Thrills and spills

JOHN MAYNARD KEYNES observed that in the late 19th century London’s influence on the global financial system was such that the Bank of England could be considered the world’s orchestra conductor. Today America is like the dominant rapper in an anarchic transnational collective. Some politicians reckon that the global monetary system is a source of American soft power. This article will argue that it is unstable and, if unreformed, poses a threat to American interests.

The global monetary system has long been a headache. The gold standard of the 19th century dissolved into depression and chaos in the 1930s. The post-war Bretton Woods system of fixed exchange rates collapsed in the 1970s, to be replaced by a freewheeling system of floating currencies and mobile capital. Today it suffers from three related problems. First, the old collective-action one that Keynes grappled with: how to resolve the imbalances between countries (their current-account deficits and surpluses) in a way that does not hurt world economic growth. If deficit countries are forced to bear all the burden of adjustment by cutting back their imports, world output will be lower. This has haunted the euro zone, where tensions between northern countries with surpluses and southern ones with deficits were partly responsible for the crisis. Countries that try to cheapen their currency to boost their exports can set off tit-for-tat devaluations that benefit no one. China’s devaluation in August has raised fears of such beggar-thy-neighbour policies.

The second problem is newer and more dangerous: the size of gross capital flows sloshing about the world. A country with a current-account surplus or deficit has to invest abroad, or attract, net funds of the same amount. In the 19th and 20th centuries economists tacitly assumed that the gross capital flows moving around the world would roughly reflect those amounts. But after two decades of financial globalisation, capital flows dwarf current-account imbalances. In 2007 they reached about 20% of world GDP. That year India’s current-account deficit, for instance, was $16 billion, but the gross capital flows washing into the country were 28 times bigger, partly offset by outflows. Since the 2007-08 crisis very low interest rates have encouraged large-scale speculation, with capital flooding into emerging countries. The chaos in the currency markets this year has reflected the unwinding of these positions.

The third problem is the dollar and America’s role in the system. The greenback reigns supreme by every yardstick for an international currency: as a medium of exchange, a unit of account, a store of value and a reserve asset held by central banks. The euro has lost ground, the yen has flopped and the yuan is still in nappies. By one estimate the de facto dollar zone accounts for perhaps 60% of the world’s population as well as 60% of its GDP (see map). It is made up of America, the countries whose currencies float in sympathy with the dollar, and countries with dollar pegs such as China.

By law the Fed sets its policy to suit America alone, but a great archipelago of offshore dollar deposits and securities exists outside America. Dollar payments pass through banks that directly or indirectly deal with New York. Countries’ trade flows and some of their debts are in dollars, so this is the currency they need. But there is no guaranteed lender of last resort. The Fed lends dollars to foreigners on ad hoc terms. The IMF has insufficient money and legitimacy to play this role. Instead, many countries have built up enormous safety buffers of dollar reserves in the form of Treasury bonds.

Those vast global capital flows tend to move to America’s financial rhythm. Countries with currency pegs have to mimic Fed policy or risk excessive capital inflows if they keep rates too high, or outflows if they keep them too low. Global banks are financed in dollars and expand and contract to mirror conditions in America. Firms with dollar debts or deposits have no control over changes in their interest costs or income. Giant global investment funds, usually headquartered in America, often borrow in dollars, and their mood swings to the beat of Wall Street.

The Anna Karenina principle

Just like Tolstoy’s unhappy families, every country in the dollar system is unhappy in its own way. The three problems listed above—imbalances, capital flows and dollar dependence—are mixed into a giant omelette that is near-impossible to unscramble. At the heart of the problem is a piece of economic logic known as the “trilemma”. It states that a country can have only two of three things it wants: a stable exchange rate, openness to global capital flows and the ability to set its interest rates freely to suit its own economy. Before the Asian crisis in 1997-98 many countries had fixed currencies and were open to money coming across their borders but had no independent monetary policy. The illusion of stability fostered by such pegs led to a build-up of dollar-denominated debts in emerging Asia. When capital inflows dried up, the pegs broke. Currencies plunged in value, pushing up the cost of dollar debts. A brutal recession followed.

The scars of the Asian crisis explain the emergence of a new consensus: countries should let their currency float so it would act as an adjustment mechanism. Their openness meant they would be buffeted by speculators, but that could be mitigated by keeping their house in order, controlling inflation, deepening local markets and avoiding borrowing in other currencies. For all emerging economies, median net foreign-currency debt (total debt less reserves) has fallen from 20% of GDP in 1995 to roughly zero today. Most countries built up immense dollar reserves and tried to minimise their current-account deficit or run a surplus. China had its own variation, pegging its currency but at a cheap rate to the dollar. That generated vast current-account surpluses which the government heaped into an ever-growing pile of American Treasury bonds.

None of this has worked as well as expected. Take the floaters first. Large capital flows can cause chaos even if your house is in order, roiling local-currency bond markets and interest rates. Just because you do not borrow in dollars does not mean you are immune to jittery foreigners’ antics. Foreigners now own between 20% and 50% of local-currency government bonds in Turkey, South Africa, Indonesia, Malaysia and Mexico. Since 2013 the Fed has pondered tightening rates, and every time it gets close, money cascades out of emerging markets.

China and other countries with fixed pegs are fed up, too. When America raises interest rates, the dollar soars and so do their currencies, hurting exports. Moreover, the value of those huge reserves appears to be periodically at risk from a falling dollar, inflation or even default. During the 2007-08 crisis American officials made weekly calls to reassure their Chinese counterparts that it would not default.

Even America has mixed feelings about the monetary regime it anchors. In theory its ability to trade and borrow cheaply and freely in its own currency is an “exorbitant privilege”, in the words of a former French president, Valéry Giscard d’Estaing. The financial crisis caused many to reconsider that view. Artificial demand for “safe assets” in dollars may have pushed up the exchange rate, hurting manufacturing jobs. Indeed, it may have helped cause the crisis. Voracious bouts of foreign buying of Treasury bonds distorted the market, lowering interest rates and fuelling a debt binge by banks and homeowners.

One response is to assume that the global system heals itself naturally. The argument goes something like this. The imbalances between surplus countries in Asia and the Middle East and deficit countries, most notably America, will narrow now that oil exporters are earning less and China is trying to move away from its export-led model. Capital flows have gone over the top as central banks have tried to fend off a depression, but as the dollar rises, emerging economies will use their reserves to stabilise their currencies. The system will start to look more normal.

But that is wishful thinking. If the system unwinds and two decades of globalisation go into reverse, things could turn messy, with emerging markets rapidly selling down their reserves, perhaps disrupting the Treasury market, and capital rushing out. It seems just as likely that the system is self-perpetuating. Imbalances reflect long-term factors, such as a culture of precautionary saving in emerging Asia, which mostly lacks social-security safety nets. The sheer scale of the world’s financial system will ensure that global capital flows remain big and violent. Governments still have a strong incentive to run current-account surpluses and to build up huge reserves if they can.

If this crisis-prone system were to stumble along for another decade, it would stretch everyone’s nerves to breaking-point. For emerging economies, their relationship with America has become lopsided. Conventional wisdom has it that an American recovery is good for all. It raises global interest rates but also global exports, which in net terms benefits emerging economies. An IMF study concludes that a rise of one percentage point in American bond yields, if driven by hopes of better growth, will push up bond yields in emerging economies, but the resulting rise in American imports will boost emerging markets’ industrial production by 2%.

The trouble is that American bond yields often rise for other reasons, which means the net effect may be bad for emerging economies. A dollar rally has been associated with emerging-market troubles in 1980-85, 1995-2001, 2008-09 and 2013-15. And whereas the effect of America exporting its financial conditions is as powerful as ever, its imports of goods from emerging economies have diminished in relative terms. America’s share of global imports has fallen by a third since 2000, to 12%. The trade-off from being in Uncle Sam’s orbit has become less favourable.

America may find that carrying on as before will become acutely uncomfortable for different reasons. One is the offshore dollar banking system and the risk that America may have to bail it out. The freewheeling Eurodollar market for banking in dollars outside America sprang up in the 1960s to get round red tape in America itself. It has been growing at a furious pace ever since. Foreign banks create dollar deposits and loans at the stroke of a pen: a bank lends a dollar to a foreign firm, which deposits it in a different foreign bank, which lends it out, and so on.

The Eurodollar market was at the heart of the 2007-08 crisis. Dollar depositors and bond investors in European banks panicked and refused to carry on funding them, piling into the safe haven of Treasuries instead and causing a run. Interbank rates in London soared relative to American interest rates. The Fed was forced to provide over $1 trillion of liquidity, by lending to foreign banks through their American subsidiaries and by extending swap lines to friendly central banks (in Europe, Mexico, Brazil, Japan South Korea and Singapore) which in turn made the dollars available to their banks. Even if these swap lines were not used in full, their mere existence calmed the panic.

Since then the offshore dollar system has become even bigger. It is now about half the size of America’s domestic banking industry, compared with 10% in the 1970s. Offshore dollar credit (bonds and loans) has risen from 28% to 54% of American GDP over the past decade and from 11% to 16% of world GDP outside America. The Eurodollar is becoming the Asian dollar. A sample of a dozen of Asia’s biggest banks (excluding Japan) have a total of $1 trillion of dollar assets, often financed by debt, with Chinese banks featuring prominently. Singapore now hosts $1.2 trillion of offshore dollar bank assets.

Some think that this is a cyclical boom, fuelled by low American interest rates. But it could just as easily be seen as reflecting the dollar’s dominance as a global currency: as emerging economies get bigger and more finance-intensive, their use of the dollar will increase. Assuming that the relationship between offshore dollar borrowing and non-American GDP stays on its current trend, the offshore dollar market could reach $20 trillion-40 trillion by 2030.

Meanwhile the link between America and the offshore system has become weaker. An elite group of banks has always settled dollar payments with each other using CHIPs, a semi-official body in New York, and a mass of other banks deal through the elite. The hierarchy was shaped like a pyramid. But America slapped so many fines on foreign banks that many lenders now keep away from it, so the pyramid has changed shape. The top has got narrower, with almost all transactions funnelled through five or six global firms, including J.P. Morgan and HSBC. They deal with America on behalf of thousands of banks around the world. These big global banks, in turn, are cutting off direct dealings with some customers—Ukraine, some African countries, third-tier Chinese banks, small firms in the Middle East—because the cost of monitoring them has become uneconomic. Those customers have taken to using layers of smaller banks to act as intermediaries with the big global ones. More and more of the offshore dollar world is trying to avoid direct contact with America, making the middle and bottom of the pyramid wider.

The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.

An archipelago too far

Could the Fed save the day again? It would be a lot harder than last time. The offshore archipelago is almost twice as large as it was in 2007 and is growing fast, so any rescue would have to be on a much larger scale. The mix of countries involved is tilting away from America’s allies. The banks in question are less likely to have subsidiaries in New York that can borrow directly from the Fed or are viewed as palatable by the American legal system. The consequences could be dire (for one possible scenario, see article).

The system’s longer-term viability may also be tested by an inadequate supply of “safe assets” in the form of Treasury bonds. In the 1960s Robert Triffin, a Belgian-born economist, worried that foreign demand for dollars would jeopardise the Bretton Woods system in which the dollar was redeemable against a limited supply of gold at a fixed price. In today’s freewheeling currency system the problem is different. Already foreigners own $6.2 trillion-worth of Treasuries, or 60% of the total available. If countries carry on building dollar reserves in line with the size of their economies, and America’s debt-to-GDP ratio remains steady, Treasuries could be in short supply by 2035.

America could find sneaky ways to create safe assets, such as offering blanket guarantees of bank deposits and corporate bonds to make them as safe as government bonds. Or it could issue far more bonds that it needs and invest the surplus abroad, acting like a sovereign-wealth fund. But after the bail-outs of 2008 Congress wants to limit the scope of the Fed’s safety net. Some believe the IMF could meet the demand for safe assets by creating more Special Drawing Rights (SDRs), a form of quasi-money based on a basket of major currencies. Yet if countries wanted to diversify their reserves they could easily do this directly, without a need for SDRs. They want dollars.

The global monetary system is unreformed, unstable and possibly unsustainable. What it needs is an engineer to design smart ways to tame capital flows, a policeman to stop beggar-thy-neighbour policies, a nurse to provide a safety net if things go wrong, and a judge to run the global payments system impartially. If America’s political system makes it hard to fill those vacancies, can China do better?