Global Policy Forum

The Naked System


International Financial Order Is an Emperor with No Clothes

By James W. Dean

The National Post
January 8, 2008

Once again we find ourselves in financial "crises" of potentially global proportions. The first is a credit crunch triggered, superficially at least, by subprime mortgage lending in the United States. The second is the long-expected "collapse" of the U.S. dollar (more prosaically, its relatively rapid decline against the euro). The third is near-panic in some quarters in the United States, and to a lesser extent in Europe and Japan, about potentially dire political consequences of "sovereign wealth funds." SWFs, government-run investment pools, have amassed some US$2-trillion of current-account-surplus assets under the control of a few foreign governments that are not necessarily friends of the West and Japan.

These three quasi-crises are interrelated byproducts of several pervasive paradoxes of 21st-century global finance. Yesteryear's crises, in particular the international debt crisis of the 1980s and the East Asian exchange-rate crises of 1997-98, were resolved by the International Monetary Fund, with heavy input from the U.S. Treasury. Rescue from the current crises will not come from the IMF, nor from an international financial system ordered and managed by international institutions. Our much-touted "international financial system" is now an emperor with no clothes.

The current financial turmoil is rooted in paradox.

1. No consensus about currency systems.
Most economists instinctively opt for flexible exchange rates as the default system. The IMF for its part has a history since the collapse of the 1944 Bretton Woods agreement of indecision and vacillation, sometimes advocating fixed rates, then reversing itself. A good argument can be made that the global imbalance and U.S. dollar "crises" we now face might have been averted had the IMF been able to enforce a single, internationally-consistent system: a new Bretton Woods with very hard fixes to a common anchor, or even a global currency. Failing that, universal flexibility might have served us better. As it is, our system has evolved piecemeal, and is now putting all the pressure for adjustment on just two or three major exchange rates: dollar/euro, dollar/pound and, putatively, dollar/yen. Dollar/yuan, dollar/Hong Kong dollar, dollar/South Korean won and half a dozen dollar/Middle Eastern exchange rates -- those of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates --are all, de facto, almost fixed.

In practice, almost all the adjustment is occurring in the dollar/euro rate. Paradoxically, Europe and China rather than the United States may bear the brunt of damage to their real economies from an imbalance that is primarily due to America's savings shortfall and its consequent current account sins.The United States can issue and sell world-wide massive quantities of low-cost debt denominated in its own currency. Europe's trade balance with China suffers more because the yuan is virtually pegged to the dollar and therefore has depreciated sharply (more than 40% in four years) against the euro. China, in turn, suffers sharp capital losses on its trillion dollars of dollar-denominated reserves in terms of their purchasing power in euros.The United States also benefits because oil prices are dollar-denominated. To the extent that the OPEC cartel raises oil prices to capture the falling euro-pur-chasing-power of the dollar (rather than simply because of fundamental excess demand for oil), it imposes costs not only on the United States, but also on Europe. In other words, Europe shares the burden for that part of rising oil prices that results from the falling dollar.

2. Poor countries that lend much more money to rich countries than vice-versa.
According to conventional wisdom, rich countries are rich because they have high capital/labour ratios and vice versa for poor. Hence the return on capital should be higher in poor countries and hence capital should flow from rich to poor. The paradox is partially explained by two facts. First, poor countries like China have underdeveloped internal banking and financial markets; hence they cannot absorb the trade surpluses they generate. Second, for related reasons, foreign direct investment (FDI) pours into China because direct investment is, by definition, already allocated to a productive use: this inflow, in turn, makes the trade surplus even more redundant. The phenomenon has been underway for the past decade, but the real puzzle is that China and other trade surplus countries have not lent their money to us in more adventurous ways: about US$1-trillion of China's US$1.3-trillion stock of reserves is invested in low-yielding U.S. Treasury bills. The recent rise of SWFs in China (and in oil-exporting countries) is a belated byproduct of the severe underperformance of their overseas investments over the past decade.

3. U.S. debt service payments that are still positive despite large and growing net liabilities to the rest of the world.
The paradox is in good part due to U.S. ability to borrow in dollars. It is also due to higher returns on U.S. FDI abroad than on foreign FDI in the U.S., arguably a tribute to American management prowess, but greatly augmented by the past four years' rapid rise in the euro against the dollar. This phenomenon has arguably contributed to U.S. tardiness in addressing its trade deficit because the current account impact of America's growing and now-massive net liabilities to the rest of the world has been slow to come home to roost.

4. Global imbalances in capital flows that cumulate for years rather than gradually adjust via market mechanisms.
This phenomenon is largely attributable to near-fixes of the Chinese yuan, and the currencies of the six major Middle Eastern oil exporters, to the U.S. dollar. Since the mid-1990s, it has also been attributable to favourable U.S. fundamentals: strong sustained productivity growth with expectations for future growth that were capitalized into the U.S. stock market. This, combined with an advanced and stable financial system and a growing labour force, attracted sustained capital inflows to the U.S., not only from poor countries like China (which lacked an advanced financial system), but also from Europe (which until recently lacked as high a productivity growth as the U.S., and which still lacks population growth).

5. Sovereign Wealth Funds
Of the world's US$5-trillion stock of official foreign exchange reserves, some US$3.5-trillion is held by non-industrialized countries. This share has increased sharply in the last five years, with an additional US$1.5-trillion to US$2.5-trillion held as official holdings of non-reserves: surpluses in stabilization funds, nonrenewable resource funds, and, notably, SWFs. SWFs embody at least three paradoxes. One is that governments own and often manage them, in a world that has almost universally embraced the private sector for most productive enterprise. A second: Countries that less than a decade ago were dependent (via the IMF) on the West and Japan for bailouts are now emerging as major saviours of Western rich-country banks. A third: SWFs are part of a much larger trend toward international portfolio diversification, a trend that in and of itself should promote global financial stability and help avert crises. Yet SWFs are viewed apprehensively by many rich-country economists, not to mention politicians, because of their potential to move large blocks of money for non-pecuniary motives. Allegedly, they could monopsonize foreign sources of natural resources like oil or copper, or even dabble in geopower politics. Not just rich countries that are worried: recently the World Bank and the African Development Bank have voiced concerns about China's resource-related development lending, fearing that sub-Saharan Africa will once again become "hooked" on unsustainable foreign debt. But China's SWF strategy is not just about securing raw materials. More broadly, it is about investing its surpluses more lucratively while at the same time sterilizing domestic monetary growth. It's a win-win for monetary management in China.

The line between foreign exchange reserves and SWFs is blurred. Technically, "reserves" are assets of central banks, which purchase them by creating liabilities in the form of domestic money. Countries can and do move funds from reserves into SWFs. Indeed, this is what China is currently doing, embracing an over-due strategy of investing overseas in assets that are more lucrative than U.S. treasury bonds. For a country like China, this would seem to be a win-win strategy compared to accumulating its surpluses as foreign exchange reserves. The first and more obvious "win" is earning a potentially higher rate of return on investment. The second "win" is that funds moved out of foreign exchange reserves and invested abroad via SWFs or the like automatically reduce the domestic money supply. As reserves they were an asset of the central bank and were mirrored by domestic-currency liabilities ("high powered money"). Their transfer into SWFs achieves the same effect as would sterilization via sales of government bonds (in China's case such sales have traditionally been made to its largely dysfunctional banks). In other words, SWFs can help solve a pressing problem in China: rising rates of inflation due to the central bank's rapid accumulation of foreign exchange reserves and consequent creation of domestic money. They may also reduce pressure to revalue the yuan, since they ameliorate the need to undertake sterilization, which is fiscally expensive.

Asset bubbles (high-tech equities, now real estate) that burst and spread from country to country, despite central banks' remarkable success in stabilizing good and services inflation almost everywhere. For a decade now, economists have debated the wisdom of targeting asset inflation rather than just goods inflation, but implementation has proved elusive. At a practical level, the appropriate measure of asset inflation is unclear: Should it be equities? Real estate? Commodities? And at a theoretical level, the very definition of "dangerous" asset inflation may be intractable: Asset prices depend on expectations, and expectations are proved unrealistic only after they are unrealized. In other words, it is clear that asset prices were a bubble only after the bubble bursts. It is fashionable now to castigate Alan Greenspan for maintaining interest rates too low for too long, but had he raised them earlier and caused a crash on Wall Street, he would have gone down in infamy. The current credit crunch, with the real estate price bubble bursting and parts of the money market starved for liquidity, has forced central banks to face a dilemma. The crunch calls for more liquidity, yet the crunch is the byproduct of too many years of too much liquidity. Moreover, the dollar needs to be bought, but the euro needs to be sold. Neither the U.S. dollar's decline nor the junkification of collateralized securities has yet led to recession in the United States, much less the rest of the world. But if these financial "crises" do become both global and real, SWFs will play a role in the rescue.

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