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Bretton Woods 2: On its last legs? Or still going strong at the end of 2006?

December 8, 2006

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Or perhaps a complicated combination of both?   That is a question that has popped up over at Martin Wolf’s forum.   It is a keyquestion for the global economy, and for financial markets.

Those betting on a benign 2007 that continues to favor risky assets are implicitly betting the central banks of the emerging world will continue to buy US dollars when no one else wants to – and in the process, finance the US current account deficit when no one else wants to.  They are betting that the economic and political calculus that supports massive reserve accumulation in emerging economies will continue.     Lewis Alexander of Citi makes this assumption explicit in Citi’s end-of-November magnus opus on how to make money in a low volatility world:

“If private capital flows into the US were to decline suddenly, important emerging economies would probably redouble their efforts to stabilize their currencies against the dollar.” 

Some of the results of those efforts would show up in central bank reserves; others might be stashed away in oil investment funds.  No matter.  Both contribute to strong demand for all kinds of bonds (See Ragu Rajan).   And so long as both key Asian economies and many oil exporters effectively peg to the dollar (the Gulf now pegs to the dollar more tightly than Asia), they almost certainly are forced to be the world’s dollar buyer of last resort.

That certainly seems to be what happened in November. We now have data on reserve growth from many of the world’s emerging economies. The combined reserves of Korea, Taiwan, Hong Kong, Singapore, Thailand and Malaysia – a set of key emerging Asian economies – rose by $15.5b in November. Some of that came from the rising dollar value of their euro reserves, but a fair amount came from actual intervention.   I suspect Korea bought at least $2.5b in the market in November, maybe more.   It is rumored to have bought another $2b today. 

And these Asian economies are not the really big players.   The three smallest BRICs combined to add $29.7b to their reserves in November:  Brazil added $5.2b; India a bit over $8b; and Russia $16.5b.   That includes a fair amount of valuation gains, but all three were active in the market too.   

The biggest BRIC of them all should come in above $30b.   Its November trade surplus brought $23.5b into China’s economy, and there are typically other sources of inflows.  And the rising dollar value of China’s existing $200b plus of pounds and euros should add at around $8b to its headline reserve growth. 

Then throw in all the funds oil exporters not named Russia (the Saudis, the Kuwaitis, the Emirates, Libya, Algeria and so on) stashed away.   Most now budget for something like oil at $35 – and have lots of cash to park somewhere when oil is closer to $60.

Sum it up, and the headline increase in emerging market reserves almost certainly will top $100b in November.   Think $60b from the BRICS, another $20b from the oil exporters (ex Russia), $15b from emerging Asia (ex China and India) and $5b from the rest of the world.  Frankly, that is conservative. 

Actual intervention – setting valuation gains aside – likely topped $70b, or a $850b annual pace.  Wow.    And more importantly, my guess is that a quite high fraction of those reserves were held as dollars.  Those central banks buying dollars (and those oil exporters getting paid in dollars) had trouble subsequently selling those dollars for other currencies without moving the market.

That in some sense is what lots of folks are betting will continue to happen.   If the markets won’t finance the US current account deficit, central banks will.   Nothing much to worry about … 

Yet even as the world’s central banks ramped up their intervention in the face of renewed dollar weakness in November, many sign suggest that this system is increasingly under strain – with more and more actors looking for ways to avoid doing what the continuation of the system requires them to do.

The evidence? 

Europe – at least European politicians – aren’t terribly keen on a world where the dollar adjusts v Europe but not Asia, leading European currencies to appreciate against both the US and China.   That helps increase dollar zone exports to the US no doubt.   But it isn’t clear why increasing Asia’s current account surplus – and its capacity to finance the US – is the best way for the global economy to adjust.

The currency guys over at the Bank of New York been on top of this for some time.  They note: 

Asia …. has remained at the top of the Euro-zone’s list of gripes for some time. But with the EUR once more seemingly at risk of bearing a disproportionate role in absorbing the USD’s downward adjustment, Asia is clearly back under the spotlight  …

Over in Asia, a lot of central banks are trying to find ways to avoid having to buy so many dollars: 

  • Thailand’s central banks is trying to make it hard for foreigners to bet on the baht.
  • Korea’s central bank is trying make it more expensive for Korean banks to borrow dollars to bet on the won ..  (Rather intriguingly, at least to me, it seems some Korean banks have been engaging in yen/won carry trades -- borrowing low-yielding yen to buy higher yielding won … )
  • China’s central bank is clearly worried about the scale of its existing dollar holdings – and the difficulties sterilizing its still growing reserves.  It is exploring all sorts of institutional arrangements that would reduce the scale of its needed dollar purchases, whether by setting up a government investment fund or encouraging (mandating?) Chinese pension funds and insurance funds to buy more dollars.   Of course, “private” Chinese investors might start to ask the same question that ICBC seems to have asked:  why hold depreciating dollars rather an appreciating RMB if the pace of RMB appreciation is picking up?
  • Some in Asia are even talking about a coordinated exit of all Asian economies from the current system …

A bit further to the west, in the epicenter of petrodollars, all the talk is about financing Asia – not financing America.   Yet Asia in some deep sense doesn’t need the money and the US does.   If more Gulf money flows into Asia, the difficulties most Asian central banks now face are just compounded. 

Finally, just as Asian central banks seems to be tiring – at some level – of financing the US on an ever bigger scale, the US Congress seems to be tiring – at some level – of the economic dislocations associated with growing Asian imports.     And if the rest of the world wants US equity in exchange for their goods, not just US debt, it isn’t clear – at least to me – that the US political system is willing to accept the trade.

Of course, that doesn’t mean that some critical threshold has been breached and that any of the key players will really start to act differently rather than just talk differently.  Bretton Woods 2 has proven more stable than I ever expected.   It has a strong base of support – on both sides of the Pacific.   Still, my subjective sense is that the political and economic calculus that supports Bretton Woods 2 isn’t quite as clear-cut as it has been.

If the dollar doesn’t rebound in 2007 on the back of stronger-than-the-bond-market-now-expects conditions in the US, a lot of folks who currently hold more dollars than they really want will need to add to the dollar portfolio at a quite rapid clip.

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