Download Comparative Politics of Developing Countries

The Future of
Bretton Woods II
Juha Seppälä
Department of Economics
University of Illinois
1
Starting Point
 Paul Krugman summarizes the current state of the
U.S. economy as follows:
“Americans make a living selling each other houses, paid for
with money borrowed from the Chinese.”
(New York Times, 8/12/2005)
2
Outline of the Talk
1.
2.
3.
4.
5.
6.
Bretton Woods I
Bretton Woods II
Problems with Bretton Woods II (U.S. and China)
Other Players
New Chinese Exchange Rate Mechanism
Conclusions
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1. Bretton Woods I
 The original Bretton Woods system was the system of
fixed exchange rates that existed from the end of
World War II (1946), until its collapse in 1971.
•
•
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John Maynard Keynes was a principle architect of the Bretton
Woods System.
Global financial system would have fixed exchange rates in
order to prevent the beggar-thy-neighbor policies of currency
devaluations that characterized the 1930’s.
The dollar could be converted to any other major currency or
gold at a fixed exchange rate.
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1. Bretton Woods I
 The Bretton Woods System was already criticized in
1953 by Milton Friedman:
•
His argument was that in the face of external or internal
shocks, for most economies, the most important channel of
adjustment is the real exchange rate. This can adjust in two
different ways: either nominal exchange rate depreciates
(appreciates) or the price level decreases (increases). The first
way is much less costly. Therefore, it would be best to let the
nominal exchange rate be flexible.
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1. Bretton Woods I
 In 1960, the economist Robert Triffin, testifying before
the U.S. Congress, exposed a fundamental problem in
the international monetary system:
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•
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Continuous U.S. balance of payments deficits during the 1950s had
provided the world with liquidity, but had also caused dollar
reserves to build up in the central banks of Europe and Japan. The
U.S. gold reserves were going dangerously low.
If the United States stopped running balance of payments deficits,
the resulting shortage of liquidity could pull the world economy
into a contractionary spiral, leading to instability.
Excessive U.S. deficits would erode confidence in the value of the
U.S. dollar. Hence, it would no longer be accepted as the world's
reserve currency. The fixed exchange rate system would break
down.
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1. Bretton Woods I
 By the early 1970s, as the Vietnam War accelerated
inflation, the United States was running not just a
balance of payments deficit but also a trade deficit.
The crucial turning point was 1970, which saw U.S.
gold coverage deteriorate from 55% to 22%.
 In the first six months of 1971, assets for $22 billion
fled the United States. In response, on August 15,
1971, President Nixon unilaterally “closed the gold
window.”
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2. Bretton Woods II
 “Bretton Woods II” is a term coined by three Deutsche
Bank economists — Michael Dooley, Peter Garber,
and David Folkers-Landau — in a series of papers in
2003–2004 to describe the current international
monetary system:
 In this system, the United States and the Asian
economies have entered into an implicit contract
where the U.S. runs current account deficits and the
Asian countries keep their currencies fixed and
undervalued by buying U.S. government debt.
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2. Bretton Woods II
 According to Dooley, Folkert-Landau, and Garber
(DFG), this system has benefits to both parties:
•
•
The U.S. obtains a stable and low-cost source of funding for
its current account and budget deficits, and can easily reduce
taxes, fight two wars, and increase government spending at
the same time.
For the Asian countries, the undervalued currency creates
export-led development strategy that produces economic
and employment growth to keep the lid on potentially
explosive pressures rising large pools of surplus labor.
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2. Bretton Woods II
 At the time when DFG were writing, many countries
in Asia exporting to the United States had fixed
exchange rates with the United States, such as China
(8.28 renminbi per dollar), or had quasi-fixed rates,
such as Japan (Japan will intervene to keep the Yen
above 100 per dollar).
 DFG predicted that the Bretton Woods II system can
last for a generation, or at least for eight years.
 Remember that Bretton Woods II system lasted for 11
years after Robert Triffin presented his dilemma.
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3. Problems with Bretton Woods II: Definitions
 A national trade balance (surplus/deficit) is the net
value of exports of tradable goods and services minus
imports.
 A national current account balance is the net value of
exports of goods, services, assets, and transfers –
minus the imports of goods, services, assets, and
transfers
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3. Problems with BW2: U.S. CAD
 Volume of U.S. recent current account deficits
(CAD):
•
In 2003, U.S. CAD was $530 billion.
•
In 2003, foreign central banks added $440 billion of dollar
reserves, thus 90 percent of total U.S. CAD.
•
In 2004, U.S. CAD was $660 billion.
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3. Problems with BW2: U.S. Saving Shortfall
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3. Problems with BW2: People’ Bank of China
 U.S. absorbs 80 percent of world’s savings not
invested at their home country.
 The large CAD sends billions of dollars abroad,
particularly to China.
 People’s Bank of China uses the inflow of dollars to
purchase assets, mostly U.S. Treasuries.
 Much of the $400 billion fiscal deficit is financed by
China.
 If China stops purchasing U.S. assets and switches to
Japan, Europe, or other markets, it will cause a fall in
the dollar and long-term interest rates will increase.
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3. Problems with BW2: Nightmare Scenario
 If dollar depreciates against Renminbi by 33%, this
could lead to capital losses for People’s Bank of China
of nearly 10 percent of China’s GDP.
 In addition, higher interest rates in the U.S. would
lead to the end of U.S. housing bubble, U.S. recession,
fall in U.S. imports, and finally a global recession.
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3. Problems with BW2: Interest Rates
 How much does the interest subsidy from the foreign
central banks lower U.S. interest rates?
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•
•
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Goldman Sachs: CB’s narrow yields by only 40 bps.
Federal Reserve: 50 – 100 bps.
PIMCO: 100 bps.
Morgan-Stanley, Stephen Roach: 100-150 bps.
Roubini and Setser: 200 bps.
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3. Problems with BW2: Interest Rates
 Roubini and Setser get a larger number because they
try to take into account also general equilibrium
effects:
•
If Asian central banks purchase fewer Treasuries, this would
affect the dollar, U.S. growth and inflation numbers, which
all impact Treasury yields.
•
In addition, private investors believe that central bank
purchases will inhibit currency rate movements. Hence they
are more willing to invest in the U.S.
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3. Problems with BW2: U.S. Financing Needs
 U.S. external debt to GDP
only 30 percent, though
could rise to 50 percent by
2008.
 Most experts believe that
deficits will continue “as far
as eye can see.”
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3. Problems with BW2: Reducing CAD
 Reducing the CAD would require either or all of:
•
•
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Stronger growth in world demand.
Slower growth in overall U.S. demand.
Change in the real exchange rate.
 Roubini and Setser believe that a 20 percent fall in
dollar is needed to impact CAD.
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3. Problems with BW2: Imports vs. Exports
 Continuation of BW2 means imports rising faster than
economy.
 This implies resources are leaving import competing
sectors toward sectors supported by low interest rates.
 Imports from China are increasing 25% year on year.
 By 2008, Chinese imports could be double the value of
oil imports.
 Exports to U.S. account for 12 percent of China’s GDP.
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3. Problems with BW2: Housing Sector
 Job growth in interest
sensitive sectors actually
exceeds losses in competing
sectors.
 Interest rate subsidy from
Asia discourages saving.
 Promotes overinvestment in
housing and underinvestment in tradable
goods.
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3. Problems with BW2: Some Numbers
 In 2004, U.S. CAD was $660 billion.
 Asia’s CA surplus was $313 billion.
 Asia’s central bank reserves increased $535 billion.
 From 2003 to 2005, China’s gross CB reserves will go
from 32 to 48 percent of GDP.
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Problems with BW2: Case of China
 Impact of reserve growth on China:
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Expanding reserves increases the money supply, fueling
excess credit and bad lending.
Klitgaard finds that only half the increases in reserves from
2000 to 2003 were sterilized.
In 2004, reserve increases were $200 billion dollars, 13
percent of GDP. According to Roubini and Setser (2005),
China sold only $70 billion in bonds, so only 35 percent
sterilized.
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3. Problems with BW2: Central Banks
 Of the world’s $3.8 trillion in reserves, $2.5 trillion is
held in dollars.
 Asia’s central banks have $2.4 trillion in assets, with
$1.8 trillion in dollars.
 If a 33 percent average appreciation of Asian
currencies is needed to reduce the U.S. CAD, the loss
to Asia’s stock of $1.8 trillion in dollar reserves will be
$600 billion.
 If the dollar falls 33 percent against the renminbi,
losses will be $150 billion for China, or 10 percent of
their GDP.
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3. Problems with BW2: China’s Potential Losses
End 2004
End 2006
End 2008
33% app
9.5%
14.7%
17.7%
50% app
14.3%
22.0%
26.6%
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3. Problems with BW2: Weak Structure
 There are no institutional constraints on the anchor
currency (dollar): U.S. can run deficits and doesn’t need
gold.
 In addition to maintaining dollar levels of reserves,
Asian CB’s must continue to add more dollars to their
reserves to absorb the additional deficits in the United
States.
 Roubini and Setser in their paper “Will the Bretton
Woods 2 Regime Unravel Soon? The Risk of a Hard
Landing in 2005-2006” (February 2005) predict that
BW2 will unravel in the next couple of years.
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4. Other Players: Short Maturity of Debt
 Average maturity of U.S. debt fell from 90 months in
1999 to 33.4 months in Dec. 2004.
 This is due to current interest rates being low.
 Because of short maturities, must roll over debt.
 If CB’s accumulate U.S. debt slower, U.S. Treasuries
will need a lot more other buyers.
 Irony: To protect dollar assets, CB’s must purchase
more of those assets. Similar to stock bubble.
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4. Other Players: Non-Japan Asia
 In 2003, only 12 percent of new CB accumulations
went to Euros and non-dollars. In 2004, estimates are
25 percent.
 Korea, Taiwan, and Hong Kong hold $500 billion.
 Singapore, Malaysia, Thailand, and India hold $350
billion in reserves.
 If these banks adjust to euros, this would move the
market.
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4. Other Players: Japan
 In 2003, about $200 billion of $485 billion the U.S.
received in CB reserve financing came from Japan.
 In 2004, this dropped to $170 billion.
 Many experts believe Japan’s Ministry of Finance will
intervene to keep yen weak against dollar.
 However, Japan alone cannot provide all the financing
the U.S. needs, and Japan will provide less in 2005 and
2006.
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4. Other Players: Europe
 If the European Central Bank (ECB) sold euros, that
would provide one of the easiest ways to prop up the
BW2 and prevent Asian CB’s from taking a large hit.
 However, ECB has shown little inclination in the past
to cut interest rates, let alone foreign exchange market
intervention.
 ECB cannot intervene as readily as China or Japan.
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4. Other Players: Foreign Investors
 Private investors continue to buy U.S. assets.
 If they believe their home CB’s will continue to also
purchase Treasuries, foreign investors will also.
 However, if investors anticipate their any CB
hesitance, there will be a stampede out of U.S. assets.
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4. Other Players: U.S. Investors
 If U.S. investors leave U.S. assets, that could unravel
the system.
 Since the end of 2002, U.S. residents have bought
more foreign securities than Treasuries.
 Total U.S. outflows could reach $180 billion in 2005.
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5. New Chinese Exchange Rate Mechanism
 On July 21, 2005 China moved to a new exchange rate
regime. Instead of pegging the dollar, China now pegs
a basket of currencies with a band of 0.3%. It is still
not known which currencies (or what weights) make
up the basket.
 For example, for the U.S. dollar the new median value
is 8.11 renminbi to the U.S. dollar (previously 8.28 —
2% appreciation).
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5. New Chinese ERM: The End of BW2?
 In the Wall Street Journal (8/15/2005), John Taylor
(Professor of Economics at Stanford University and a
former U.S. Under Secretary of Treasury for
International Affairs) called this the end of Bretton
Woods II and wrote:
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“The new policy shift in China from a pegged to a flexible
exchange rate regime starts a new chapter in international
finance, comparable to the dramatic end of the Bretton
Woods system of pegged exchange rates in 1971.”
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5. New Chinese ERM: Maybe Not
 According to Stephen Jen (Morgan Stanley), the
estimated weight of the U.S. dollar is 85% or more of
the basket.
 During the first month of the new basket regime,
USD/CNY has declined by cumulative 0.15% — half
the daily allowable range.
 For all practical purposes, Bretton Woods II is alive
and well.
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5. New Chinese ERM: Japanese Example
 There are strong parallels between Japanese currency
policy after World War II and Chinese currency policy
today:
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After two decades of pegging at 360 yen, Japan decoupled
from the dollar on August 1971 and then repegged at a
revalued rate of 308 yen.
After stabilizing the exchange rate at this new level for about
a year, greater flexibility was introduced.
This phased adjustment resembles recent Chinese policy
initiatives.
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5. New Chinese ERM: The Future?
 If China intends to allow a series of small
appreciations in the renminbi then it either has to
1. Keep its interest rates below U.S. rates, so that low interest
rates offset the expected return from renminbi appreciation
over time (currently bank deposit rates in China are capped
at 2.5%, below the 3.5% federal funds rate).
2. Intervene a lot.
3. Or do both.
 Either way, this policy prevents independent Chinese
monetary policy.
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6. Conclusions
 In any case, the new Chinese Exchange Rate
Mechanism is a step to the right direction.
 The United States, in contrast, has not done anything.
 President Bush has not vetoed a single spending bill.
The government spending has increased faster than at
any time since the 1960’s (“the Great Society” welfare
programs and Vietnam War).
 The massive tax cuts passed in 2001–2003 are set to
expire in 2008–2010.
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6. Conclusions: What the U.S. Should Do?
 Since these are temporary tax cuts and the likelihood
they will be made permanent is low, basic economic
theory tells us that their positive incentive effects are
small.
 Since the President and the Congress are unable to
control spending, the simplest way for the U.S. to
reduce its fiscal deficit (and, indirectly, current
account deficit) would be to repeal the 2001–2003 tax
cuts.
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