Saturday, April 3, 2010

Time for a New Currency System?

The modern currency system has it’s roots in the Bretton Woods System which was instituted by representatives of 44 Allied nations towards the end of World War II. Prior to this, Currencies were normally issued against holdings of Gold Reserves. Exchange rates were not required as all international settlements were made in Gold, which was the accepted common currency.

The Bretton Woods System sought to move away from this system to a system of ‘negotiated exchange rates’ which were fixed in term of Gold and countries were required to maintain this peg within certain pre-defined limits. An International Reserve Currency was proposed, but shot down by the US which insisted that the US Dollar should be nominated as the Reserve Currency. To convince the other nations, the US undertook to exchange USD for Gold at a fixed rate of USD 35 per ounce.

However, inherent flaws in the system saw it go through many pangs and adjustments. And on August 15 1971, President Nixon announced that the USD would not be directly convertible to Gold except through the open market. This decision was taken by the US unilaterally and was the equivalent of sovereign default. The countries holding their reserves in USD, who till the day before believed they effectively held a certain quantity of Gold, were left holding just another currency. While more attempts were made to tweak the Bretton Woods System to make it work, the loss of its very foundation saw it fade away and by early 1976, most currencies were ‘floating’.

Through the Bretton Woods agreement, the US pursued expansionist monetary policy that saw the ratio of its Gold Assets to total outstanding currency fall steadily. The US Congress had however, specified that this ratio could not fall below 25%, but removed that restriction in early 1968. At the time of the default, the coverage ratio was 22%.

After the Bretton Woods System faded away, Central Banks across the world realized that in the new order of things, their currencies did not need assets to back them. It was thought that no central bank would risk issuing too much currency for fear of it weakening against other ‘floating’ currencies and domestic inflation. A real peg had been replaced by an ‘ethical’ peg.

But as the US continued to expand monetarily through the following years, other countries could follow suit primarily because (i) it wouldn’t change the value of their currencies vis-a-vis USD as the US was doing the same and (ii) because if they didn’t they would miss out on the ‘progress’ that this additional money offered. There was great reward without any downside.

This global order worked to the US’s advantage as well, as the world, instead of rejecting it’s currency in the face of this monetary expansion, joined it. Currency issuance across the world had been unfettered. Not only from underlying assets, but from the value of these underlying assets as well.

But this outcome gave Governments & Central Banks unprecedented power over the value of their respective currencies. Currencies which did not ‘float’ had also been delinked from assets, but were not priced by a free market. Instead their value was what the Government decided it was. Armed with this power, under-developed nations undertook voluntary devaluations of their respective currencies in a bid to increase their competitive advantage in the global market. But once the cycle started, it could not be stopped. Over time, nations sought to devalue their currencies just because their competitors did so, and the competitors followed them. The race was on and no one wanted to come in second.

Of this pack, a few nations (Japan, being the largest) also took essential steps to free their manufacturers from restrictive regulations and allow them to compete globally. This was a link that other countries like India missed completely. Japanese success in gaining significant market share in the US inspired others in the region. The Asian Tigers undertook meaningful reform, but the Dragon did it the best. India undertook reforms grudgingly, and only after faulty fiscal and monetary policy drove it to the brink of default.

But the underlying trend of competitive devaluation which had started almost immediately after the collapse of the Bretton Woods System hasn’t lost it’s followers. China is today one of the biggest currency manipulators and holds its currency at an artificially weak level. It learnt this trick from Japan, which started currency manipulation much earlier, but has been left behind by China in sheer magnitude.

The mechanism of devaluing one’s currency would not have been available if currencies needed to be supported with real assets. But since they were unfettered, a Central Bank can create a virtually unlimited amount of it’s own currency without any restriction. This allows it to sell it’s own currency in the market and buy foreign currencies (the currency of choice here being the USD due to it’s exalted status). It can then suck the excess domestic currency liquidity so created by mechanisms such as increasing reserve requirements. But this is possible only because there is no way left to arrive at a value for the currency. No assets, no free markets. These currencies are valued by Central Bank diktat.

While the US enjoyed the benefits of the USD’s status as a Reserve Currency when the going was good, Currency Manipulation by China has hurt prospects of a quick recovery from the effects of the financial crisis. On April 15 2010, a scheduled report by the US Treasury Department may label China a Currency Manipulator, something it has been avoiding for the last 15 years. If it does, it will give legitimacy to a bill supported by 130 US Senators seeking to institute measures designed to force China to allow it’s currency to appreciate. Amongst these, is the proposed levy of a penal import duty of 25% on all Chinese products.

While China’s currency policy is as protectionist as the proposed levy, China’s manipulation is perceived by many to be a domestic issue. However misguided this view, imposing an explicit levy is likely to be perceived as a very aggressive stance, which may trigger off a trade war.  As I mentioned in an earlier note, “Is it time for De-globalization?”, this trade war will change the world as we know it.

Apart from other things, it will certainly give the world the required incentive to discuss a new currency arrangement. A currency arrangement which will not allow the blatant manipulation of a currency’s value by it’s Central Bank. A system which insists upon a ‘real’ value for currencies, instead of allowing Central Banks to create it out of thin air. A system which would result in currencies worth more than just words.

A Real Currency, for a change.

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