from Follow the Money

Are US companies to Bretton Woods 2 …

August 3, 2005

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What gold was to Bretton Woods 1?

In the post war Bretton Woods system, the dollar was - at least in principle - fully convertible into gold at a fixed rate.   In practice, after a certain point in the mid 1960s, the world's central banks held more dollars in reserves than the US held gold.  The system was only sustainable so long as the world's central banks were willing to keep on adding to their dollar reserves with the full knowledge that not all of them could convert all their dollars to gold. 

France was unwilling to go along with this deal - it did not like financing the United States "exorbitant privilege."  Ironically, one of France's big complains was that the world's willingness to hold dollars at an inflated price let US companies buy up too much of Europe on the "cheap" ...  

Germany (and Japan, I think) initially held onto their dollars even as France slowly shifted into gold.  I think the deal for a while was that France could not convert its existing dollars into gold, but any incremental growth its reserves could be switched into gold. Eventually, the pressure got to be too great, the US suspended the convertibility of dollars into gold and the postwar Bretton Woods system of fixed exchange rates unraveled.   For the full story, read this - and maybe this too.

Yesterday, it became 100% clear that the dollar is not freely convertible into US companies.    That should have been obvious to those accumulating huge dollar claims on the US.  The US was never going to let China convert its surplus dollars into control over US companies.  But should have been obvious is not quite the same as 100% crystal clear.

The sustainability of the current Bretton Woods 2 system therefore hinges on the willingness of a set of countries to continue to accumulate "inconvertible" dollar claims on the US.    Dollars that can be invested in Treasuries, agencies, mortgage backed securities or even high quality corporate debt.    But those Treasuries and agencies cannot be traded for US companies.

That is the deal.

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And so long as the countries providing the most financing to the US are not close friends and allies that is not likely to change.  Right now, three of the biggest financiers of the US are China, Russia and Saudi Arabia.   None are friends of freedom.  None completely share US values.   And the state plays a far bigger role in the economies (and particularly the financial systems) of each of these three countries than in say France.

That in a sense is the core irony of Bretton Woods two circa 2005.  Setting Japan aside, the countries with the biggest current account surpluses and fastest growing reserves are not allies or democracies (Russia is perhaps more of a democracy but it is not an ally, Saudi Arabia is an ally of sorts but not a democracy).   That helps to make the system sustainable in some ways.   No elected representative will hold China's central bankers -- and their masters on the State Council -- accountable for the massive, leveraged and ultimately losing bet they are now making on the dollar.  But in other ways, it hurts.  China is not the UK.   CNOOC is not BP.   Or even Total.

CNOOC's bid was not just doomed by the loud noises coming from a Republican controlled Congress.   As both the Wall Street Journal and the New York Times note, the Bush Administration did not exactly go to bat for CNOOC.  It never told the Republicans in Congress to cool it.  The congressman from Chevron - Richard Pombo - never got called to Dick Cheney's woodshed.  The Bush Administration got the outcome it wanted: Chevron got Unocal, and CFIUS (The Committee on Foreign Investment in the US) did not have to make a formal ruling. 

That said, CNOOC's claim that it is just another commercial oil company rings rather hollow.   CNOOC may be more commercial than PetroChina and SinoPec.  Its management may be more professional.  And unlike PetroChina and SinoPec, it has not done deals with Iran and Sudan.  That makes it a better partner for US firms leery of potential US sanctions against firms that do business with firms that do business with rogue states.   But the simple reality is that no firm that gets dollar financing from its state owned parent (read the central bank, it holds the "state's" dollars) on as favorable terms as CNOOC is operating completely on its own. 

Moreover, so long as the ultimate owner of CNOOC is sitting on what will soon be the world's largest cash stash, the commercial risk of extending it credit is close to nil.  The close links between China's state, state-owned banks and state owned firms are a real issue. Chinese firms on the prowl - unlike the firms in other emerging economies - potentially have better access to dollar financing than even US firms ...

That is only one reason why the issues that CNOOC's bid raised will not go away.  China's reserves were growing by over $20 billion a month (taking into account valuation effects) even before it adopted a messy compromise of an exchange rate regime that sure looks like an open invitation for further speculation.   That's one Unocal a month.

At the end of 2005, China's cash hoard - including reserves transferred to China's state banks - will be close to $950 billion.   And that cash horde will - barring major shifts in China's exchange rate regime - be growing by $300 billion a year.     Indeed, China's reserves could grow faster than that.  The pace of China's reserve accumulation has gone up every year since 2002 - China's 2005 reserve accumulation will be almost twice its 2003 accumulation.

Those betting on the continuation of the Bretton Woods system are betting that by the end of 2008, China will be willing to hold something like $1850 billion of reserves, mostly in inconvertible dollars.   And that the US will be willing to let China hold that large a claim on the US.  China's dollar holdings (assuming a 65/35 reserve split) would by then be approaching 10% of US GDP, and 50% of China's GDP.

That may be a good bet.  But it is no slam dunk.

They are betting that Fred Bergsten is wrong, and that there won't be "a serious economic clash" between the US and China this fall.  Or that the clash won't derail China's willingness to keep adding to its reserves.

And don't even ask about the size of China's exports if 30% y/y growth continues til 2008, or even if China's export growth slows to just 20% ... 

A viable international monetary system has to be politically as well as economically sustainable.

And just to be clear, if I were in Beijing sitting on China's State Council, assessing the world as it is rather than the world as I would like it to be, I would make that assumption that my euro reserves are just as inconvertible as my dollar reserves.  If Danone is not for sale, neither is Total.

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