The World Has Changed, the International Monetary System Needs Some Serious Re-Thinking
Over the past few years, however, most currencies’ exchange-rates fluctuated at an unprecedented pace, hampering capital transfers and commercial activity. The US dollar (USD), the Euro (EUR) and the Japanese yen (JPY) witnessed policy-driven exchange-rate volatility (Box 1). Emerging market currencies appreciated rapidly as international capital chased economic performance, to abruptly depreciate when foreign money fled, driven by risk aversion. Over the next few years, currency markets’ uncertainty and volatility is likely to remain high.
… nor fostering an efficient allocation of global capital. If able to trust currency markets, current-account-surplus countries would certainly lower their demand for foreign-exchange reserves – hence reducing the imbalances in the world’s production and consumption. Over the past eight years, however, the demand for foreign-exchange reserves rose steadily – from USD1.3 trillion (5 percent of world GDP) in 1995 to USD10.7 trillion (15 percent) in 2012. Emerging economies holdings, at two-thirds of the total, de facto reduce global demand. Indeed, while they should invest in their local economy, developing countries end up lending cheaply to (wealthier) economies that need to save rather than spend. In other words, reserve accumulation increases global imbalances and – by pushing down long-term interest rates – sows the seeds of future financial instability.
At the macro level, money needs to flow smoothly across countries … In order to grow, countries need a stable, predictable external environment. To ensure capital flows, trade relations, and global prosperity, the monetary system needs a few internationally-trusted currencies – the so-called “global reserve currencies” (Box 3). These currencies facilitate the setting of prices, the payment of goods and services in global markets, the holdings by governments and institutions of foreign exchange reserves, the denomination of balance sheets for both public and private actors, and the accumulation of savings and (central) bank reserves.
… but fears of currency wars are limiting prosperity prospects. Since the onset of the 2008-crisis, periodic uncertainty about the global economy resulted in increased currency volatility, which in turn brought additional uncertainty into currency and commodity markets and the real economy. Search for safety privileged the USD, as policy intervention kept the Swiss franc (CHF) from overvaluation and led to de-facto JPY devaluation. In the Eurozone (EZ), capital flight created a quasi-currency market within the single currency area. The “German” EUR became sought after, with 10-y Bunds yields below 1.4 percent. Monetary expansion in advanced economies and real exchange-rate appreciation in commodity-exporting economies triggered concerns about currency wars. Protectionist pressures grew, mostly via nontariff measures, such as restrictive import licensing and local content requirements. International trade volumes declined below their pre-crisis trend.
At the micro level, firms need stability … Businesses need to be able to count on stable cost structures, gradual exchange rate adjustments, predictable business outcomes and orderly rebalancing of external accounts. Firms – in particular small and medium enterprises exposed to currency movements by a disaggregated supply chain – suffer exchange rate volatility and its effects on costs and prices, especially when incapable of complex treasury operations (e.g. active hedging).
… but exchange rate uncertainty is hampering business. Currency uncertainties created important managerial challenges over the past years. Companies faced greater difficulties in pricing their products and anticipating their costs. Decade-long global imbalances caused – and were reinforced by – a series of financial crises. Uncertainty became the base case, currency forecasting turned into an impossible endeavor and as a consequence, medium-to-long-term planning became more challenging, in particular vis-à-vis liquidity management, investment decisions, and revenue targets. A more cautious business approach brought about reluctance to hire new employees.
Box 1. Why currencies became volatile over 2008-2013?
High exchange rate volatility is mostly due to two global policy responses to the ongoing global crisis.First, massive central bank intervention. Over the last five years, the combined balance sheets of the eight world’s main central banks – US Fed, People’s Bank of China, European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE), Germany’s Bundesbank, Banque de France, and Swiss National Bank – tripled from $5 to $15 trillion. In particular, the US Fed has completed two rounds of “quantitative easing,” bringing its balance sheet to roughly 20 percent of US GDP; the third open-ended round, announced in September 2012 and still ongoing, adds $40 billion a month. Over the same period, the ECB brought its balance sheet to roughly €2.8 trillion, close to 30 percent of EZ GDP. Two long-term refinancing operations provided more than €1 trillion ($1.3 trillion) in low-cost financing to EZ banks for three years. The “outright monetary transactions”, announced in August 2012, allow for further purchases of sovereign bonds of pro-reform Eurozone Governments.
Second, borrowing is cheap. Paradoxically, more money was thrown at a problem generated by exceptionally low interest rates and poor financial regulation. Five years later, real rates are still negative in most countries across the world. There is plenty of liquidity out there. As a consequence, investors chase scarce opportunities (including currencies), but – given the fragility of global growth – money is withdrawn as soon as risks rise. In other words, excess liquidity in a frail macroeconomic environment creates foreign-exchange volatility.
What is happening? Why isn’t the IMS delivering stability as before? Structural and cyclical factors are driving a tectonic shift in the world’s economy, unlikely to be frictionless.
1. Global growth is slowing below-trend … Global growth – yet to recover from the 2008-crisis – slowed to almost 3 percent in 2012, a half a percentage point below the pre-crisis long-term trend, and is likely to remain below-potential until the developed world pays down sovereign and corporate debt, and emerging markets undergo needed structural transformations. With lower growth ahead, competitive devaluation is becoming an attractive alternative to cutting public spending (Box 1).
… increasing the risk of competitive currency devaluations. In most developed countries, fiscal consolidation risks hampering growth and causing another recession. Instead, depreciating the exchange rate is an easy way to spur exports, limit imports, attract investment and tourism, and create jobs. In Japan, since the inception of the Abe Government in December 2012, the BoJ lost independence, monetary policy became looser and the yen significantly depreciated, about 15 percent versus the USD and 20 percent against the EUR. Going forward, the US and Europe – but also China, Brazil and Russia – would prefer a weak currency and direct monetization of deficit spending. A debased currency helps, especially in times of crisis. In the 1930s, a few countries avoided the Depression by devaluing against gold. In the late 1990s, Asian countries’s devaluation against the USD established the conditions for future strong growth. Alas, competitive devaluation is not an option for the entire world economy: it cannot be done simultaneously by all. If everybody exports, who imports?
2. Emerging markets have emerged … Today, about half of global output is produced in emerging and developing economies. These countries also account for two-thirds of global growth in purchasing-power-parity (PPP) terms. By mid-century, China, the US and India are likely to be the largest economies in PPP terms – followed by Brazil and Japan. Russia, Mexico and Indonesia could become larger than Germany and the UK, and Turkey might overtake Italy. With their healthy balance sheets, emerging economies are a candidate for sustaining global demand, and their exchange-rate choices should reflect this responsibility. Yet, Central Banks try to maintain a stable not-overvalued real exchange-rate (Box 2).
… but their currencies have yet to appreciate in real terms. Led by Asia, emerging markets will have to accept important – and inter-linked – developments: first, as their growth model mature from investment-intensity to domestic consumption, their currencies need to gradually move away from supporting the export-led model. The overall export strategy has to evolve: as the West reduces its borrowing and consumption, Asia will have to increase competitiveness via home-grown innovation – and not by managing currencies or technology transfers. Second, investors want emerging markets exposure. These fast-integrating markets are increasingly creating wealth and accumulating net claims on the rest of the world. From 1995 to 2010, emerging markets’ share of international trade rose from 30 to 45 percent. Today, one third of FDI flowing into emerging markets comes from other emerging markets. While in 1990 the developed economies held two thirds of total official foreign reserves, today it is the emerging markets that held two thirds of the total. Sovereign Wealth Funds have become a key source of international investment. All of this will translate into international demand for emerging markets’ currencies.
Box 2. Exchange rate: theory and practice
The exchange-rate between two currencies is the price of one currency in terms of the other. This price depends on the issuing countries’ fundamentals, such as real GDP growth, inflation, fiscal and current account balances, return on investment, trade and investment flows with other countries, and what the currency can buy in terms of purchasing power parity (PPP). Policy makers manage the currency value, or heavily influence its price, by increasing or decreasing the quantity of their currency relative to others via reserve accumulation, capital controls, policy rates, and – after the 2008 crisis – quantitative easing policies. Their objective is to contain volatility, minimize vulnerability to external shocks, maintain regional competitiveness in global markets, and sustain growth. To achieve this delicate balance, they can either opt for “fixed” or “flexible”exchange-rate regimes – the so-called “corner solutions” – or for “intermediate regimes”.A fixed exchange-rate is achieved via a currency union, a currency board or a hard peg. It entails giving up monetary independence. A flexible exchange-rate (e.g., free-floating or managed float) is allowed to vary against that of other currencies. It is determined by the market forces of supply and demand; it allows for monetary independence but brings about currency volatility.
Policy makers in emerging markets want neither. They are likely to keep opting for“intermediate regimes”, by pegging their exchange-rates to the currencies of major trading partners (via basket pegs or crawling bands). Their goal is to maintain high domestic savings, and – as competitive exchange-rates increase demand for exports – enjoy current account surpluses. The resulting boost in import substitutes and aggregate demand accelerates investment and employment. China is the present-day example, but in recent years this was the case of high performing Asian economies (South Korea, Malaysia, and Thailand). Unfortunately, this is a status-quo-scenario, in which the lessons of the 2008 crisis are not learned and global imbalances are to persist.
3. The fundamental structure of the world economy has changed … The global economy is undergoing a long-term, structural transformation. In the past 30 years, the contribution of key sectors to global output shifted: agriculture fell, manufacturing declined, and services rose as shares of global value added and employment. Capital became an unpredictable driving force, more influential and systemic than trade. The foreign exchange market grew to be the world’s largest market, with average daily trading volumes in excess of $4 trillion. The scale of financial flows and their volatility rose, and crises became more frequent. Global consumption and production patterns created global imbalances that require currency devaluation in developed economies and appreciation in emerging ones for the world economy to recover.
… globalization increased co-dependence and made the ”Trilemma” evident … Rapid cross-border economic, social, technological exchange enhanced interdependence, increasing at the same time resilience and fragility. Via macro-financial linkages, a rising number of countries can influence the performance of the global economy and its financial stability. As per the International Monetary Fund (IMF), 25 financial systems, because of their size and connections with other countries, can have a systemic impact and need regular monitoring. According to the “Trilemma of international economics” (also known as the “impossible trinity”), if capital can flow freely across borders, fixing the exchange rate will bring about asset bubbles and inflation. In other words, policy makers cannot simultaneously get: a) absence of capital controls; b) a fixed exchange; and c) sovereign monetary policy. Examples abound: from the end of World War II until 1967, under the Bretton Woods system many countries maintained fixed – but adjustable – exchange rates with the USD, in turn tied to gold at USD35 per ounce. Initially, with limited capital mobility, countries could control their monetary policy. But as many countries removed capital controls, pegged exchange rates started to hamper monetary policy autonomy, and the risk of a gold run hampered expansionary policies. In the US, Vietnam-war-induced spending spurred domestic inflation, and increased fiscal and current account deficits. Led by France, a few nations began to redeem from the US government their USD reserves for gold. The system collapsed in 1971, when the US decided to end the convertibility in order not to subordinate its domestic policies to the gold link. Another example is the Chinese yuan renminbi (RMB), pegged to the USD at RMB 8.2768 to USD1 between 1994 and 2005. The creation of the Euro is the modern day example; as the EU crisis shows, currency co-habitation and sovereignty do not mix – to avoid a Euro-breakup, national fiscal sovereignty will have to eventually be sacrificed.
… but the IMS is adjusting (too) slowly. The IMS governance does not reflect these changes. The increased importance of developing economies needs to be acknowledged, so they can be held responsible for the performance of the system as a whole. Regrettably, today there is an asymmetric distribution of benefits and costs: emerging markets have almost no role in the international monetary system, but they also don’t participate in “system maintenance”. As emerging markets, led by China and India, get more established as a new “world powers”, they will have to increasingly accept their rising monetary responsibilities – but also enjoy the benefits. Today’s negative real interest rates in most Asian countries are at odds with Asia taking monetary responsibility at the global level. In other words, global interdependence calls for stronger cooperation.
The world needs more reserve currencies, but there are no viable alternatives. As economic interdependence among emerging markets intensifies and the correlation between their currencies grows, firms are increasingly driven to switch trade contracts from USD or Euros to local currencies. Furthermore, analysts and investors are voicing concerns about the future stability of the USD and the EUR and a weakening of their role as “store of value”. The economies of the US and the EZ are fragile, face high debt and will undergo significant internal structural adjustments; these factors are likely to constraint their role as leading international currency areas. The global financial system is asking for more than one reserve currency, and a few monetary zones of regional significance. The world might drift towards a multiple reserve-currency system shared among the USD, the EUR and – sometime in the future – the Chinese RMB. No one currency is likely to take over.
Box 3. What is a global reserve currency?
The rise of a currency as leading “global reserve currency” reflects the role of the issuing state in transnational trade and finance: the more powerful the state is in the global economy, the more its currency is internationally accepted. When a “global reserve currency” becomes widely exchanged, the global economy can sustain growing levels of international trade and investment. In the past, several currencies became dominant in international transactions: Athens’ silver drachma (5th century BC), the silver coins in India (4th c. BC), Rome’s gold aureus and silver denarius (1st c. BC – 4th c. AD), the Byzantine Empire’s gold solidus (6th c. AD), the Arabian dinar (7th c. AD), the fiorino issued by Florence (13th c. AD), the ducato of Venice (15th c. AD), the Dutch guilder (17th c. AD), the Spanish dollar (Real de a ocho, 18th c. AD), the Chinese Liang (or silver Tael) in Asia (19th c. AD) and, more recently, the British pounds sterling (until WW1), the French Franc and the German Mark (after WW2), and over the last 70 years the US dollar.
The requirements of a global reserve currency are: a) sound fundamentals – a large economy, sustainable growth, low inflation, open and deep financial markets; and b) confidence in its long-term worth. With these attributes, such a currency can play at the international level the three essential roles of money: 1) unit of account; 2) medium of exchange; and 3) store of value.
A global reserve currency delivers large economic benefits for the issuing country: first, seigniorage, that is the difference between the minimal cost of printing a banknote and its face value in terms of goods and services. Second, the ability to borrow at exceptionally favorable interest – and pay for imports – in domestic currency. However, this is a mixed blessing, known in the literature as “Triffin dilemma”: given high global demand for foreign-exchange reserves denominated in the “global reserve currency”, the issuing country ends up providing the world with an extra supply of its currency, usually by selling government bonds. The funds received in exchange are used to purchase imports, thus causing a trade deficit and fundamental imbalances in the balance of payments, via the current account. Normally, this is the beginning of the end: the issuing country starts consuming beyond its means and becomes the world biggest net debtor. As the debtor is tempted to use devaluation to reduce its external deficit (hardly a desirable property for a reserve currency), its currency loses its “global reserve” status.
USD and EUR still play a large role. Currently, the IMS heavily depends on the USD and the EUR. Together, the two “global reserve currencies” account for: a) about two-thirds of global foreign-exchange trading – these are deep and liquid markets, with an average daily turnover of about US$4 trillion; b) nearly 90 percent of the foreign exchange reserves held by central banks and governments; c) almost 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the IMF and its members; and d) more than three-quarters of all debt securities denominated in a foreign currency. This supremacy does not reflect the realities of the world economy, and leaves all other countries vulnerable to US and EU domestic monetary policy.
The IMS needs a multipolar evolution, but it will not happen anytime soon. Managing a multi-polar global economy without additional “global reserve currencies”, more representative of the rise of emerging markets, will present serious challenges. In the future, the global financial system is likely to have less national currencies (not all of the approximately 180 currencies existing today are likely to last), a few monetary zones of regional significance, and more than one reserve currency. For the system to be redesigned, a coordinated adjustment at the global level is needed, with the G-8 to allow a change in the geopolitical monetary hierarchy. As the new financial architecture needs coordinated global answers, a reformed IMF should play a key role in helping distribute benefits, costs and responsibilities. Of course, national and regional politics can lead to sub-optimal global outcomes. Until this process is complete, expect uncertainty and volatility to stay.
Over the next decade, the USD will not lose its reserve-currency status and will remain the major investment currency. In the short term, there is a lack of viable alternatives and the USD will remain a key “unit of account” and “medium of exchange”. Still, its centrality in the global monetary system will be gradually re-appraised. Indeed, a multi-polar currency system implies a slow, steady reduction in the long-term share of USD assets in central banks’ vaults and private portfolios. The trend is there: the USD’s share of global foreign-exchange reserves has already fallen from 80 percent in the mid-1970s to around 65 percent today. It is likely that the greenback will continue its downward trend against other major currencies and its position will slowly deteriorate. There are advantages: if other major currencies constitute greater portions of the world’s foreign exchange reserves, the US might find increasingly easier to maintain its current account deficit at manageable levels.
The EUR will remain the primary alternative to the USD. The turmoil in Europe has caused a loss in confidence in the future of the EUR, and until a new governance and a fiscal union are built the shift from USD to EUR is likely to pause. But if the EUR survives – as it is likely to – the rebalancing in favor of EUR of countries with large reserves now overweight in USD will resume, especially if doubts about the US long-term fiscal sustainability were to rise, causing the value of the EUR to rise again relative to the USD.
The Chinese RMB will incrementally be accepted in trade settlements and outbound investments. If China were to let its currency be used in international transactions, the RMB could quickly become a global reserve currency. China is already allowing firms to issue RMB-denominated bonds in Hong Kong. However, bigger steps are needed, such as cooperate in global currency management, promote regional integration, and deepen the domestic bond markets. For China there are clear benefits: as the RMB becomes global, the country will be able to enjoy the financial advantages of printing a reserve currency (seignorage – Box 3), domestic macro-economic autonomy, balance of payments flexibility (i.e., it will be able to run sustained current account deficits), low borrowing costs, and a financial markets hedge.
Article based on material prepared for the session: “Euro, Dollar and Yuan Scenarios”, World Economic Forum on the Middle East, North Africa and Eurasia 2012.