What will replace the $
The fallout of the Wall Street-triggered global financial meltdown and the Fed Reserve's crises management has brought into sharp focus the need for an alternative global financial architecture that can provide a framework for the inevitable shift in the axis of economic power towards the emerging economies. This debate by itself is not new but has assumed a much greater sense of urgency after the unprecedented financial meltdown on Wall Street last October amowing the housing derivatives crises.
Many renowned American economists have begun writing America's obituary and question whether it can indeed lead the world economy in the decades ahead and provide stability to the global financial system. Two Nobel prize winning economists have generally been very scathing in their criticism of the way the US economy has been managed. Noted US economist has said "These days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along". Very strong words, indeed.
Another Nobel winning economist Joseph Stiglitz has made out a case for ending the dollar's primacy as an important component of the change in the world financial architecture. Many other reputed economists have now begun to speculate whether the US economy, as well as the dollar, is in long term decline.
There is a growing school of thought in the US that its economy might go the way of Japan of 1990s when a massive bailout of the banking system by the government and excess liquidity in the economy in general had created conditions for a long term low growth trap in that country. However, there are others, though in a minority, who say the US still has enough inherent dynamism to bounce back to its trend growth rate of close to 3%.
However, it is now a near consensus view that the deeper cause of America's larger economic crises was the ever growing imbalance in the global economy in which the rest of the world was constantly feeding the American consumer's over indulgence by lending cheaply to the US. It is almost like vendor financing that one sees in the consumer durable market. Nations accumulated massive forex reserves by exporting to the US and used the same money to finance America at 2 to 3 per cent interest by buying its treasury bills.
This over-indulgence of America by the emerging economies exacerbated the global imbalance and indeed contributed to the complacency seeping into the whole global financial system. The consequent structural weakness afflicting the US economy, its financial system and its currency is now coming to haunt the emerging markets who were the prime lenders to the US.
Therefore, it is fair to argue that the emerging economies were clearly accomplice in the aggravation of the structural imbalances that developed in the US during the big boom years after 2002. So paradoxically, the bloc of emerging economies gained from the growing structural imbalance in the US so it will have to accept its own share of responsibility, though indirectly. To further illustrate this point the BRIC economies, as per a study by Goldman Sachs, had contributed 55% percent of world GDP in PPP terms between 2000 and 2005.
They accumulated 30% of world reserves. BRIC countries share of global inward FDI also rose rapidly to 15% in this period, three times what it was in 2000. BRIC's share in oil demand increased to 18% of world demand. The first decade of the 21st century, in a sense, might be seen as an inflexion point for the emerging economies gathering a critical mass. The flip side of this great story in the emerging markets was the growing structural imbalance in the US, now threatening to spoil the global party.
Today, it is estimated that more US assets in value are held by entities outside the US than within. No wonder Americans have begun to say ,"The dollar is our currency but your problem". As a consequence, the US's monetary policy is also the world's monetary policy to the extent the rest of the world economies are holding most of their forex reserves in dollars. The Fed is the world's Central Bank, in some ways.
Consequently, any alternative financial architecture will have to be evolved in close cooperation with the United States. Of course, this will not be easy because any decentralization of the US-centric global financial order or talk of a new reserve currency is much more a political/strategic matter than a purely rational/economic one in which everyone will happily agree to a solution provided by a bunch of sensible economists. After all, currency is a strategic instrument that can also serve as a hegemonic tool.
It is not for nothing that Britian decided not to collapse the Pound into the single euro currency. In an interdependent world, the search for an alternative financial architecture has to be within a cooperative framework, the way the dollar emerged as a reserve currency post war. After the Bretton Woods agreement in the forties America emerged as the major driver of world growth.
The Pound Sterling could not hold its own as a global currency amowing the havoc wreaked on the British economy by the War. America won the confidence of the global community by committing to peg the dollar to gold at the Bretton Woods meeting. In the same meeting, John Maynard Keynes had argued for a truly representative global currency called Bancor, but was in a minority.
Indeed, it is fascinating that sixty years after Keynes' suggestion
the Chinese Central Bank recently mooted a similar idea
that the world could adopt IMF's SDR, a weighted average of major currencies used by the IMF as a unit of account. The idea is interesting and workable for many reasons. The BRIC economies could support the Chinese idea for many reasons. One it is being done within the framework of a democratizing IMF. So it can be evolved within a truly global, cooperative framework.
The Chinese are more keen because they are really worried that any precipitous fall in the value of the dollar in the future could jeopardize their dollar assets which possibly exceed 70% of China's GDP. As per a Citi Bank report China, in its anxiety to diversify its risks, China has extended almost $100 billion in 3-year swap lines to six emerging economies. These are Yuan denominated loans aimed at building claims on foreigners in local currency as a hedge against a possible fall in its dollar loans extended to United States. China is hoping that the global demand for Yuan could rise in the future after this beginning.
Even while working on IMF's SDR as the basis of a world reserve currency, which is a slightly longer term project, the BRIC countries, and indeed other strong emerging economies, could start partially diversifying their foreign currency assets by lending to each other, rather than only to the United States.
This is what the Chinese are essentially doing.
In the medium term this could act as a confidence building measure for the BRIC economies, as also for the larger emerging market universe.
Sometime later, the loans/bonds issued by the BRIC countries within the emerging markets could be institutionalized as BRIC bonds.
The value of BRIC bonds could eventually be derived also in terms of the new SDR reserve currency, as and when it evolves.The BRIC bonds could also fund large infrastructure projects in developing economies. This would certainly give more returns than putting money in US treasury bills as many central banks in developing economies do.
However,
if China and other BRIC nations are to seriously internationalise their own currencies in a bid to move away from the dollar as a leading currency, capital account restrictions will have to be eased by these nations so that their currencies are bought and sold without they being a direct counter party. The Chinese officials are well aware of this and do have capital liberalization as a long term goal. India, Brazi and Russia will also have to amow suit if any meaningful system of internationalization of BRIC currencies is to be pursued as a goal.
The approach to evolving an alternative global financial architecture must be informed by rational and pragmatic rather than emotional considerations. There is no point blaming the United States alone for all the ills visiting the global financial system today.
As Barry Eichengreen, Professor of Economics at the University of California, Berkely, recently wrote in The Economic Times," Despite the trials and tribulations of the American economy dollar securities remain a dominant form of reserves because of the unparalleled depth and liquidity of the US markets. Central banks can buy or sell dollar assets without moving those markets".
So how could the IMF's SDR based global currency replace the dollar, ask skeptics. After all,
the SDR is a simply composite accounting unit which the IMF issues as credit to its members.
If the SDR is to be elevated to a reserve currency a beginning has to be made in creating a market with a reasonable depth and liquidity for SDR-denominated assets. Eichengreen has argued this is within the realm of possibility if the G-20 countries, of which BRIC is a major block,
start issuing SDR-denominated bonds. "Initially the investors may demand a novelty premium to buy these bonds. But nothing is free. This price would be an investment in creating a stable financial system", says Eichengreen.
The dollar had acquired an international currency status in the 1920s when the newly established Federal reserve started buying and selling dollars, enhancing the market liquidity. Going forward, a more democratized IMF can be empowered to do the same. Eichengreen says there would be a cost to this process too.
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The IMF will be using real resources to subsidise the market until private market makers saw it attractive to provide those services at comparable costs.
The Funds' shareholders must initially agree to bear those costs. Transforming the SDR into a truly international currency would required surmounting other obstacles.
The IMF will have to be able to issue additional SDRs in periods of shortage, just as the Fed intervened to provide dollars in the latter half of 2008", according to Eichengreen.
Thus the IMF will have to be truly decentralized and made autonomous of any influence from any major shareholder if it is to work like the Federal Reserve.
The BRIC economies must vigorously lobby for a world reserve currency in the form of SDRs which reflect the weighted average of major currencies used by the IMF as a unit of account.
If BRIC economies are seen to dominate global output and trade in the next forty years, then it stands to reason that they will indeed evolve a critical mass to be able to create an alternative financial architecture. This is what America did after Bretton Woods.
This is a logical process which the global community will inevitable accept.
As per a Goldman Sachs report, by 2025 the economies of China ($12 trillion), India ($4 trillion), Russia($3 trillion) and Brazil($2.5 trillion) will exceed the US economy's size at $19 trillion. Mind you, this is just 15 years away.
It is time the BRIC nations, as also other emerging economies, worked towards a robust alternative financial architecture, within the IMF and outside, to reflect these changing realities.
As Eichengreen points out, this is well within the realm of possibility given the rapidly changing global economic realities. The time has now come to implement Keynes' seminal idea of establishing a truly international reserve currency. The OECD bloc must give positive cooperation in this process, if only to realize the universal objective of correcting the deep structural imbalances in the global economy which makes so many emerging markets dependant on feeding the unbridled consumption of the West.
An alternative global financial architecture must have another key component. The BRIC economies, going forward, will constitute the biggest commodity exporters and importers. Brazil and Russia are massive exporters of commodities, and China and India are importers. In this context, there must be some decentralization of the current global commodities markets in the West which enable price discovery in these commodities. The commodity bubble in metals, for instance, left millions of small businesses in emerging markets in total bankruptcy.
Mind you, these businesses were merely taking a futures cover for their genuine raw material needs. They suffered because of a massive, irrational bubble created by a dozen Wall Street banks and hedge funds. This has caused havoc with smaller businesses.
It is totally logical that an alternative price discovery mechanism be evolved within the BRIC framework for commodities which are largely bought and sold by these economies. Why should the price for what BRIC nations largely trade be discovered in the West?
Finally, it is inevitable that an alternative financial architecture will emerge to fully reflect the inexorable shift in the balance of real economic power towards the developed world. History has away of forcing the truth on those who refuse to concede that the ground is shifting from under their feet.
Wisdom by Hindsight:M K Venu's blog-The Economic Times
