Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Geoeconomics: What can we learn from the end of the “real” Bretton Woods system of fixed exchange rates?

by Brad Setser Saturday, February 26, 2005

Dan Drezner started a post with the Triffin dilemma, so I figure I too can digress into the realm of history.

The Bretton Woods system of fixed exchange rates (Bretton Woods 1) collapsed, in some sense, when Western Europe decided it was no longer willing to hold its reserves in dollars, and demanded gold instead.

The Bretton Woods system was based on the gold-dollar standard: the world, or at least the free-world, pegged to the dollar, and the dollar was pegged to gold. Initially, the system worked because the US held most of the world’s gold at the end of World War 2. But dollar reserves grew quickly along with an expanding global economy, and dollar reserves exceeded the US gold stock by 1966.

No problem. The world’s central banks agreed that they would not convert their dollars into gold, and the system kept going. After all, the countries holding dollar reserves were also, by and large, allies of the United States military allies, and no one was all that keen to end an international monetary system that had underpinned Europe and Japan’s spectacular recovery from World War 2.

Alas, though, the alliance (or coalition?) supporting Bretton Woods 1 eventually frayed: the countries that defected from the financial coalition propping up Bretton Woods 1 tended to be countries that concluded their broad national interests would be better served with a higher degree of political independence. West Germany held on to its dollar until the end. De Gaulle’s France, famously, moved out of NATO’s integrated military command, and if not NATO per se; worried about the “exorbitant privilege” the US got by virtue of issuing the international reserve currency, and converted its dollar reserves into gold before Germany and the UK.

Fast forward thirty years. An influential group of economists argue that a new Bretton Woods 2 ties together the countries of the Asian-Pacific to the US. Critics challenge parts of the analogy: there are fewer constraints on the anchor currency in Bretton Woods 2 than in the Bretton Woods 1, since the dollar is no longer tied to gold; many Asian countries do not formally peg to the dollar, even if they intervene heavily; etc. But even critics of the analogy — and critics of the argument that Bretton Woods 2 provides a stable international monetary order — recognize than Asian reserve accumulation has played a critical role in the financing the US current account deficit — hell, even the AP now has noticed.

Can we also learn something from the political events that defined the end of Bretton Woods 1? After all, the system came apart because key members of the alliance supporting the dollar eventually concluded that the broader US-led system was no longer serving their political as well as economic interests.

Asian central banks, fortunately, cannot demand that the US exchange their dollars for gold — or even for another reserve currency. The US has not promised to maintain the dollar’s value vis a vis the euro, or supply euros or any other asset on demand. On the other hand, just as every individual central bank had an incentive to convert its dollars into gold before other central banks, central banks now — at least the smaller central banks — have an incentive to be among the first, not among the last, to shift the composition of its reserves. Any country that stops adding to its dollars reserves as rapidly, whether because it is diversifying its reserves or intervening less, effectively shifts the burden of financing the US onto the other members of the cartel. So there are certain parallels.

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Has Argentina changed the rules of the sovereign debt game?

by Brad Setser Saturday, February 26, 2005

Argentina is on the verge of completing one of the largest sovereign debt restructurings in history. Argentina is seeking to restructure about $82 billion in bonds, plus $21 billion or so in past due interest. The biggest preceding bond restructurings were Ecuador ($6.5 billion) and Uruguay ($4 billion of international bonds) — so Argentina’s restructuring is absolutely massive. It dwarfs Russia’s 2000 restructuring of about $30 billion in international sovereign debt. (technically, Russia restructured syndicated bank loans, not bonds, but since lots of the loans had been sold into the market, the difference between bank loans and bonds was bit blurred).

Investors had until Friday to tender their bonds in the exchange. The final results will be announced next week. Recent estimates suggest that 75%, maybe more, of all eligible debt participated in the exchange.

Investors who participate in the exchange are giving up their legal right to full payment of principal and all past due interest. But since the legal right to full payment is nearly impossible to enforce, investors effectively are giving up an old bond that won’t be paid for a new bond that Argentina should pay. The catch? Argentina offered a maximum of $42 billion in new bonds in exchange for roughly $82 billion in old bonds. Or, to think of it a bit differently, the market value of the old bonds was about $26 billion ($82 billion face worth roughly 32 cents on the dollar). If all holders of old bonds swap into new bonds, the new bonds will also be worth about $26 billion ($42 billion face, and an average price of 62 cents on the dollar), and probably a bit more if there is a post-restructuring rally. So investors are recovering only a bit more than 30 cents on their original dollar, assuming they initially bought the bonds at par.

Argentina, consequently, is about to carry off not just a big restructuring, but also to get substantially more relief from its creditors than debtors have gotten in previous debt restructurings — something that Argentina’s President, Nestor Kirchner, never hesitates to point out.

Kirchner clearly thinks the deal is a good thing for him.

But is it a good thing, or a bad thing, for the broader international financial system?Some — and not just creditors with skin in the game — argue that Argentina’s exchange is nothing more than a mugging of creditors. Walter Molano, quoted in this Reuters story, is typical of those who worry that Argentina is setting a terrible precedent:

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Oil, and a bit of geopolitics

by Brad Setser Friday, February 25, 2005

On Thursday, the Financial Times, the New York Times and Tom Friedman all weighed in on Asian reserve diversification.

Paul Blustein of the Washington Post has an A1 story today on another of my common themes: the US is taking on external debt not to invest in new export industries, but rather to fund the budget deficit and a housing boom.

It is clearly time to change the subject.

The Saudis indicated that they really don’t mind $50 a barrel oil. Shocking, I know.

The Saudis do want the world to eventually buy all their oil, and thus don’t want too rapid a move to alternative fuel sources. Consequently, they sometimes do start to worry if rising oil prices lead to a fall in demand for oil. This time around, though, high oil prices have not triggered much of a reduction in demand.

Asian economies (huge oil importers: most Asian economies have higher oil imports as a share of GDP than the US) have generally resisted letting gasoline prices rise in line with rising oil prices. Remember, China is still a communist country. The state oil companies seem to have been told to keep retail prices low. That is one way to contain inflation.

In India for example, our colleague Chetan Ahya reports that the government is not allowing the oil companies (mostly government-owned) to increase profit margins. This is akin to taxing oil companies’ profits to subsidize consumers. In China, where retail taxes are negligible, our colleague Denise Yam reports that the state development and reform commission publishes retail price “guidance” for industry participants. As a result Chinese retail energy price increases in 2004 (20%) lagged behind those in international markets (40%).

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An Asian OPEC?

by Brad Setser Thursday, February 24, 2005

A less kind headline might be “Asian policy makers meet, agree to continue manipulating foreign exchange markets”

Still, this Bloomberg article (link thanks to Calculated Risk) suggests that there may be a bit of back story behind the statements that Japan, Korea and Taiwan put out indicating that they each had no intention of diversifying the currency composition of their reserves.

Asian officials agreed on Feb. 22 to set up an organization called the Asian Bellagio Group to stabilize regional foreign-exchange markets, the Korea Times reported … “What happened with Korea was not desirable and not what they wanted,” said Stephen Jen, global head of currency research at Morgan Stanley in London. “The interests of the group is that they should do nothing to undermine the value of the dollar.”

Barry Eichengreen of Berkeley has argued that Bretton Woods 1 — the system of fixed exchange rates set up after the World War 2 — only lasted as long as it did because it was backed by a set of institutions that made it easier for the world’s central banks to cooperate to support the system. The key players at the time were mostly in Europe, so most of the institutions had an “Atlantic” tilt. These institutions were more than just talking shops: there was a core commitment by the central banks not to convert their dollars into gold (and to jointly intervene in the gold market). Remember, in the initial Bretton Woods system, the dollar was pegged to gold, and everyone else pegged to the dollar. This kept Bretton Woods 1 going long after it was clear that the US lacked the gold needed to back all the dollars that the world’s central banks were holding.

Eichengreen observed that similar institutions to facilitate cooperation were lacking, and concluded that Asia would not be able to agree on who should bear the burden of supporting the dollar. The temptation to diversify (or at least try to diversity) before the other guy would be too strong.

Of course, there is an alternative thesis: new institutions will be created to help generate the needed cooperation.

Count me a skeptic. I want to see the “Asian Bellagio” countries do more than just coordinate the announcement that the big players have no intent to diversify.

Sure, all the big Asian economies would rather not see their currencies appreciate against the dollar, particularly if China remains wedded to its peg. But each Asian economy would presumably also prefer to see someone else add to its dollar reserves and take the (future) losses associated with providing the US with the financing the US needs for the system to keep on going.

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Monty Python takes on Asian reserve accumulation

by Brad Setser Wednesday, February 23, 2005

This is too good for me not to link to it.

Billmon has reduced the Roubini-Setser critique of Bretton Woods 2 down to its essential elements.

The Lex column in the Financial Times covers similar ground, but in a less entertaining way.

The FT’s bottom line: the system is “structurally unstable.”

Asian central bank reserves almost doubled to $1,900bn between 1999 and 2003, and swelled further in 2004, mostly in dollars. This is starting to resemble a pyramid scheme. If nobody dumps dollars, banks may avoid losses on these holdings, but if any bank tries to protect itself from possible losses by selling dollars, everyone will be hurt. … Right now, it is hard to see any central bank breaking rank. … However, just because everyone has a tactical interest in playing the current game now, that does not make it structurally stable in the long term. If or when the distortions linked to these pumped-up reserves unravel, the “pop” will be painful.

If any of you want to update the FT’s charts to reflect 2004 reserve accumulation by Asian central banks, my calculations suggest that Asian central banks added $535 billion to their reserves last year, pushing their overall reserves above $2400 billion ($2.4 trillion).

Net US external debt probably rose to around $3.3 trillion at the end of 2004 (with FDI valued at market rates). So the debt the US owes to Asian central banks accounts for a substantial share of the United States’ net external debt, and a not-insignificant share of the United States’ roughly $11 trillion gross external debt.

Reserve Diversification

by Brad Setser Tuesday, February 22, 2005

Three somewhat wonky and technical thoughts:

1) Do not underestimate Korea just because it does not hold as many reserves as China and Japan.

$200 billion is $200 billion. Moreover, the combined reserves of Taiwan, Korea, Russia and India are larger than China’s reserves: $685 billion v. $610 billion at the end of 2004. Taiwan, Korea, Russia and India added $152 billion to their reserves in 04. That is a bit behind China’s $200 billion increase, but it not a small sum. If all those reserves went into dollars (unrealistic, i know, particularly since some of the increase reflects valuation gains), it would have been enough to fund about 1/4 of the United States’ 2004 current account deficit.

News about what any of these four central banks intend to do is hardly marginal news in my book. Three of the four — Russia, India and Korea — have now indicated a desire to either diversify their reserves or to spend their reserves on “infrastructure.” Some say Taiwan has made similar noises as well, though Taiwan’s central bank officially denies any such intent.

Right now, I think it is fair to say that their continued willingness to add to their dollar reserves at the same pace as in 2003 and 2004 is somewhat in doubt — though there ability to accept the consequences of not adding to their reserves and letting their currencies appreciate remains equally open to question.2) Reserve diversification alone cannot protect a central bank’s balance sheet all that much; the overall size of the central banks stock of reserves probably matters more.

Shifting from dollar reserves to euro reserves back in 2002 certainly would have made a lot of sense: the central bank would have seen the value of its assets rise (in dollar terms) as the euro rose against the dollar, and some central banks might now be sitting on fat capital gains. But the past is the past: central banks cannot buy a euro for less than a dollar anymore. Shifting into euros now only protects the central bank against future falls in the dollar against the euro. It won’t necessarily cut the capital losses many Asian central banks face when their currencies are revalued.

Take the following example. Suppose China lets the value of its currency rise by 20%, from 8.28 renminbi to the dollar to 6.62 renminbi to the dollar. (Incidentally, in local currency terms, the value of the renminbi has gone up by 25%, from 12 cents per renminbi to 15 cents per renminbi — be careful with percentages with large exchange rate moves). If the euro/ dollar exchange stays constant, the renminbi will also go up be 20% against the euro, rising from 10.76 to the euro to 8.61 to the euro. If the central bank has sterilized its reserve accumulation by selling renminbi debt, and has renminbi liabilities offsetting its dollar and euro assets, the capital loss on its dollar and euro reserves will be identical. Now suppose the Euro/ dollar is not constant. Rather suppose the euro falls against the dollar by 20% (from say 1.30 to 1.04) when China revalues the renminbi. The renminbi then goes from 10.78 renminbi to the euro to 6.88 renminbi to the euro — the renminbi appreciates v. the dollar and the dollar appreciates v the euro, so the renminbi really appreciates v. the euro. The net result: larger capital losses on euro than on dollar reserves. Now suppose the renminbi appreciates against the dollar and the euro also appreciates against the dollar, so euro rises from 1.3 to 1.56. If I did the math right, one euro is worth 10.78 renminbi before the currency move, and 10.33 renminbi after. The net result: smaller capital losses on euro than on dollar reserves, since the local currency value of the euro stays more or less constant.

So diversification may, or may not, help at this stage: it depends on the future course of the dollar/ euro.

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Korea, enough said

by Brad Setser Tuesday, February 22, 2005

It looks the remarks of Korea’s Central Bank President last week were a leading indicator of today’s big news: Korea plans to diversify its reserves away from the dollar!

Bloomberg is right: the real question is who [formerly, how — oops] else follows suit — Thailand already has shifted out of the dollar (look at how its reserves moved in January, when the dollar rose v. the Euro), Russia too. But most central banks are still massively overweight dollars.

“The market will now be looking to other central banks and what they will be doing, including the European central banks and Middle Eastern banks,” said Mansoor Mohi-Uddin, head of currency strategy at UBS AG in London. “The market has got nervous and has continued selling the dollar.”

“Support for the dollar is quickly disappearing,” said Kenichiro Ikezawa, who manages $1 billion in overseas debt at Daiwa SB Investments in Tokyo. Korea’s report “feeds into suspicion that others are also seeking to cut their exposure to the dollar.”

It will be interesting to see how far Korea is willing to let the won appreciate. Diversification in the context of rapidly growing reserves is a bit different than diversifying your existing holdings. If a country’s reserves are growing faster enough, their dollar holdings can go up even as the share of dollars in their overall portfolio goes down. I suspect that is what happened with Russia last year, for example.

The other big question, of course, is how much additional pressure this all places on China: the Bretton Woods 2 system of central bank financing of the US current account deficit increasingly hinges on the People’s Bank of China’s willingness to keep adding to its dollar reserves at an accelerating rate.

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The confused conservatives on the Washington Post oped page …

by Brad Setser Monday, February 21, 2005

The Washington Post put out an oped on the partial privatization of Social Security over the weekend, which Kevin Drum appropriately jumped on.

One item in the oped jumped out at me:

The second risk in personal accounts is that their transition costs might scare financial markets. As we have argued before, investors shouldn’t take fright. The transition borrowing merely swaps government debt to future retirees for government debt to bondholders. Indeed, if personal accounts are coupled with a benefit cut, as they should be, the government’s total debts would fall; if anything, investors should be heartened. But financial markets are not perfectly rational. Coming on top of the president’s irresponsible budget policies, a flood of new bond issues might possibly frighten investors, perhaps triggering a fall in the dollar and higher interest rates.

While the Post oped writers include some appropriate caveats at the end, they basically endorse the White House argument that “debt issued to finance Social Security privatization should not count” because it will be offset by future benefits cuts, and thus will reduce the government’s implicit liabilities.

You have gotta be kidding me.

Let me tell you why:

1) If the markets care about implicit liabilities, they are not showing it. The prescription drug benefit, as Paul Krugman and others (including many conservatives) have pointed out, created a larger “implicit liability” than the current “implicit liability” associated with the Social Security system (the funding gap that arises from a roughly 1.5% of GDP gap between promised benefits and expected revenues after 2052, per the CBO, and after 2042, per the Trustees — the gap is less than 1.5% of GDP in 2052, but it rises over time). I don’t think there is much evidence that the markets penalized the US government for the increase it the government’s implicit liability.

2) Best I can tell, using realistic forecasts, the consolidated government has a gap between its projected revenues and its projected expenditures of 3.5% of GDP from now until eternity, and probably more (expenditures start rising sharply after 2010). Take Social Security’s cash flow surplus – including the interest income from the Trust Fund that Social Security reinvests in governments bonds – out of the consolidated budget and that gap is well over 4% of GDP for the next few years, indeed close to 5% of GDP. The general government’s cash flow deficit, assuming no change in current policies, has a much higher present discounted value than the gap in the Social Security system: the gap is bigger than the gap in Social Security, and it starts today, not in 2052. If the markets want to worry about something, they have plenty of things to worry about that “hit” long before the Social Security funding gap emerges in 2052.

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Banker? Strategic competitor? Both?

by Brad Setser Sunday, February 20, 2005

The US borrows about 1/5 of all the money the federal government spends, and most of the borrowed money comes from abroad: foreign purchases of Treasuries in 2004 exceeded the (net) issuance of Treasuries required to finance the deficit. So a decent chunk of the Defense Department’s budget comes not from tax revenues, but rather from a loan from the world’s central banks.

Even if China is not financing the US Treasury directly, it certainly is supporting the US housing market through its purchases of Agency debt and mortgage backed securities. That helps to make W’s policy of guns (defense buildup, war on terrorism), butter (prescription drugs & the pork in the stalled energy bill) and tax cuts consistent with low interest rates and rising housing prices. Take away the “low interest rates and rising housing prices” and there would be a lot more pressure to choose among guns, butter and tax cuts.

That is why the Pentagon’s sense that China is a future strategic competitor, along with the incipient Sino-American rivalry created by China’s growing interest in financing the investment required to meet China’s growing need for natural resources, is so interesting. A sage commentator on this blog noted that Japan can hardly invest its reserves in US corporate debt, since that would finance the US rivals of major Japanese firms. Can the something similar be said of China? Will China want to finance the US government, through the purchases of Treasuries, as US seeks implement a strategy intended to contain China’s regional, if not global, ambitions? Or will it prefer to step up its own direct investment in the production of the world’s oil and other commodities, even if that means investing in places that the US labels pariahs? Will the Pentagon brass start to worry (publicly) about the United States’ financial dependence on China? Worry (publicly) about the large quantities of Treasuries that China could dump on the US market in a crisis?

Make no mistake, China acted as the world’s banker in 2004. Its total reserve accumulation of $200 billion represented about a quarter of the world’s aggregate current account surplus: the People’s Bank of China in effect determined the allocation of a significant fraction of all (net) cross border savings.

Not all of that reserve accumulation was financed by China’s comparatively modest (roughly $50 billion) current account surplus. But that only make China’s government look more like a bank. During 2004, China’s external liabilities rose by roughly $150 billion while the People’s Bank of China’s external assets increased by $200 billion. China’s government effectively uses global demand for Chinese assets to finance its own purchase of asset abroad, and in the process, determines (or perhaps distorts) the allocation of much of the world’s savings.

This is something that I would like to see “strategists” like Tom Barnett take up, but in a slightly more (financially) sophisticated way.

Barnett, author of the Pentagon’s New Map, is a big Sinophile within Pentagon circles, and a major critic of the “China as strategic competitor” thesis. He sees the US and China as natural allies, since both are winners from economic globalization (in Barnett’s terms, they are part of the integrating core). Rather than compete, they should cooperate to bring order and stability to those regions of the world that have yet to benefit from globalization (Barnett’s gap).

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Will US (and Chinese) economic policy pass the Korean test?

by Brad Setser Friday, February 18, 2005

Korea thinks China should get rid of its peg.

And the governor of Korea’s central bank, Mr. Park, thinks the US should take steps to reign in domestic US demand and reduce its twin deficits.

Park also called on the US to adopt policies to lower domestic

demand and raise private savings levels in order to reduce the country’s budget and current account deficits.This, he said: “Should be followed by global exchange rate adjustment and cooperation in economic policy. The dollar needs to weaken gradually within a range of values that is sustainable for East Asian countries.”

He also had a stark warning for the US, saying that Asian central banks may become reluctant to help the US finance its deficits.

“A steep downtrend in the dollar would make East Asian countries reluctant to buy more dollar assets, which would make it difficult for the United States to finance its deficits,” he said.

The fact that Korea is adding its voice to those calling for China to adjust its peg is significant — if for no other reason than in suggests that Korea does not like its current set of choices.

In the fourth quarter, Korea’s reserves grew by $25 billion ($100 b annualized), an absolutely unsustainable pace. Korea understands the value of reserves: Korea’s 1997 crisis stemmed in large part from a gap between short-term foreign currency debt and liquid foreign currency reserves. But there is a limit to the size of the war chest any country needs for self defense. $200 billion seems to be quite enough.

On the other hand, Korea also worries that if it does not intervene and the won rises further, its own economy will be squeezed by China.

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