreciated v. the euro and the yen). Moreover, the growing monetary supply inside China is helping to feed a credit boom, and that credit boom in turn risks feeding a risk-asset bubble (in housing, commercial real estate, and even in new manufacturing plants). The rest of Asia learned in 1997 that credit booms can turn into credit bust even in high savings, high-growth economies.
4. The financial risks associated with continuing to provide low-cost dollar-denominated financing to the United States. Asian central banks are already taking an enormous financial risk by holding most of their reserves in dollar-denominated assets, given that the United States’ large current-account deficit suggests the need for further dollar depreciation. Yet sustaining the current system requires that Asian central banks continue to keep their existing stock of reserves in dollars (and not, for example, diversity into euro, putting pressure on the euro/ dollar rate and ultimately on their own rates as well) but also substantially increase their holdings of U.S. dollar-denominated assets. Indeed, recent trends suggest that private investors are becoming increasingly unwilling to take the risk of capital losses on U.S. assets in return for current returns. Relative to 2000, Asian central banks and other official actors are financing a larger share of the U.S. external imbalance and private actors are financing a smaller share, and the share financed by Asian central banks was particularly high in 2003. As the U.S. current account continues to expand, the absolute amount of financing the U.S. needs will also increase, even as rising deficits and a growing debt stock suggest that the risk of further dollar depreciation also is rising. It seems likely that the U.S. would only be able to finance such large deficits implied by the current system without a major increase in interest rates only if Asian authorities are willing to absorb an ever larger share of an ever increasing U.S. external deficit. Consequently, current trends imply an accumulation of reserve assets by Asian and foreign central bank that is truly exorbitant. As the attached chart shows, Asian forex reserves may have to increase to over $7 trillion by 2010 based on our baseline forecast of the U.S. NIIP. This forecast could well be an underestimation, since it does not assume that the U.S. has to turn increasingly to Asian central banks for financing as the debt levels rise. Rather, it assumes that the current ratio between the U.S. NIIP, Asian reserves, and Treasuries held abroad stays constant.
5. Incentives to free ride and opt out of the cheap dollar financing cartel. Individual Asian countries at some point will have an incentive to diversify out of U.S. dollar reserves into euro reserves, so as to avoid capital losses should their currencies appreciate relative to the U.S. dollar. The incentive to do increases over time, as the United States growing stock of external debt increases the risk of a major depreciation and the Asians growing stock of dollar assets increases their prospective losses in the event of a devaluation. Indeed, while an individual country can diversify its reserves out of U.S. dollar assets without affecting either its currency value relative to the U.S. or the value of the U.S. dollar relative to the euro, if a large number of Asian central banks were to start such diversification the value of the U.S. dollar will start falling relative to the euro thus causing capital losses on U.S. dollar reserves. If all Asian economies tried to diversity their reserve holdings, they would put pressure on the dollar/euro rate, reducing the value of their remaining dollar reserves and put pressure on their own currencies to appreciate versus the dollar. The Bretton Woods system can only be sustained if the Asian central banks act as a cartel and both keep their existing reserves in dollars and invest the reserves obtained from ongoing current account surpluses in dollars. An individual central bank can only protect itself if it either shifts out of dollars and into euros ahead of the others, or buys a euro/dollar hedge before everyone else. This gives rise to a classic problem of collective action: all central banks may be better off if no bank tries to diversify its reserve holdings, but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from large losses. Moreover, as Barry Eichengreen (2004) has emphasized, Asia lacks the institutions that helped the first Bretton Woods system survive when it faced an analogous problem in the 1960s. Consequently, it is likely that the current equilibrium where everyone invests in mostly U.S. dollar reserves will eventually unravel.
THE LATEST VARIANT OF THE BW2 HYPOTHESIS
In the latest variant of the BW2 hypothesis the Folkerts-Landau, Garber and Dooley offer a new twist of BW2 that is aimed at explaining the large accumulation of forex reserves by Asian central banks. The core of their argument is as follows:
China and other emerging market economies have poor financial markets and it is better if their savings to investment projects are not intermediated by domestic financial markets but rather by international financial intermediaries. So, Chinese and Asians should put their savings in international banks (say Deutsche) and these funds with return to Asia in the form of foreign direct investment. The problem with FDI, however, is that you need international collateral to sustain FDI: as Argentina shows, there is always a risk that FDI may be -- explicitly or explicitly -- effectively expropriated. Thus, the chronic U.S. current account deficit is an integral and sustainable feature of a successful international monetary system where capital flows to emerging markets. The U.S. deficit supplies international collateral to the periphery in the form of an accumulaton of foreign reserves by Asian central banks. Thus, this international collateral in turn supports two-way trade in financial assets that liberates capital formation in poor countries from inefficient domestic financial markets. The implicit international contract is analogous to a total return swap in domestic financial markets: using market-determined collateral arrangements from these transactions they compute the collateral requirements consistent with recent foreign direct investment in China. They argue that the data are remarkably consistent with such calculations: the accumulation of reserves by the central bank of China is closely related to this implicit collateral. Thus, they argue that their analysis helps explain why net capital flows from poor to rich countries and the recent evidence that net outflows of capital are associated with relatively high growth rates in emerging markets.
Does this explanation of the the accumulation of Asian reserves based on a need for international collateral makes sense? Hardly, in a number of dimensions.
Are FX reserves of China and other Asian central banks an implicit or explicit collateral for FDI? The experience of Argentina suggests otherwise. Argentina in 2002 took policy decisions that effectively amounted to some implicit partial expropriation of foreign FDI (pesification of bank assets, freezing of utility tariffs, etc. that led to severe capital losses on FDI investments), the kind of risk that the BW2 apologists would worry about (as explicit expropriation is unlikely in today's world). Argentina was also sitting on a pile of foreign exchange reserves in 2001; so, in the BW2 view those reserves should have been the collateral for this expropriation risk. Were those reserves attached and seized by the U.S. government or the foreign creditors of Argentina after the so called "FDI expropriation." Not a penny of it!
So, would investors in China and Asia be able to seize the "collateral" of the Asian reserves if such "expropriation" were to occur in China or elsewhere in Asia? Hardly. The reality is that foreign reserves of a central bank cannot be easily seized given effective sovereign immunity. Also, any policy action short of actual expropriation of FDI but that leads to capital losses on FDI investments can always be justfied as being driven by a financial crisis that requires losses for both domestic and foreign agents and investors. The actions taken by the Argentine government were, in many ways, justified or justifiable given the severity of the Argentine crisis. And no one even thought about seizing those reserves as collateral for the FDI losses.
So, in reality foreign reserves are not a collateral at all for FDI or other foreign claims on a emerging market economy. Can we conceive of the U.S. government not servicing its government debt held by Asian central banks in 1997-98 when most of the financial and corporate system of Korea, Indonesia, and Thailand defaulted on its foreign debts? And would the U.S. government (or international creditors via the U.S. government as their proxy) be willing to default on its debt to punish China if China were to take policy actions that hurt the asset value of foreign FDI in China? That is outright far-fetched. The U.S. would never risk losing its status as a non-defaulting sovereign to punish a foreign government that takes actions that are harmful to foreign investors.
And would Japanese and European FDI investors in China be able to seize U.S. Treasury bonds held by China in retaliation for such policy actions by China? Would the U.S. government allow that? Wishful thinking!
And can we explain why Japan is accumulating foreign reserves at the same pace as China via a collateral story? There is not much foreign FDI in Japan to begin with. And the idea that Japan keeps on piling up U.S. Treasuries to make sure that the FDI that comes in Japan has an international collateral is also altogether far-fetched.
The simple story for the Asian central banks reserves accumulation is very different. Given U.S. savings-investment deficit (the U.S. current account deficit) and the Asian savings-investment surplus (their current account surplus), Asian central banks need to accumulate reserves to prevent the appreciation of their currencies from occuring. This explains the accumulation of reserves, not a collateral story.
SUMMARY OF THE BW2 CRITIQUE
In summary, Asia’s desire to avoid dollar appreciation has created the kernel of a new Bretton Woods system of fixed exchange rates. But this regime is highly unstable, fragile, and unsustainable and more likely to break apart than to expand and consolidate. The flow and stock imbalances associated with Bretton Woods Two are much larger than the imbalances created by the initial Bretton Woods regime. The scale of these imbalances and the difficulties sustaining a cooperative equilibrium in a game with strong incentives for free riding make it likely that the Asian dollar-renminbi standard will crash in years, not decades.