The St Petersburg Economic Forum just wrapped up yesterday (June 6). Russian officials have traditionally used this forum to advocate for greater use of the ruble as a reserve currency, the importance of developing a financial center in Russia and in particular to point to vulnerabilities of relying on the U.S. dollar and U.S. financial regulation. They have also tended to pledge that Russia’s investment climate will become more predictable and that Russia is putting diversification away from oil as a key priority. This year was no exception.
Medvedev’s plan (which was downplayed by Finance Minster Kudrin) envisages a set of regional reserve currencies (perhaps the ruble in the CIS etc, the RMB in parts of Asia) perhaps accompanied by greater use of the IMF’s special drawing rights.
What is different though is that Russia is by no means the only such voice. Chinese central bank governor Zhou highlighted such vulnerabilities in recent months. With the dollar under pressure, expect more of this rhetoric especially now that Russian calls come at the same time that Chinese officials are raising questions about the value of their U.S. assets. In particular, such discussions may well dominate the upcoming meeting of BRIC countries in Russia on June 16.BRIC countries and other emerging market economies have been playing a more significant role in responding to the financial crisis. They have roles on the working groups of the G20 financial committees, new financial institutions include EM representatives and many are trying to improve their regulations. This is a key time for them and other EM and frontier markets to slot themselves into the global regulatory system.
So how seriously should we take Russia’s proposals? Perhaps not very in themselves. There seem to be many obstacles to the hierarchy of currencies that Medvedev suggested. Arthur Kroeber noted that some of the Chinese proposals may reflect more politics than economics. Such political dynamics are even more likely with respect to Russia than China or Brazil. Yet clearly there is more thought being given towards to international monetary system. John Lipsky of the IMF noted that a greater role for the IMF’s Special Drawing Rights (SDR) might come in the future. However as he notes that would require some significant institutional and financial reforms including the creation of a global central bank. Given how much trouble there has been to change the weighting of votes in the IMF, that might take some time. Moreover, the difference of interests among the BRICs countries and others could limit cooperation. But there are some changes in the air.
As I noted in the midst of Lula’s visit to China, it will take a change in the savings pattern of countries to have a significant effect on fx markets. But that could be coming. As Nouriel Roubini noted, recent steps by China to allow greater use of the currency outside of the country, suggest that a Chinese reserve currency move over the next 10 years should not be ruled out. China is allowing greater use of their currency abroad through currency swaps with a range of developing countries. Brazil and Malaysia are considering denominating more of their trade in RMB. While these are small steps, they are reflective of some challenges to the international monetary system and suggest that the U.S. may not be able to count on being able to finance its debts as easily as it has in the past.Setting aside the significant obstacles to greater use of these currencies (including their lack of full convertibility which is addressed below), there seem to be obstacles to such a multipolar system in itself. Such systems tend to evolve rather than being legislated and the costs of shifting from one to the other could be quite significant. But the first step to any change in the system would be a change in savings. So any such change may be quite a ways off.
In the literature on international trade, one tends to ask whether regional trade agreements are building blocks or stumbling blocks to global trade agreement. Agreements like the NAFTA pushed forward at a time when global trade talks were stymied and in turn pushed the hands of global interlocutors. However the deeper regional or bilateral deals can take away negotiators attention from multilateral talks, standing in the way of negotiating a global regime. Willingness to even discuss imbalances has been quite limited among major economies. Its hard to imagine that forging a new monetary system would be that much more successful.
The escalation of the global financial crisis and recession did result in a narrowing of global imbalances. The U.S. current account deficit fell to under 4% of US GDP from the heights of earlier this decade, The current account surpluses of Germany and Japan have shrunk and in Q1, most oil exporters shifted into deficit. Similarly some of the emerging economies with the largest deficits, especially those in eastern Europe were forced to shrink somewhat as it became more difficult to attract capital.
However, some of these flows may be restarting in the new search for yield. Brad Setser calls it Bretton Woods 2.1 China is adding to its reserves again. At near $70 oil, many oil exporters may start saving despite the f.act that their spending is also up. There is a risk that we could return to the bubble inducing system of recent years. However, weaker than expected macro news and a more sluggish recovery could reverse some of the moves in EM assets and commodities.
For real rebalancing and likely more sustainable growth we might need more stimulus and more consumption oriented stimulus from surplus economies. In China’s case this means more spending on health, unemployment benefits and retirement funds. A return to business as usual, in which many countries rely on the U.S. consumer to drive growth seems hard to fathom even in given ample liquidity from ZIRP in most advanced economies. Moreover such a response could re-expose us to bubbles. If surplus countries scale up production, in the absense of an increase of domestic and external demand, there is a risk that it could further add to global overcapacities. However, boosting consumption is not an overnight process.
It remains to be seen if some of these new challengers are willing to bear the costs that would come with regional or global responsibility. In particular, would countries like China and Russia be willing to accept a stronger currency? If these currencies are demanded for savings and transactions globally, their values might rise. This is perhaps a more significant question for China. The renminbi, determined by market forces would be significantly higher than today. Russia’s non-resource exports are relatively small meaning that the appreciation of the ruble has less of an effect. However the inflow from resources and a stronger ruble did create some dutch disease symptoms including allowing the government to freeze some structural reforms and removed the pressure to increase productivity. Assuming expensive +$70 a barrel oil in the long term, the Russian rouble would face further appreciation pressure, despite Russian statements that the currency will not always move with commodity prices.
However there are several obstacles to even a more regional role for the ruble – and perhaps even
more so for Moscow or St Petersburg as an international finance center.
Like the renminbi or the real, the ruble would have to become freely convertible and based on market pressures. The ruble continues to be heavily managed. Given the return of hot money inflows into Russia in recent months, the ruble has been under pressure and has appreciated 17% against the US dollar since March. Without Russian central bank intervention, it would be even stronger. The central bank is trying to manage its appreciation just as it tried to manage the depreciation.The Russian currency could be used more significantly in its near abroad either by issuing loans in the currency, by requiring rubles to be used in transactions etc. Already the currencies in the CIS tend to move vaguely in accordance with the ruble. Most are heavily managed meaning that several (Kazakhstan, Belarus, Ukraine among others) lost some of their reserves in forestalling depreciation. Once the ruble had devalued, so did many of the currencies of Russian neighbors. But greater use of the ruble would create some significant political issues.
The desire to create a regional financial center to boost economic growth and financial depth could contribute to the sort of financial regulatory and tax policy reform that Russia has needed for some time. First step: improving some of the enforcement of legal regulations, improvement of the business climate etc. In fact, it would have helped Russia’s cause it it had been the Russian legal system and not Putin’s actions that compelled the back payments of wages in Pikalevo. However the risk of defaults is one examples of the vulnerabilities that Russia’s corporate sector faces, and one of several reasons that Russia’s economy is forecast to contract by well over 5% this year.
The increase in the price of oil does ease Russia’s fiscal vulnerabilities, lessening the size of Russia’s fiscal deficit as it spends on anti-crisis measures. But it will still deplete a good half of its 2004-8 savings. Moreover oil production is down in Russia. And there are few prospects of increasing it in the coming years. Some export tax changes have removed the disincentive to export oil but these may come even as foreign demand for (Russian) oil is weaker.
However, Russia’s financial system remains under strain with uncertainty about the solvency of some banks. The bank-dominated financial system is rather fragmented. While several large banks dominate most lending, many smaller and still less well capitalized banks exist. Investment banks in particular faced severe cash flow issues as the value of their investments, mostly highly levered, shrank in 2008. While the local equity markets have been one of the best performing and most frothy markets in 2009, these institutions still face financing issues. Even some companies linked to the state are facing defaults.
However Russia should also take on board some of the same concerns it levies at the U.S. financial regulators. Russia’s own financial regulations increased its vulnerabilities. Although the Russian government saved much of its resource windfall (amassing over $200 billion in its sovereign funds), its private sector and banks borrowed heavily, accumulating foreign debts of well over $450 billion by mid 2008. Doing so allowed Russia’s banks to increase lending domestically at a much sharper pace than if they had had to finance lending growth by concurrent deposit growth.
When the wall of free money stopped, Russia seemed very vulnerable, especially once the price of oil began dropping precipitously. The investment portfolios of key banks were heavily levered as they were around the world. As the value of these assets dropped, their clients and the banks themselves were forced to sell on margin calls. Russia’s regulators had done little to ensure that lending growth was sustainable and moreover the very negative real interest rates contributed overcharged property markets which have now been reversed. So Russia’s vulnerabilities seem to be at least in part home-grown.
There are major costs of shifting. A sharp devaluation in the value of US assets would erode the large stocks held by surplus nations (China, Oil exporters). So it is important to watch the changes in the savings pattern
As noted before, China’s exposure to the US dollar remains high and growing, with diversification only possible on the margins. Despite limited reserve growth in Q4 2008 and Q1 2009, China continued to add reported US dollar holdings. It shifted to the safest US assets (treasury bonds and especially bills). In fact the recent shift into EM assets, driven in part by expectations that China would outperform the global economy, may well have increased their purchase of US assets. The RMB has maintained its quasi dollar peg even as evidence suggests that there could be a resumption of inflows (or at least a reduction of the outflows that we saw in early 2009). More will be clear when China releases its Q2 reserve growth figures in July.
Russia itself has been moving away from the dollar in its savings. By the end of 2008, the euro share of Russia’s reserves surpassed that of the dollar. The shift to boost euro holdings and erode dollar holdings has been going on for some time. Given Russia’s trade ties with Europe, a Euro-heavy portfolio makes a lot of sense. However with a weakening dollar, they may well have been adding to their dollar holdings as they sought to limit rouble appreciation.
Russia’s reserves fell from a peak of almost $600 billion in July 2008 to a low of $376 billion in mid March. They have subsequently climbed again to over $400 billion at the end of May. Russia has been adding to its reserves in the last two months as it seeks to pare the ruble’s rise. By rough calculations and adjusting for valuation changes, Russia has bought almost $20 billion to limit currency appreciation.
The balance of Russia’s USD assets has also shifted. Russia liquidated its holdings of short-term agency bonds in favor of treasuries. Its sovereign funds are now not allowed to hold assets more risky than core government treasury bonds. It also reduced foreign deposits shifting to securities. Some of the massive reduction in Russian deposits with foreign banks (as seen in the BIS data) reflects the private sector paying off its debts, but much of it reflects the drawdown of Russia’s reserves.
So if there are obstacles to the ruble’s role, what about the SDR?
Obstacles to using the SDR are significant. So far it is only used for official purposes, particularly concerning the role of countries deposits with the IMF. Even the planned issuance of bonds denominated in SDR are likely to be available only to national governments and even they may be unable to trade them to others. Moreover there is not a payment system set up with the SDR. While these issues are surmountable there is another issue about liquidity. A primary attraction of reserve currencies is the ability to liquidate the assets when needed meaning that an illiquid asset would not be sought after
Moreover, the depth and liquidity of the US market has helped the U.S. maintain its reserve currency role. Michael Pettis noted that New York and London might actually see their role as a international financial centers strengthened by the financial crisis and contraction of the financial sector as investors will come where the liquidity is and issuers will follow. Although regional centers benefit particularly from liquidity booms, they may be vulnerable in tougher times unless they are connected to a latent market (aka Hong Kong’s role as a Chinese outflow point.) Similarly, any reserve currency would need to be liquid and have a deep market. Developing a deeper domestic capital market as well as allowing more convertibility of the currency would not only shield the economy, allowing governments and others to raise more fun
ds at home but also increase its attractiveness to both domestic and international investors.
While there are significant policy obstacles to reserve currency challengers, the ability of the U.S. to keep financing its deficit could become more difficult. If not today than in the more distant future. US may not find it as easy to set the terms in attracting its financing going forward given that the costs of maintaining managed pegs are finally being publicly acknowledged by some of the creditors. So while there may not be any immediate changes, the currency rhetoric is currently heating up. It could be a hot summer.