Can Asia Dump Bretton Woods II as Dollar Falls? by Andy Mukherjee
Bloomberg
Nov. 9 (Bloomberg) -- President George W. Bush's second term may be a challenging time for Asian central bankers.
With the dollar hitting an all-time low against the euro yesterday, traders are betting that Bush may add to the $412.6 billion U.S. budget deficit, increasing the pressure on the dollar to decline. And unlike during the last three years, the brunt of the dollar's fall may not be borne by Europe alone.
Bank of America Corp. says China may allow its currency to fluctuate in a wider range as early as the first quarter of 2005. Together, the two factors -- record current account and budget deficits in the U.S. and a possible appreciation in the yuan --may lead to stronger Asian currencies next year.
The adjustment could mean an end to the current system of semi-fixed Asian exchange rates that has been termed the ``Revived Bretton Woods,'' by Michael Dooley of University of California at Santa Cruz, David Folkerts-Landau, Deutsche Bank AG's head of research, and Peter Garber, the bank's strategist.
Revived Bretton Woods, or ``Bretton Woods II,'' is supposed to be a re-embodiment of the Bretton Woods arrangement, a post World War II system in which the U.S. was obliged to pay gold at $35 an ounce to its official foreign creditors. Other countries pegged their currencies to the dollar.
Whereas the original Bretton Woods system collapsed in 1973, its replacement is seen as an ongoing and mutually beneficial agreement between the U.S., which is the world's financial ``core'' and Asia, which is its ``periphery.'' The periphery is allowed to expand its exports by keeping its currencies cheap, as long as it supplies capital to the core to pay for its spending excesses.
Bretton Woods II
As Dooley and the Deutsche economists pointed out in their paper last year, ``Exporting to the U.S. is Asia's main concern. Exports means growth. When their imports do not keep up, the official sectors are happy to buy U.S. securities. Their appetite for such investments is, for all practical purposes, unlimited because their growth capacity is far from its limit.''
At the heart of Bretton Woods II is China's 200 million underemployed rural population. ``And even if this reserve of labor was gone,'' the authors say, ``India is ready to graduate to the periphery with its vast supply of underemployed workers.''
If it's in the interest of Asian central bankers to keep a lid on their home currencies until every surplus worker in rural China and India has found a job in an export factory, then why should there be a change in Asia's currency policy in the next four years of Bush's presidency?
Weak Dollar
There are strong reasons. On the U.S. side, the issue is political. Jobs are at stake. A weak dollar is ``ultimately what the economy needs,'' says Bill Gross, the chief investment officer at Pacific Investment Management Co. in Newport Beach, California. On the Asian side, the reason why the region must now choose to live with higher currencies is inflation. By increasing interest rates for the first time in nine years, China has sent a signal that it's taking inflation seriously.
Yet, if the People's Bank of China increases domestic interest rates significantly -- and keeps the currency pegged at 8.3 to the dollar -- it will invite more speculative capital into the country, aggravating inflation.
There's another important reason why Bretton Woods II may have to be dumped. Nouriel Roubini, a professor of economics at New York University's Stern School of Business, says that the current global financial system can be sustained only if Asian central banks act as a cartel and keep their existing and future reserves in U.S. dollars.
There is, however, no formal cartel. As a result, every Asian central bank will want to protect itself against an erosion in the value of its assets from a decline in the dollar.
Tragedy of Commons
In other words, what's in the interest of one Asian central bank isn't for all. Social scientists have a name for this phenomenon: ``Tragedy of the Commons.''
``All central banks may be better off if no bank tries to diversify its reserve holdings,'' Roubini says, ``but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from losses.''
Losses could indeed be large. Asian central banks own more than $2.2 trillion in foreign-exchange reserves out of a global total of $3.4 trillion. At the end of last year, almost 64 percent of central bank reserves globally were denominated in U.S. dollars, according to the International Monetary Fund.
As Asia tries to diversify out of the dollar, the U.S. currency may decline further. An individual central bank ``can only protect itself if it either shifts out of dollars and into euros ahead of the others, or buys a euro/dollar hedge before everyone else,'' Roubini says.
Adjustments will be painful. Still, it would be better for everyone concerned to end the Bretton Woods II agreement now before it's too late for both the U.S. consumer and the Asian exporter.
To contact the writer of this column:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net.
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