I don’t think that Nouriel Roubini and I ever argued Bretton Woods 2 – an international monetary system based on central bank financing of the US deficit -- would absolutely collapse by the end of 2006. But we did say that there was a “meaningful risk” that the Bretton Woods 2 system would “unravel before the end of 2006.” It is quite fair to say that our tone suggested far bigger risks than have been realized, and that Bretton Woods 2 has been far more stable than we expected.
The dollar has not fallen significantly against most currencies since we wrote our paper warning that Bretton Woods two might prove to be unstable: the dollar rallied against the euro in 2005 before falling in 2006, rallied v. the yen and stayed basically stable v. most emerging markets. All signs indicate that central bank reserve accumulation has remained quite strong, and that the lion’s share of those funds are still lent to the US.
Simon Derrick of the Bank of New York – in his note yesterday -- rather graciously decided not to dwell on the fact that my timing was off. He instead opted to highlight that the various forces that Nouriel and I argued might make Bretton Woods unstable are still in play. They just may have a longer fuse than we thought at the time.
Back in February of last year the Federal Reserve Bank of San Francisco hosted a seminar entitled “Revised Bretton Woods System: A New Paradigm for Asian development?” Among the speakers at the event were Nouriel Roubini from the Stern School of Business at New York University and Brad Setser from University College, Oxford who together presented their paper “Will The Bretton Woods 2 Regime Unravel Soon?” In the paper they highlighted the fundamental reasons why they believed the “Bretton Woods 2 international monetary system” is unstable and would unravel “before the end of 2006.” What are particularly interesting to note now (as the end of 2006 approaches) are the potential sources of instability they identified nearly two years ago that they believed would feed through into the systems potential break-up. These were:
1. “The intrinsic tension between the United States’ growing need for financing to cover its current account and fiscal deficits and the large losses that those lending to the US in USDs are almost certain to incur as part of the adjustment needed to reduce the US trade deficit.”
2. “The significant internal dislocations in the US associated with rising trade deficits, along with distortions in the allocation of US investment stemming from the combination of cheap central bank financing and an overvalued USD.”
3. “The significant burden financing the United States imposes on Asian governments and the risks it poses to the stability of Asia’s domestic financial system.”
4. “Rather than joining Asia governments in financing the US, the European governments are likely to join with the US to demand exchange rate adjustment in Asia – and barring such adjustment; a new burst of protectionism is more likely than sustained intervention.”
5. “The institutional infrastructure behind the “Bretton Woods 2” system is too weak to support the pace of USD reserve accumulation required to sustain the system.” More particularly, they noted: “The country providing the system’s anchor currency – the US – is unfettered by any institutional commitment to protect the value of the world’s USD reserves.” Equally, they highlighted that “Many Asian economies do not even formally peg to the USD and are under no requirement to continue to build up their USD reserves. Oil exporters are already defecting, increasing the pressure on China (and a few others) to accelerate the pace of their USD reserve accumulation.”
The reason why we highlight these potential sources of instability is that almost all seem to be in play at the present time. We note:
1. The growing calls from a wide range of Chinese think tanks for a part of the USD 1 Trn reserves to be used to buy oil, gold, silver and other rare metals as a hedge against USD risks.
2. The rising tide of complaints from US car manufactures about the effective subsidy that an “undervalued” JPY provides to their Japanese competitors and the growing pressures on the US administration to deal with this.
3. The rising tide of currency market intervention (Thailand, India, South Korea etc).
4. The growing complaints from Euro-zone politicians about the value of the EUR.
5. The number of nations in 2006 that have announced their intention to diversify a portion of their reserves away from the USD.
Given all this, it is difficult not to see today’s headlines as fairly robust evidence that the day when this “system” breaks down is approaching at a reasonably sharp pace. Thus, although the current price action for the USD may be proving less than exhilarating, it seems to us that this may represent the calm before the storm. Given this, the weekend’s G20 meeting central bankers and finance ministers (not to mention the APEC Leaders Summit) will bear watching closely to see what additional pointers it may provide towards what is becoming the critical issue: the timing of the start of the USD’s decline.
I have been chastened by the at best premature warning Nouriel and I issued at the beginning of 2005. I wouldn’t go quite as far as Simon Derrick does in the last paragraph. But I do think there is growing evidence that the current incarnation of the Bretton Woods 2 system is showing more signs of strain than it did earlier this year.
The debate inside China about how to slow the pace of China’s reserve growth – a debate that most in the market seem to assume won’t lead to major policy changes – is one bit of evidence. Fan Gang of China's Monetary Policy Committee hasn’t exactly hidden his doubts about China’s growing exposure to the dollar:
"The U.S. dollar is no longer a stable anchor in the global financial system, nor is it likely to become one," said Fan Gang, a member of the Monetary Policy Committee of the Chinese central bank and director of the National Economic Research Institute. "Thus it is time to look for alternatives."
China does seem increasingly willing to hold a small fraction of its reserves in a wider range of currencies (including yen). That is perfectly consistent with large ongoing inflows from China to the US so long as Chinese reserves continue to grow rapidly. The real risk is not that China will increase its yen holdings at the margin -- it is that it will no longer be willing to add to its dollar holdings.
Another potential sign of instability? Rising inflation in the GCC. The Gulf Cooperation Council has been a big part of Bretton Woods 2 recently. The GCC countries peg to the dollar even more tightly than China. They initially saved most of the oil windfall – using fiscal policy to sterilize the surge in oil revenues. But the scale of this fiscal sterilization has clearly been scaled back (see box 4 of the IMF’s latest regional outlook). And, as a result, I think there are growing signs that the GCC’s dollar peg is risk to price stability in the Gulf (more here for RGE subscribers) – and that it is putting more strain on the Gulf’s financial system.
Of course, it is quite possible that China will conclude that the risk of not financing the US far exceed the risk of financing the US. It could – despite Fan’s concerns – continue to increase its dollar portfolio rapidly. China is on track to buy about $300b of the world’s debt this year (counting “private Chinese” purchases), and probably about $200b of that will be US debt. Nothing says that it couldn’t buy $400b of the world’s debt next year, and provide the US with $275b or so of financing.
And it is quite possible that the Gulf countries will opt for higher inflation and the current peg rather than for less inflation and stronger currencies. Or that GCC central banks will start doing more sterilization to offset the impact of more spending … (and less fiscal sterilization). The GCC countries remain very committed – at least publicly – to the dollar peg in the run-up to their monetary union.
Betting against the continuation of the status quo isn't easy. I have learned that. The status quo exists for a reason. But it does seem to me that you can still buy insurance against a sharp change in market conditions rather cheaply --- Iceland notwithstanding.