Posted on 08/10/2003 7:07:49 PM PDT by comnet
The paradox of global liquidity China and India must try and develop a regional long-term bond market based in Singapore, says S Sivakumar
Published : August 11, 2003
The rising US current account deficit as a per cent of GDP over the years has led to a build up of dollar reserves in the rest of the world, especially in Asia. The de facto dollar standard has led some to claim that it can be sustainable over the long-term. This article tries to present a quick overview of the international monetary arrangements of the past, highlight the global liquidity situation, its consequences and the implications for India.
The evolution of international monetary arrangements has been driven either by historical forces or by accident. The shift from commodity based money to paper money, centralised control over paper money within a nation state were landmark developments.
The gold standard era (1879-1913) was known for its incredible free movement of capital and goods. One of the key aspects of this period was that a country with a balance of payments deficit would experience an outflow of gold and a country with a balance of payments surplus would experience an inflow of gold.
This adjustment mechanism worked through relative prices and prevented persistent deficits or surplus. During the inter war period, a gold exchange standard was adopted. The Bretton Woods conference led to the creation of the International Monetary Fund (IMF).
The sole purpose of the IMF was to maintain the fixed exchange rates and provide liquidity to enable countries to stabilise their temporary balance of payments problems.
The post-war economic expansion commenced. US started running current account surplus and helped Germany and Japan rebuild their economies. Between 1969-72, world foreign exchange reserves doubled. An increase that was equivalent to all previous centuries of recorded history.
Prof Robert Triffin observed that, as the paper-based system became the post-war norm, the US dollar became the source of international liquidity for international settlements and reserve accumulation. The expansion of liquidity can take place only when the US runs a current account deficit.
Such persistent deficits will undermine the value of the currency and therefore the reserve asset. This became known as the Triffin’s Dilemma.
The three ways out of this dilemma are: A new international currency to replace the dollar, global deflation by reducing supply of dollars and the last option was to eliminate the convertibility of the dollar to gold.
President Nixon shut the gold window in August 1971, the industrialised countries moved toward generalised floating of their currencies in 1973. Since then, the dollar has been as good as gold. We are on a dollar standard.
The three key parameters that need to be monitored for reserve currency are: confidence, liquidity and adjustment. While the dollar is solid on the first two counts, the lack of adjustment in its value in response to fundamentals till recently has become a source of concern.
Over the last 12 years, US current account deficits have been persistent. A substantial portion of the current account deficit is the trade deficit.
The rest of the world has been exporting its goods and services to the US and there has been a corresponding increase in international liquidity. The surge in dollar reserves have been ploughed back to invest in US treasury bonds, equities, corporate bonds and mortgages.
Richard Duncan in his recent book The Dollar crisis has identified the surge in international dollar liquidity as a direct consequence of US current account deficits. He asserts that the dollar liquidity is the key driving force behind global excess capacity and asset price bubbles.
His radical solution is move towards a global minimum wage to stimulate global aggregate demand and a global central bank to manage global money supply. The situation is not as dire as projected by Richard Duncan, as the cumulative annual growth in reserves held by all countries in the ’90s was slightly higher than in the ’80s and lower than in the ’70s. It is important to get a sense of these numbers.
The total reserves minus gold measured by SDRs (special drawing rights — a unit of account of the IMF and its value is determined by a basket of currencies consisting of the euro, Japanese yen, pound sterling and US dollar) of all countries, industrialised countries and Asia.
In 1971, out of the total international reserves, industrialised countries held 73 per cent, 8.2 per cent was held by Asia (excluding Japan) and 6.6 per cent by the Organisation of Petroleum Exporting Countries (OPEC).
By 2003 Q1, 38 per cent of the international reserves were held by industrial countries, 39 per cent by Asia and only 5.9 per cent by the OPEC. It is the first time in post-war history that the reserves held by Asia exceed those of the industrialised countries. The bulk of these reserves are held in dollars.
The cumulative annual growth rate of reserves held in Asia between 1991 Q1 to 1997 Q1 was 14.9 per cent , between 1997 Q1 and 2003 Q1 it was only 12.8 per cent. So the Asian crisis has not dramatically changed the reserve accumulation strategy of the region.
Three issues emerge: the sustainability of US current account deficits and its adjustment, better management of global liquidity and calibrating the adjustment process with minimum disruption to trade and investment.
The net international investment position (NIIP) as a per cent of GNP. It is close to 25 per cent and observe the sharp deterioration in the ’90s. The disturbing factor is the approximately four-fold increase in US NIIP as a per cent of GNP over the last ten years.
This is clearly unsustainable, given the other vulnerabilities in the US government finances such as the under-funded social security system, growing budget deficits etc. However the most important issue is to calibrate the adjustment process carefully.
The persistent US current account deficits and the resulting surge in dollar liquidity led to a rise in the value of the dollar. The paradox is that despite the excess dollar liquidity, the main US trading partners were glad to support the strong dollar till recently.
The global imbalances created as a result of this belated adjustment in the value of the dollar need to be dealt with now. The US centric world economy for growth needs to be broad-based with the other regions such as Europe and Asia taking up the bulk of the future growth dynamics.
By undertaking structural reforms to rejuvenate domestic demand, Europe, Japan and the rest of Asia can make this happen. The euro can play a greater role as a reserve currency and take some of the strain from the dollar.
The implications of global liquidity are important for India. Large economies such as India cannot pursue export led strategy as a core driver for growth. Though the process of creating domestic demand may be arduous and time consuming, it is essential for the evolution of a balanced structure for the economy and efficient allocation of resources.
From an Asian regional perspective, with so much to catch up with the industrialised economies, holding reserves beyond the optimal level is counter- productive. The large holders of reserves such as China, India and Korea must explore the possibility of developing a regional long-term bond market to be based in Singapore.
The purpose of dedicating 5-10 per cent of the reserves toward this initiative must be with the explicit objective of financing projects which can boost domestic demand. A market-based allocation will ensure efficiency and being regional in scope will create economies of scale for the operation of the bond market itself.
""The rich rule over the poor and the borrower is slave to the lender." Proverbs 22:7
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