The return of Bretton Woods Two? (or Bretton Woods 2.1?)

If you read the headlines earlier this week, you might well have concluded that the dollar’s days as the world’s leading reserve currency are numbered. Yu Yongding of China’s Academy of Social Sciences suggested that China should shift away from the dollar.* He isn’t alone. China’s population is no longer convinced that US Treasuries should be counted among the world’s safest asset.** Try feeding that into the Caballero, Farhi and Gourinchas model.***

On the other hand, if you ignore the headlines and just look at cold hard numbers, you likely would conclude that central bank demand for dollars has picked up -- not slowed down. The Fed’s custodial holdings aren’t a perfect proxy for the growth in the world’s dollar reserves. Countries can hold their dollars elsewhere. But they are decent proxy -- and data from the custodial accounts, unlike the IMF’s more comprehensive data, are available in close to real time. And over the last four weeks, central banks have added $71.36b to their custodial accounts at the Fed. Their Treasury holdings are up even more: $74.62b.

Those numbers, annualized, imply $900-1000 billion of demand for US financial assets -- mostly Treasuries -- from the world’s central banks. That isn’t a small number. It is close to half of the Treasury’s likely net issuance this year. It would go along way toward answering the question of who will absorb the expected increase in Treasury supply.

Last fall -- and even in January -- the rise in the Fed’s custodial accounts seemed to reflect funds that were being withdrawn from the international banking system. Not anymore. A host of indicators suggest that the banking system has stabilized. European banks aren’t scrambling for dollar financing. The Fed’s swap lines are shrinking. Bank stocks have rallied. And nearly every Asian economy that has reported its end-May reserves has reported a big increase. And it isn’t just that the dollar value of Asia’s euros and pounds has increased.

And with oil now back above $70 before global activity has rebounded (Mark Gongloff calls it a few form of decoupling: "decoupling" once described the hope that emerging markets could grow without developed markets. Now it could refer to commodities and economic fundamentals") a host of oil-exporting economies are likely to start adding to their reserves as well.

Bretton Woods Two has come storming back. As Tim Duy notes, it increasingly looks like 2007 all over again.

So why the angst? After all, a few years ago conventional wisdom held that Bretton Woods two was a fundamentally stable system. That was why bets on a low volatility world made sense even in the face of the obvious imbalances inside the US and in the global economy.

Well, central banks are buying dollars and Treasuries in huge quantities, but they still aren’t comfortable buying longer-term Treasury bonds. There is a glut of central bank demand at the short-end of the curve, and less than usual at the long-end. John Jansen’s ongoing commentary suggests that high levels of reserve growth haven’t translated into demand for five and ten year Treasury notes.

And popular support in key creditor countries for buying dollars has fallen.

Some attribute that to the risks posed by financing the US fiscal deficit. But that ignores the risks that were previously associated with financing the United States’ large household deficit. It isn’t clear that risks actually have increased -- not so long as the trade deficit is down (see this chart from my colleagues at the Center for Geoeconomic Studies).

But it is certainly easier to grasp onto the risks created by the budget deficit. The flows are a lot more visible. No one needs my help to follow the money.

I suspect though there is another reason. Bretton Woods 2.1 isn’t quite the same as Bretton Woods 2. In Bretton Woods 2, central bank reserve growth financed a growing US trade deficit. And that it meant the countries adding to their reserves were also enjoying strong export growth.

Now the trade deficit is down. And trade is way down. The countries adding to their reserves are incurring the costs of piling up dollars that some don’t really need. But they aren’t getting the same benefits they used too.

Same costs and fewer benefits means more opposition. Especially when the costs are a lot more visible.

The $1 trillion question: does this make the system less stable than before?

* He also publicly called for China to move away from its dollar peg in 2004; Dr. Yu doesn’t set Chinese policy.

** China’s population seems worried that a Chinese investor who puts a dollar won’t get a 6.83 RMB back, not that a Chinese investor who puts a dollar into a US Treasury bond won’t get a dollar and change back. On the first point, China’s population has every reason to be concerned -- but no cause to blame the United States. The United States has never promised to direct its macroeconomic policies to maintaining the dollar’s external value. The US has been absolutely clear about this: the Fed’s monetary policy is directed solely at stabilizing domestic economic conditions in the US. In the past that never prevented China from stockpiling dollars, as China had a policy of in effect overpaying for dollars to maintain an undervalued exchange rate to support its export sector. As the Peterson Institute’s Dr. Subramanian has noted, such a policy has a price.

*** The latest incarnation of this model can be found here. And this offers an accessible version of the argument.