Key Points from The Cost of Free Money

Another well-written and provocative economic book I read last month was written by Paola Subacchi, Professor of International Economics at Queen Mary University of London and thought leader in global capital flow. In her book published last year, she argued that unfettered capital flow has caused disruption in Emerging Markets in the past few decades and the need for multilateral institutions similar to the Bretton Woods era post-WW II. Her book touched on the subject of inequality, geopolitics and the role of China in global order. The key points below serve as a personal note for me and my friends to come back to in the future.

As money moves around, it binds the global economy together. Developing countries have enjoyed strong economic growth in the last thirty years by becoming more integrated in the world economy through trade and investment – a process that is referred to as globalisation. We, as consumers, have all benefited from lower prices – but only if we don’t include environmental and human costs in our calculations. But what happens, then, when the world enters into a phase of transition where economic growth no longer lifts all boats,4 where rules become confused, confidence evaporates and politics becomes conflictual?

The Bretton Woods monetary system was designed to limit the scope for domestic policies that are detrimental to other countries, indeed ‘beggar-thy-neighbour’ policies – such as securing an unfair advantage for one’s own country through a competitive devaluation of the exchange rate, at the expense of another country. It also aimed to establish a level playing field for international trade, while at the same time providing the flexibility to pursue domestic interests such as full employment. Under these arrangements, the dollar came to replace sterling as the key international currency and the United States came to replace Great Britain as the leading global power, rendering it responsible for the provision of public goods: finance for development and the global financial safety net.

In desperate need of exchange rate stability, many developing countries have anchored their currencies to the dollar, but in doing so they have tied themselves to the monetary and policy decisions of the United States and consequently run into a whole heap of problems.

Until the end of the 1970s, living standards in the United States grew in line with the growth of the economy, but between 1980 and 2016, 90 per cent of the population’s income grew at a pace that was slower than the national average, with that of workers in the bottom 40 per cent of the income distribution growing by 0.3 per cent a year. Over more than three decades, pre-school teachers and carers saw their annual income grow from $26,400 to just $29,800. On the other hand, those in the top 0.1 per cent of the income distribution – for example, an investment banker or a corporate lawyer – almost quadrupled their post-tax income.

The post-Second World War golden age was the result of extraordinary economic and political conditions. These conditions supported the expectations that progress could only be linear and ascendant – that is, that social, economic and physical conditions could only improve. In the opening of this chapter I identified four trends – demographics, health conditions, economic growth and geopolitics – that, through their interplaying, came to shape the golden age.

The postwar years were blessed with exceptional economic activity that resulted in strong and sustained economic growth. In the two decades after the war, the advanced economies, including Western Europe and the United States, saw their annual real gross domestic product (GDP) grow at a steady average rate of 5 per cent.11 Unemployment was low. By the mid-1960s, the average unemployment rate across Europe was 1.5 per cent – effectively a situation of full employment. The United States also saw a significant improvement, with the unemployment rate dropping to around 4 per cent at the same time.

The overlapping of these trends meant that, for the first time ever in human history, people who were not endowed with wealth and capital, exceptional talent or even just sheer luck, could aspire to a decent life for themselves and their children. For many people from blue-collar backgrounds, a white-collar middle-class future was no longer a wild dream.

Brands have become global because the world economy has become global. The world has changed beyond recognition in the last forty years; it has become larger, ‘flatter’19 and more connected. The reduction or removal of trade barriers (as in the case of Europe’s single market), the opening of new markets and the integration of transnational supply chains have become the defining stories of our time.

Barriers to mobility started to crumble around the time of the fall of the Berlin Wall in 1989, which marked the end of the Cold War and the beginning of an intense period of trade and financial integration. With the barriers to mobility removed or reduced, markets opened up, fostering innovation in technology, information, ideas, governance and institutions. This in turn created the conditions for more cross-border business, shaping the development path of many countries and underpinning the transformation of the world economy. These dynamics are reflected in the dramatic increase in international trade flows over the last three decades.

What really differentiates the later phase of globalisation, however, is not the speed of integration within a relatively short space of time, nor the rate at which international trade grew. It instead lies in the fact that the countries that had, for the last seventy years, largely remained at the periphery of the world economy, are now key components. These include China, India, Russia and Brazil, with South Africa added at a later stage – the BRICS as they have become known (as I will discuss in chapter 7) – but also Mexico, Indonesia, Thailand, Vietnam, Nigeria and Turkey. All of these countries have come to epitomise the broadening of the world economy both in terms of the increase in the share of the world GDP they currently produce (about 40 per cent at current market prices) and their contribution to global growth (approximately 60 per cent).

Capital flows, even more than trade, have grown robustly since 1990. This is true of both portfolio investments and foreign direct investments.

In the mid-1990s, gross cross-border capital flows accounted for approximately 5 per cent of world GDP; at their pre-crisis peak in 2007 they were about 20 per cent. Capital flows, then, increased at a pace approximately three times faster than that of world trade flows.39 Nowadays, foreign direct investments account for around 1.4 per cent of the world’s total GDP.40 (Foreign direct investment are a type of investment that reflects lasting interest and control by a foreign investor, such as when an investor who resides in one country buys or establishes a firm in another country.) In 1990 this figure was much lower, at approximately 0.9 per cent. Portfolio investment – such as when an investor buys shares in a foreign company or a portion of a country’s or a company’s debt such as stocks and bonds – are by far the bulk of the overall investment activity. They account for approximately $58.7 trillion – approximately 68 per cent of global GDP.41 Since 2001, when the data series began, they have increased by four times their level.

Capital flows are a positive force for the economy as they support economic activity and growth. If they are directed towards activities that increase productivity and add value, they can – directly or indirectly – create new jobs and have a long-term impact. However, when international capital flows are directed towards speculative activities without any intrinsic value creation, they can often end up feeding speculative bubbles or excessive and unstable credit growth, generating significant risks for financial stability. When this happens the recipient countries can make themselves hostages to fortune and vulnerable to external shocks. Not only do these developments make it difficult to manage the domestic economy – for instance, by creating inflationary pressures – but they make countries vulnerable if money inflows suddenly reverse. The Organisation for Economic Co-operation and Development (OECD) has estimated that after large capital inflows, the probability of a banking crisis or a sudden stop increases by a factor of four.

The outbreak of the First World War, however, showed that geopolitical rivalries and even personal antagonism could overcome commercial and economic considerations.55 Despite this, the call for a sound international economic order that promoted cooperation and minimised ‘beggar-thy-neighbours’ actions remained embedded in the intellectual debate of the interwar years.

In The Economic Consequences of the Peace (published in 1919), Keynes identifies trade as the key driver of prosperity which, in turn, was believed to promote domestic order and moderation, resulting in international stability and peace. He further argued that obstructions to trade lead to impoverishment, which then fosters domestic extremism and disorder, and eventually international conflict. By the same token, those who identify their interests with trade are more likely to pursue peace than those who do not, and those who recognise that their well-being depends on trade will be much more likely to pursue policies of international ‘peace and amity’.

Playing by the rules seems to work better when economic conditions are symmetric, such as when the countries in Western Europe were rebuilding their economies at the end of the Second World War. Asymmetric economic conditions – in terms of economic growth and domestic welfare, for example – prevail when some countries experience stronger activity and better labour market conditions than others, as is currently the case in Europe. Even within Europe’s monetary union, divergent economic and financial conditions indicate that some countries (such as Italy) find it more difficult than others (such as Germany) to play by the rules and reduce public spending in order to rein in the public debt.

three supranational institutions – the European Commission, the ECB and the IMF, otherwise known as the Troika – played critical roles during the resolution of the sovereign debt crisis that affected Greece between 2010 and 2015. As I will discuss in chapter 5, the urgency of the crisis and the need to minimise the risk of financial contagion to other economies in Europe – especially Italy with a public debt far larger than that of Greece – put the Troika, i.e., unelected public servants, in charge of crisis resolution. This raised the question of whether the management of global capitalism – of which crisis resolution and crisis prevention are important components – transcends the traditional model of democracy, possibly even making it impracticable.

In a document that the British government had published in 1940 in response to Nazi Germany’s plan for a ‘New Order’ in international economic relations,6 Keynes made it clear that the mistakes of 1919 could not be repeated; a return to the Gold Standard – the monetary arrangements in place until the First World War and reinstated from 1925 to the early 1930s – was not a viable option.

The experiences of the interwar period – during which unemployment rates peaked at roughly 20 per cent in Great Britain and roughly 25 per cent in the United States – had also shown the need for a system that could accommodate domestic policy objectives, such as full employment, as well as the objective of maintaining the external balance. The risk, otherwise, was to again undergo a competitive struggle for markets – the key economic cause of war.

The system worked as long as wages and prices were flexible enough to allow adjustments and maintain the external balance. In the event of a deficit in the trade balance, for instance, domestic prices and wages would drop, making exports more competitive and imports more expensive relative to domestic prices. Restoring the trade balance thus ensured that gold reserves were maintained to back national currencies – having too low gold reserves increased the risk of a convertibility crisis, i.e., when countries were unable to convert their outstanding liabilities into gold at the fixed parity.22 The system, however, was not suitable for an expanding world economy. There simply wasn’t enough gold to support the economic expansion of the late 1890s and early 1900s, for example, and it was difficult for domestic prices to adjust during this period.

Being reinstated in 1925 as the Gold Exchange Standard,23 it came under pressure during the Great Depression that followed the Wall Street Crash in 1929, when the commitment to gold convertibility proved to be an impossible stranglehold for the countries that adhered to it. As countries in the euro area know all too well (I’ll discuss this in Chapter 5) attempts to restore the external balance in a situation where the exchange rate is fixed lead to an undesirable dilemma. In these circumstances, labour productivity – that is, the output produced given a certain amount of labour force – needs to increase for the balance to be restored. As productivity increases, the cost per unit goes down; exports then become cheaper and therefore more competitive, helping to restore the required balance. Output per worker can be increased through improvements in skills – due to education and training – and in technology and innovation. But both these routes take time to deliver the desired effect and so are of little use when the situation requires urgent action. In this case, there are two options. The first one is to decrease wages, either by paying less for the hours worked or getting people to work for longer for the same pay; the second is to decrease the number of workers, leaving the remainder to pick up the slack. The internal adjustment therefore requires an internal devaluation that in turn is conditioned on an increase in unemployment and/or a cut in wages; neither option is fair or politically feasible.

To combine rules with flexibility, the new system had to focus on achieving the two objectives of internal and external balance – rather than subordinating one to the other as was the case within the Gold Standard. Fiscal policy and adjusting exchange rates when they came to differ from their ‘fundamental equilibrium exchange rate’ values became the key policies of the new system.26 Fiscal policy would be used to manage domestic demand to ensure full employment and contain unemployment and the consequent downward impact on wages. At the same time, the cooperative approach to the exchange rate adjustment would restrain governments’ discretionary power of pursuing competitive devaluations and their potential ‘beggar-thy-neighbour’ impact. The way to achieve this was through an adjustable peg system of fixed parities that could be changed only under exceptional circumstances.

Put otherwise, the IMF was designed as a financial safety net – an insurance policy that member countries could turn to when they could no longer control the exchange rate. Its goals were to help countries maintain full employment, support rapid economic growth, keep exchange rates stable and avoid competitive devaluations. In addition, the IMF was tasked with creating a multilateral payments system, eliminating exchange restrictions and supplying funds to backstop and contain balance of payments disequilibria.

Thus the whole international monetary system relied on the ability of the United States to maintain liquidity in the system – that is, its ability to supply dollars ‘on demand’. As the economy of Western Europe was expanding on the back of the postwar reconstruction, the private and official demand for dollars was growing too. Dollars were supplied through private and official long-term capital outflows in excess of a current account surplus.

There were three issues that were undermining the Bretton Woods system and would ultimately result in the American decision to unilaterally unravel it. The first problem concerned the adjustment of countries with a persistent deficit in the balance of payment, as was the case for Britain. Like in the 1920s, deficit countries were bearing the burden of adjustment,

The second problem consisted in an increased risk of a run on the dollar. Although the dollar convertibility outdid the Gold Standard in creating liquidity, the link between the dollar and gold had been exacerbated by the perceived gold shortage – even more so than it had been the case in the past. As the United States provided dollars to the fastest growing economies, such as those of continental Europe and Japan, they ran persistent deficits in the balance of payments. The result was that the outstanding dollar holdings increased relative to the US monetary gold stock, ever widening the gap. The third problem, related to the second one, was brought to light by economist Robert Triffin in his 1960 testimony before the US Congress. He heeded that the ‘dollar overhang’65 was growing larger than America’s gold stock. The persistent deterioration of the United States’ net reserve position would ultimately undermine confidence in the value of the dollar. Lacking this confidence, the dollar would lose its standing as the world’s leading reserve currency. The so-called Triffin dilemma came to express the choice that the United States faced. On the one hand, they could improve confidence in the dollar by embracing contractionary policy that would have a deflationary impact on international liquidity. Alternatively, they could support liquidity by embracing expansionary policy, but in doing this they would risk undermining dollar-holders’ confidence.66 Put otherwise, the United States could retain confidence in the dollar by reducing the deficit, but only at the cost of reducing liquidity in the global system and constraining the growth of the domestic economy.

The deterioration of confidence in the United States vis-à-vis the dollar indicates the fundamental problem within the Bretton Woods system that eventually resulted in its dismissal. Indeed, once confidence was damaged, governments and central banks began to question what they should do with their large dollar holdings and whether they would be better off converting them into gold before the dollar is devalued. If the Bretton Woods countries had requested to convert just a quarter of their dollar holdings at the same time, the United States would not have been able to meet its obligation.

As public opinion in the United States was becoming more hostile towards the war in Vietnam, it was also becoming increasingly aware and less tolerant of the cost of putting the needs of foreign allies before domestic policy objectives. In particular, there was a growing concern over the commercial threat posed by Europe and Japan. Governments and central banks in Europe and Japan, in turn, were growing increasingly uneasy about holding dollars. The Europeans and Japanese had just one critical tool to hand that could rein in the monetary policy autonomy of the United States – the right to demand to convert their dollar holdings into gold. As each side accused the other of being uncooperative, the cracks in the Bretton Woods system deepened even further.

Thus the end of Bretton Woods was more than just the end of dollar convertibility; it ushered in a new light-touch policy framework focused on deregulating domestic financial systems and limiting fiscal policy so to minimise political discretionality and attempts to manipulate the economy. As a result, monetary policy became the main policy tool for managing domestic demand. Alongside floating exchange rates, monetary policy can manipulate movements in the exchange rate which can result in the required changes in demand. Indeed, demand can be stimulated by cutting interest rates, which will in turn support growth and boost employment rates. Part of this stimulus happens through the depreciation of the exchange rate, as a reduction in the interest rate curbs demand for financial assets denominated in the domestic currency. A weaker exchange rate helps increase exports while making imports more expensive. As such, it was concluded that all that was needed in terms of active policies was flexible exchange rates, disciplined fiscal policies and government budget deficits that are balanced in the longer term.

Starting in the 1980s, the advanced economies and many developing countries removed capital controls to stimulate international trade and expand output. It was the beginning of the financialisation of the world economy. Thatcher liberalised Britain’s capital movements in 1979 – one of her government’s first moves. This was followed by the French socialist government’s ‘tournant de la rigueur’ in 1983, which paved the way for more financial liberalisation within Europe. As a result, capital has accumulated globally and the global economy has developed strong interdependencies, trans-border linkages and global networks; compared with earlier versions, its scale and scope are both wider and deeper. This has translated into bigger markets, lower labour costs, tax cuts, less regulation and new opportunities for accumulating wealth through intangible assets such as information and knowledge.77 This process of financial integration has considerably delinked money and finance from territorial space.

the liberalisation of capital movements that followed the breakup of Bretton Woods, coupled with the belief that markets should be left to their own devices with little intervention and limited regulation, resulted in recurrent episodes of financial instability. These, in turn, have eroded the rules-based international order

grappling with capital flows becomes even more daunting when foreign capital is underpinning the domestic banking sector; the necessary adjustment of the exchange rate to support the real economy can trigger speculation and eventually capital outflows. This can result in the collapse of domestic banks, as happened in Asia in 1997 and then in Argentina in 2001. The British and Italian ‘Black Wednesday’ of 1992, which I also discuss, seems like an odd choice, but it is here to show the risks of embracing a monetary straightjacket while keeping free movements of capital – exactly the opposite of Bretton Woods.

After the 1990–91 recession in the United States, the Fed responded to high and rising unemployment rates by reducing the federal funds rate from 6 per cent in mid-1991 to 3 per cent by October 1992, where it stayed until February 1994. These Mexican and US policy decisions resulted in large amounts of capital flowing into Mexico in the early 1990s, as many mutual funds and other financial intermediaries were chasing higher returns. As a result, portfolio capital inflows became a critical source of foreign savings for Mexico.

The large amounts of capital that were flowing into Mexico did not help. The appreciation of the exchange rate worsened even further as the supply of domestic non-tradables – for example, services such as hairdressing that need to be performed locally – came under pressure, undermining the policy of containing inflation. This caused actual inflation to again be higher than the target, even though the Mexican government’s reforms had overall contributed to reducing it. Savings fell in line with an increase in investments, and widened the savings-investment gap. Private investments increased on the back of positive expectations about Mexico’s future economic performance; the Mexican government’s market-oriented reforms (which began in the mid-1980s) complemented its stabilisation efforts and turned investors’ sentiment.

The real exchange rate appreciation penalised exports and encouraged imports, resulting in a widening gap between what was produced and what was consumed, and a growing disequilibrium in the current account. There is an important point here that is worth stressing. The fixed exchange rate system embraced by Mexico could be sustainable, but only if the growth in productivity was fast enough to impact on the real exchange rate. Otherwise, the economy would experience sluggish growth or – at worst – if imports continued to be stronger than exports, Mexico would fall into a balance of payments crisis yet again. Such a crisis could be held off for as long as the current account deficit was financed by foreign capital inflows.

For a while, Mexico’s current account deficit was ‘overfinanced’; there was so much capital flowing into the country, that its central bank was able to build up its reserves. This strategy, however, was not sustainable. The low domestic savings rate meant that Mexico was vulnerable to problems in debt servicing and subsequent swings in international investors’ sentiment.

There are three important lessons to be learned from the Mexican crisis.14 The first is that countries that rely on foreign capital instead of domestic savings do so at their peril. However, as we will see with subsequent crises, relying on domestic savings is easier said than done. This is because financial globalisation has made it much easier for developing countries to achieve high rates of GDP growth by attracting foreign capital than it is for them to do so by developing their economies slowly and sustainably. The second point, related to the first, is that policy measures to deter speculative capital flows should be applied – even if that implies reducing such flows in the short term. The final point is that exchange rate policies need to be flexible. For if policymakers can’t make adjustments without losing credibility, damaging capital flight is certain to ensue. A corollary is that when capital movements are unrestrained, a flexible exchange rate allows adjustments that a fixed exchange rate system doesn’t. The debacle of the European Monetary System (EMS) shows the problems with rigidity and lack of international cooperation,

Like the United States’ decision to end the convertibility of the dollar into gold in 1971, the suspension of the EMS was a key moment in the development of the postwar economic order. The relationship between Germany and France, and Germany and the United Kingdom, was put under strain – with consequences that last to this day. The French felt that they were paying for the cost of German reunification, just like in the 1960s when they felt that the United States was using the dollar to fund their budget deficit.20 The British shared this sentiment. As Prime Minister John Major wrote to German Chancellor Helmut Kohl: ‘German reunification is at heart of these problems [. . .] Britain strongly supported [this] but many in Britain believe that we are now having to pay a high price.’21 The British and Italians felt that the speculative attacks on sterling and the lira could have been mitigated, or even avoided, if Germany had been willing to actively drive the value of the deutsche mark down, allowing the other currencies to adjust. Recall that equilibrium in the ERM was achieved by participating nations selling the strongest currencies for the weakest ones – and the mark was the strongest currency at the time. There wasn’t a technical obstacle preventing the Bundesbank from purchasing sufficient quantities of British pounds and Italian lira to avert the precipitous depreciation of sterling and the lira against the mark. But the Germans were persuaded that their economy was booming and monetary policy should be steered towards avoiding inflation regardless of the impact on other countries in Europe.

Prior to the Asian crisis, the broad exchange rate stability and rapid credit growth muted investors’ and banks’ capacity to adequately assess risk. As such, currency mismatches on corporate balance sheets and the highly leveraged positions of the borrowers went under the radar. Banks were also increasingly exposed to maturity mismatches, so much that foreign borrowing was short-term and domestic lending long-term. Lax prudential regulatory and supervisory practices also contributed to the problem. Indeed, many non-bank financial institutions had emerged in the region in the runup to 1997. This was because the licensing requirements were much lighter in places such as Thailand, and regulations in South Korea and the Philippines – including lower capital requirements – were much less stringent than those applied to commercial banks. As long as money was flowing in, however, the system was kept in equilibrium. In 1996, Thailand amassed inflows equal to 14 per cent of its GDP. As domestic borrowers were tapping into cheap foreign-currency loans, the situation was becoming clearly unsustainable.

The Asian crisis, once again, put the problem of unfettered capital flows under the spotlight – especially for developing countries. There are four critical lessons to be learnt here. First of all, financial globalisation and the liberalisation of capital movements without an appropriate regulatory framework put the financial stability of many countries at risk. The second point, linked to the first, is that the speed and impact of financial contagion among economies interconnected through capital flows can generate a vicious cycle of debt, and hit the real economy. Third, rebuilding and expanding foreign exchange reserves in countries that were affected by the crisis is seen as a form of self-insurance against further crises. But the final and most important point is that the Asian financial crisis brought to light the need for greater financial cooperation within the region in face of a common crisis. Indeed, in May 2000, finance ministers from ASEAN+3, the Association of Southeast Asian Nations plus China, Japan and South Korea, met in Chiang Mai, Thailand and agreed on a series of bilateral swap arrangements.

The problem here is that often the monetary policy and political decisions that will benefit the United States domestically are exactly those that will cause havoc for the countries that rely on the dollar system. This highlights the broad and deep contradiction in having an international monetary system that has retained the dollar standard of Bretton Woods bar gold.

China epitomises the constraints of immature lenders13 – another is Singapore with a current account surplus in excess of 16 per cent of GDP. With a surplus in its current account, even if it has significantly narrowed over the years, China tends to offset this excess by investing abroad. In one sense, this is not dissimilar from Britain when it invested sterling all over the world in the nineteenth century, or Germany nowadays, which lends heavily to other countries in the euro area. But in another sense, it is radically dissimilar because China invests abroad in dollars – not in renminbi. Over the years, China has offset its trade surpluses by accumulating dollars and financial assets denominated in dollars and, increasingly, by expanding its financial diplomacy in Asia, Africa and Latin America. It is indeed the renminbi’s reduced international circulation and liquidity, as I will discuss in Chapter 7, that has limited worth for international lending, dictating that China’s external claims must be made in dollars. In doing so, however, China continues to take on the exchange rate risk.

Rapid credit growth underpins the overheating of domestic economies and the buildup of vulnerabilities, and it results in growth that is not sustainable and often leads to bubbles and subsequent bursts. Between 2010 and 2013, issuance of below-investment-grade debt in developing countries, especially India and Turkey, rose from 15 to 35 per cent of total debt issuance.20 When inflows turn – and they always turn when economic growth eventually slows, financial conditions become tighter and exchange rates depreciate – then a financial and banking crisis may be just around the corner. For developing countries with weak economic fundamentals and unsustainable exposure to capital inflows, this has always been the case.

The remedy devised by the Fed did kickstart the US economy and therefore the world economy after the global financial crisis, but simultaneously landed the developing countries in a difficult position. At the time QE was presented as an almost inevitable measure, but it was not the case. Given the downturn in demand was large enough to require exceptionally loose monetary policy, fiscal policy should have been used to sustain demand, but it was politically unfeasible.

The portfolio flows mainly fed into local currency sovereign and corporate bond markets. In 2013, corporate bond issuance in developing countries reached $630 billion – in 2000, they had amounted to just $13 billion. During the same period, the share of debt issued in local currency expanded from close to zero to over 50 per cent.25 We have seen in the previous chapter, with examples such as Mexico and Argentina, that mixing heavy capital inflows with sovereign debt in a developing country tends to create a breeding ground for crises. Indeed, all crises since the 1980s have been triggered by excessive indebtedness and excessive reliance on portfolio inflows, and banking crises are frequently born out of debt crises. In addition, a surge in capital inflows is conducive to stimulating strong credit growth. In some countries, as I will discuss in the next section, some of these inflows were channelled in the shadow banking sector.

So, for China, a stronger renminbi equated to a drastic reduction in the value of its dollar reserves – a lessening of the ‘wealth of the nation’. But, to some extent, China could only blame itself and its exchange rate policy. As the renminbi was appreciating against the dollar, the central bank was intervening in the foreign exchange market to curb the strength of the Chinese currency and as a result continued to expand its dollar holding. China’s official reserves would go on to peak at just over $4 trillion in June 2014.29 This story illustrates the risks of sitting on a large pile of dollars. Dollar accumulation means taking on a large exchange rate risk and also being exposed to the domestic politics of the United States as well as vulnerable to swings in US foreign policy.

But holding reserves has a cost for countries that are still developing their economies, where a significant share of the population is poor and where the income per head is relatively low. Indeed reserves are capital that is accumulated instead of being used for domestic development.

China’s central bank, the PBoC, holds onto the dollars that are earned through trade, stashes them in its foreign exchange reserves and gives exporters renminbi in return. In other words, the PBoC buys dollars in exchange for renminbi, which changes the dynamic between supply and demand of the two currencies and prevents the renminbi from appreciating against the dollar. In practice, this equates to injecting a lot of renminbi liquidity into the banking system that, in turn, feeds domestic demand and pushes up both consumer and asset prices. Coupled with capital markets’ limited diversification, this has the potential to result in the creation of asset bubbles in markets such as real estate,

To avoid any undesired effects on consumer prices, the Chinese authorities need to control monetary expansion in the domestic market. They have an array of policy tools at their disposal to mop up the excess liquidity – or sterilise it. One option is to increase the reserve requirement ratio for large domestic banks, which has been raised by up to 20 per cent of banks’ capital. Another option is for the central bank to sell financial securities such as bonds. Between 1999 and 2005, the PBoC bought nearly all of the foreign currencies that came into the country, invested them and then sterilised them by issuing local currency bills to take the funds – mainly dollars – out of circulation. Around 90 per cent of China’s reserves have accumulated from the joint process of foreign exchange intervention and sterilisation.

It is true that China’s development over the last three decades has been facilitated by the dollar. But ‘free-riding’ on the dollar – an endless source of annoyance for the United States, as I’ll discuss later – has not come without its own set of burdens. Although it may have suited the Chinese leadership’s goals in the heyday of reforms and opening up, there is no doubt that it has become a constraint. Having the dollar at the core of China’s financial and monetary system is a constant reminder of the limitations of such a system. For, despite the size of its economy, financially China remains a developing country. Further to this, there are costs implied in using the dollar such as mismatched assets and liabilities on firms’ balance sheets, and exchange rate and liquidity crunch risks. Another facet of China’s dependency on the dollar is that the renminbi is an ‘immature’ international currency with limited convertibility outside of designated markets, restricted payment facilities and so constrained international circulation. As for the United States, China’s (and other countries’) large dollar holdings highlight that the dollar can be a powerful weapon in the event of geopolitical tensions.

Being offered the possibility to rely on a dollar liquidity line from the Fed is a highly effective way to stabilise a country’s banking and financial system. The Fed indeed agrees to accept some countries’ currencies in return for a loan in dollars, acting as de facto lender of last resort.

Unlike in Japan, where well over half of the debt is public, in China it is mainly private. The rate at which China’s debt has grown is a cause for concern and this is what prompted the monetary authorities to keep a tight grasp on capital movements. As I will discuss in Chapter 7, capital controls have ensured that individuals’ and families’ savings remain in the country and are channelled back into the banking and shadow banking sectors. This means that China’s highly indebted companies and the banks that lend to them are never without financial resources. As long as China keeps control on capital movements, then, its current account surplus and large holding of foreign exchange reserves should keep its debt sustainable and ward off financial instability.

The IMF has warned that high corporate debt levels will amplify stresses and put financial stability at risk52 – and there are many potential sources of stress in the global financial system. Trade tensions could worsen the outlook and cause investor sentiment to sour, resulting in stress from an increase in risk premiums, for example. A shock of this type would result in increased interest rates, corrections in stretched asset valuations (such as properties), exchange rate volatility and sudden international capital flow reversals. Such developments would bring leveraged companies, households and sovereigns under strain, deteriorate banks’ balance sheets and cause damage to public finances, especially those of emerging market economies.

Austerity programmes and constraints on fiscal policy pushed the burden of the post-crisis adjustments on deficit countries – like Greece – while no adjustment was required from surplus countries – like Germany – which were allowed to accumulate surplus and push onto others the impact of their deflationary policies.

Europe’s monetary union has been built around the idea that the integrity of the union needs to be protected from the fiscal profligacy of its member states. This idea is solidified in the Maastricht Treaty fiscal rules, which – in addition to the sovereign debt and the annual budget deficit thresholds – state that no member country should have an inflation rate higher than 1.5 per cent, and that the union will not assume or be liable for the commitments of member states’ central governments. The bottom line of this is that the union will not bail out its members if they have not respected the rules.

Playing the role of lender of last resort means that central banks provide liquidity to the commercial banking system in times of stress by lending against good collateral and charging interest rates. This function is now critical to our modern economy. Without the assurance that a central bank is both willing and able to provide liquidity, problems specific to one single bank will likely cause savers to withdraw their funds from other banks too. What this means is that a solvency crisis that begins in a specific part of the system can quickly evolve into a systemic liquidity crisis that has the potential to bring down the entire system. Unconstrained capital flows mean that a lender of last resort cannot limit its action to commercial banks. As it became evident throughout the unfolding of the Greek crisis, the lender of last resort should be prepared to provide liquidity to the bond market by actively intervening if a lack of liquidity and rising interest rates threaten to trigger a sovereign debt default.

The issue of how to shape a balanced relationship between democratically elected bodies and delegated bodies lies at the core of organisations like the WTO, the IMF, the multilateral development banks, and the OECD. By providing the infrastructure (including data and analysis) critical for the implementation and monitoring of the rules that inform the international economic order, these institutions increasingly play a decisive role in shaping and influencing the economic policies of sovereign states that are part of such order.

Looking at Italy and Greece, the moral of the tale is clear: dealing with debt can disrupt domestic politics, especially when the adjustment required as part of the debt-management strategy disproportionally hits the most vulnerable in society. For debt-afflicted countries, either they play by the rules – and those in the single currency fit in the monetary straightjacket – or they risk losing market confidence and so undermining or even stopping capital flows that are necessary to refinance the existing debt. This, as we have seen in Greece, can bring havoc or simply push up the cost of servicing the debt as in the case of Italy.

To borrow the words of Jean-Claude Juncker who, having served as prime minister of Luxembourg between 1995 and 2013, and president of the European Commission between 2014 and 2019, is easily one of Europe’s most seasoned politicians: ‘Politicians are vote maximisers [. . .] for the politician, the Euro can render vote-maximising more difficult, as a smooth and frictionless participation in the monetary union sometimes entails that difficult decisions have to be undertaken or that unpopular reforms have to be initiated.’36 Juncker clearly refers to Europe’s monetary union, the most constraining framework that countries can sign up to. But this is true for all countries that are exposed to capital markets, for debt is in principle at odds with democracy if debt management imposes policy choices that are difficult to reconcile with voters’ preferences.

close international cooperation is critical for keeping the economic order in equilibrium and containing instability when crisis hits. International cooperation is difficult to maintain, because it often conflicts with national interests. It is impossible, however, when countries start from an uncompromising nationalistic position where domestic interests are too strong or the domestic political costs are too high.

in a world where capital moves in and out of markets freely, sovereignty – and especially fiscal sovereignty – is a fluid concept. International investors have not been shy to voice their concerns regarding Italy and, as we have seen repeatedly throughout this book, governments that struggle to maintain credibility in the eyes of international investors find it difficult – if not impossible – to refinance their debt when the money eventually leaves the country. Italy has all the ingredients for this to happen: stagnant growth, delays in the improvement of its debt position, a weak banking sector, falling saving rates – and no perceived urgency, let alone a clear plan to address structural reforms.

Putin declared that the liberal order had ‘outlived its purpose’ and become ‘obsolete’ as the political balance of power is shifting from ‘traditional western liberalism to national populism’. The reason? ‘Public resentment about immigration, multiculturalism and secular values at the expense of religion.’52 The interview – Putin’s first with a major international newspaper in sixteen years – leaves many questions unanswered. Why now? Was this a way to tell the world that Russia is back at the top table with history on its side, as the Financial Times argues? And the idea that liberalism has run its course and has ‘come into conflict with the interests of the overwhelming majority of the population’, is it what ‘our Western partners’ believe or what they are led to believe?

China’s outward direct investment really took off in the mid-2000s; by 2018 China’s direct investment outward stock had reached almost $2 trillion, making it a net exporter of capital for the first time, and the second largest outbound investor in the world.20 By investing abroad, China has managed to connect itself to a variety of resources that have been invaluable for its development, including commodities such as oil, iron ore and copper.

Thus, the large pool of savings that have been accruing in China’s domestic banks for several decades have been instrumental for the country’s rapid economic growth. Indeed, the Chinese authorities have channelled these savings towards the country’s industrial transformation. By tightly controlling the maximum deposit rate (capping savers’ returns), the minimum lending rate (and so keeping the cost of borrowing low) and credit quotas, the monetary authorities have adequately managed the allocation of these savings from the banking system into state-owned enterprises.

Such a system has created some serious distortions and vulnerabilities. Banks are saddled with too much low-quality lending and non-performing loans, and they are vulnerable to insolvency that can in turn trigger a liquidity crisis. Savers, on the other hand, feel the pressure as they do not get much for their money, and so they turn to non-bank financial institutions instead in the hope of getting better returns. Within the so-called ‘shadow’ banking sector savers can invest in unregulated short-term instruments, such as, for example, commercial papers that pay high interest over three months, but are riskier than the bank deposits – with the offer of increased returns, of course, comes an increased rate of risk. Low interest rates can create problems for borrowers too. Chinese firms often borrow more than they need, and give little consideration to efficiency or profitability. After all, if they were to incur any financial losses, this would simply be covered by state subsidies.

The so-called ‘policy banks’ – the Agricultural Development Bank of China (ADBC), China Development Bank (CDB) and Export–Import Bank of China (Exim Bank) – are the other pillars of China’s banking system. They were all established in 1994 to finance trade, development and state-led projects. Not holding any deposit, they get their capital by issuing bonds on the domestic capital market where they are dominant. Indeed, approximately three-quarters of the total bonds on the Chinese market are issued by the policy banks.

By keeping controls on capital movements, the Chinese monetary authorities are able to maintain domestic financial stability. Due to China’s combination of high savings and financial repression, unrestricted capital movements would pose a threat. If the authorities were to loosen controls, Chinese people could choose to invest their savings abroad for better returns. China’s domestic banks would then be left with two options – compete or collapse. A similar threat could also arise from a change in external conditions such as a change in the US monetary policy that could trigger domestic financial instability in China. Managing capital movements to avoid sudden shifts in the demand for renminbi and renminbi-denominated assets ultimately feeds back into the Chinese monetary authorities’ control of the exchange rate. For example, in the years after the global financial crisis when the Chinese economy was growing strongly, interest rates in the United States were zero and the dollar was weak, controls on capital movements served to restrain the inflows, helping maintain financial stability and keep the exchange rate at the level consistent with China’s economic objectives.

So, if it is true that ‘great nations have great currencies’,48 then not having a great currency is preventing China from achieving its ambition of being a great nation. But what does the obstruction actually consist in? I have already discussed the limitations that face countries lacking an international currency when they have to issue debt (the original sinners) or lend (the immature creditors) on international markets, using currencies that are not their own. With an excess of savings, China is a lender rather than a borrower and so suffers from the latter of these issues with all of its related costs and risks.

‘Made in China’ should help to push the country to the second stage of such industrialisation and achieve 70 per cent ‘self-sufficiency’ in high-tech industries by 2025. The aim is not only to reach a point similar to that of advanced economies in the earlier stage of their industrialisation, but also to respond to the competition from other developing countries. Without an ad hoc industrial strategy, the authorities felt that the advantage in terms of competitiveness acquired over the first stage of industrialisation would be dissipated, and China would be squeezed in between advanced economies and developing countries with a lower cost base.

It is the relative competitive position of different countries in international trade as a result of the rise of China – and other developing countries – that bothers the United States. Through its process of ‘opening up’ China has challenged the multilateral trade system to accommodate for the increase in cheap exports that have resulted from its exports-led growth model. The world is still grappling with the impact of this on labour market arrangements, consumption patterns and environmental sustainability.1 In addition, China’s large accumulation of savings, a consequence of its export-led growth model, has exacerbated the imbalances between creditor countries (i.e., China itself) and debtor countries (such as the United States). And controls on capital movements in and out of China constrain the adjustment through the exchange rate.

Thus, despite the catchy soundbite, the call for the ‘new Bretton Woods’ was not answered. There are a number of reasons for this. Firstly – as I have already stressed – Bretton Woods did not come out of the blue and was the result of years of intellectual debate and policy discussions. Second – again a point already mentioned – the post-2008 initiatives were driven by the urgent need to reset the system, so there was simply not enough time – and possibly not enough inclination – to consider any alternative. The third reason was the fact that the global financial crisis, despite its devastating effects and long-term impact, did not compare to the knock-on effect of two world wars. The state of affairs was undeniably severe, just not severe enough to trigger the rebuilding of the international economic order – as had happened in 1944.

As in the 1930s, and at any point of crisis in the international order, trade is the lightning rod for geopolitical tensions and rivalries even if the lightning comes from monetary imbalances. The constrained monetary system of the 1930s led to a rise in protectionism which in turn resulted in political catastrophe, global conflict and the collapse of international cooperation.

There are three broad lines along which the governance of the Bretton Woods institutions needs to be reformed: the developing countries need to be better represented, they need to be given an adequate voice in decision-making processes and the leadership needs to be appointed on the basis of merit and through a transparent process.

while China is happily heading down the path of development finance through the AIIB and to a lesser extent the NDB, it lacks the financial capacity and the political clout to mitigate and absorb the risks that are implicit in providing the global financial safety net. While the dollar remains the key international currency, the risk of supplying liquidity in dollars is far too much even for a country with deep financial resources like China. China is fully aware of this fact. And in any case, seriously challenging the long-standing Bretton Woods institutions doesn’t seem to be the ultimate goal of the AIIB and even less the NDB. Instead, these institutions appear to be a step towards the creation of a long-needed economic and financial regional network to embed and support Asia’s economic and financial integration, or regionalisation. Nonetheless, the United States’ approach to China has changed from ambiguous ‘engage and contain’ to open hostility,

The bilateral swap agreements arranged by the PBoC are fundamentally different from the CMIM and the BRICS Contingent Reserve Arrangement because they are not designed to create a liquidity line and make dollars available between central banks. Instead, their purpose is to establish a domestic currency liquidity channel between these banks to support bilateral trade and investment relations and feed, if necessary, the offshore renminbi markets. As domestic currencies are increasingly used in bilateral trade – as China has been pushing for some time – it becomes even more important that liquidity in those currencies is assured.

Ultimately, bilateral swaps are an instrument of financial diplomacy. They are flexible, quick to deploy, easy to manage and suitable for winning friends. As a result they are becoming an increasingly important tool in China’s financial diplomatic toolbox.

Arguably the AIIB and the NDB are China’s own contributions to the global financial architecture, based on forty years of reform and development experience. China is also taking greater responsibility in providing financial support to countries that are experiencing short-term liquidity problems. Here it has chosen to work collaboratively with the ASEAN. There are, however, two operational issues for which, at least for the foreseeable future, China is both unwilling and unable to take up the mantle of leadership and create a system parallel, or in competition with, the existing one. First of all, as long as the renminbi remains an immature international currency with limited circulation and liquidity, China fundamentally lacks the financial capacity to take up this role. Providing finance for development and stability are the critical goods that the country at the helm of the international order must provide, but China would have to do so in dollars, which would be costly and risky. It would have to tap into its dollar reserves which, admittedly, are large, but ultimately finite. China would emerge as a lender of last resort with limited capacity, essentially a contradiction in terms.

‘The 1929 depression was so wide, so deep and so long because the international economic system was rendered unstable by British inability and the United States unwillingness to assume responsibility for stabilizing it’, writes Charles Kindleberger in the last chapter of his magisterial book The World in Depression.3 According to Kindleberger, when the Wall Street stock market crashed, the United States should have stepped up and taken responsibility for: ‘(a) maintaining a relatively open market for distress goods; (b) providing countercyclical long-term lending; and (c) discounting the crisis’.4 Put otherwise, the United States should have provided liquidity and ensured policy coordination among the main economies. Instead, it chose to raise import duties by implementing the Smoot–Hawley Tariff in 1930, opening the door to other countries to embrace ‘beggar-thy-neighbour’ trade policies and exchange rate depreciation in order to protect their domestic markets. ‘When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all.’

As a ‘new Bretton Woods’ is unlikely to emerge, the best option is to create resilience to respond to economic and financial instability. Regional arrangements and regional currencies will lend resilience to this framework. If the large economies can agree to blend their rivalries within existing, but reformed, international institutions and new multilateral regional ones, then the economic and monetary system will accommodate regional arrangements and regional currencies so to balance the fading US leadership.

If the United States begins to use the dollar to confront its adversaries in an increasingly challenging geopolitical background and selectively supply dollars in line with its foreign policy objectives, then this situation could easily materialise. These questions inevitably lead to the key issue of how long the dollar should remain at the helm of the international monetary system – is it finally time to take suggestions of an alternative seriously? Inevitably, there will come a time when dollar-holders will lose confidence in the value of the American money, taking it to be less predictable and less secure. Geopolitical reasons have driven recent shifts in the use and holding of dollars, but these have been on the margin. The most notable case is that of Russia, where the central bank’s dollar holdings have been halved in favour of euros, renminbi and yen; 32 per cent of Russian reserves are now in euros and 22 per cent in dollars.

There is no indication that the Chinese leadership’s plan is for the renminbi to replace the dollar as the pivotal currency in the international monetary system, and the authorities have actively sought to play down such expectations since the launch of the renminbi strategy in 2009.

The development of the renminbi as the reference currency for Asia is consistent with China’s strong trade ties in the region. As the renminbi becomes more frequently used to settle trade transactions between China and its neighbours, China’s persistent trade deficits with other Asian countries – it is a net importer in the region – suggest that renminbi are expected to accumulate in their reserves.39 Initiatives such as the BRI are likely to drive the use of the renminbi for payments in the region as the Chinese companies involved in the construction of these projects will offer renminbi, or even demand them, for settling payments.40 In addition, closer links to China mean that movements in the renminbi should become more relevant for Asian exchange rate markets. For example, the currencies of Asian economies in the same production chain as China and those of large commodity exporters are likely to respond to global demand shocks in the same way as the renminbi. By the same token, China’s neighbouring countries will have an incentive to stabilise their currencies against the renminbi and hold more foreign exchange reserves denominated in renminbi.


About Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.
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