Speculative Central Bank Reserve Diversification as the End Game Trigger for BWII?
The news today (see the FT story) that some central banks – India, Russia and “other petrodollar-rich Middle Eastern investors” – are starting to dump dollars to avoid the capital losses from further weakening of the U.S. dollar, may be the starting trigger – discussed in my paper with Brad – for the end of the so-called Bretton Woods Two (BWII)regime. As reported today by the Bloomberg columist Andy Mukherjee who cited my comments:
“President George W. Bush’s second term may be a challenging time for Asian central bankers.
With the dollar hitting an all-time low against the euro yesterday, traders are betting that Bush may add to the $412.6 billion U.S. budget deficit, increasing the pressure on the dollar to decline. And unlike during the last three years, the brunt of the dollar’s fall may not be borne by Europe alone…
The adjustment could mean an end to the current system of semi-fixed Asian exchange rates that has been termed the “Revived Bretton Woods,” by Michael Dooley of University of California at Santa Cruz, David Folkerts-Landau, Deutsche Bank AG’s head of research, and Peter Garber, the bank’s strategist…
There’s another important reason why Bretton Woods II may have to be dumped. Nouriel Roubini, a professor of economics at New York University’s Stern School of Business, says that the current global financial system can be sustained only if Asian central banks act as a cartel and keep their existing and future reserves in U.S. dollars.
There is, however, no formal cartel. As a result, every Asian central bank will want to protect itself against an erosion in the value of its assets from a decline in the dollar.
Tragedy of Commons
In other words, what’s in the interest of one Asian central bank isn’t for all. Social scientists have a name for this phenomenon: “Tragedy of the Commons.”
“All central banks may be better off if no bank tries to diversify its reserve holdings,” Roubini says, “but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from losses.”
Losses could indeed be large. Asian central banks own more than $2.2 trillion in foreign-exchange reserves out of a global total of $3.4 trillion. At the end of last year, almost 64 percent of central bank reserves globally were denominated in U.S. dollars, according to the International Monetary Fund.
As Asia tries to diversify out of the dollar, the U.S. currency may decline further. An individual central bank “can only protect itself if it either shifts out of dollars and into euros ahead of the others, or buys a euro/dollar hedge before everyone else,” Roubini says.
Adjustments will be painful. Still, it would be better for everyone concerned to end the Bretton Woods II agreement now before it’s too late for both the U.S. consumer and the Asian exporter.”
Indeed, in my paper with Brad on the US current account deficit, we made a detailed critique of the BWII hypothesis and presented five arguments why this regime is fragile and unsustainable. One of them was the free riding game on reserves by the central banks in this regime:
“Incentives to free ride and opt out of the cheap dollar financing cartel. Individual Asian countries at some point will have an incentive to diversify out of US dollar reserves into Euro reserves, so as to avoid capital losses should their currencies appreciate relative to the US dollar. The incentive to do increases over time, as the United States growing stock of external debt increases the risk of a major depreciation and the Asians growing stock of dollar assets increases their prospective losses in the event of a devaluation. Indeed, while an individual country can diversify its reserves out of US dollar assets without affecting either its currency value relative to the US or the value of the US dollar relative to the Euro, if a large number of Asian central banks were to start such diversification the value of the US dollar will start falling relative to the Euro thus causing capital losses on US dollar reserves. If all Asian economies tried to diversity their reserve holdings, they would put pressure on the dollar/ euro rate, reducing the value of their remaining dollar reserves and put pressure on their own currencies to appreciate versus the dollar. The Bretton Woods system can only be sustained if the Asian central banks act as a cartel and both keep their existing reserves in dollars and invest the reserves obtained from ongoing current account surpluses in dollars. An individual central bank can only protect itself if it either shifts out of dollars and into euros ahead of the others, or buys a euro/dollar hedge before everyone else. This gives rise to a classic problem of collective action: all central banks may be better off if no bank tries to diversify its reserve holdings, but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from large losses. Moreover, as Barry Eichengreen (2004) has emphasized, Asia lacks the institutions that helped the first Bretton Woods system survive when it faced an analogous problem in the 1960s. Consequently, it is likely that the current equilibrium where everyone invests in mostly U.S. dollar reserves will eventually unravel.”
And now the news that some central banks may be starting to get out of this cheap financing cartel may signal the breakdown of BWII scheme, if this free riding trend picks-up.
But now, as many central banks may be starting to abandon the leaky BWII boat, others may soon start to jump on board and give some further momentary relief to the US dollar and the cheap financing of US fiscal and current account deficits. As the Dollar is getting close to 130 relative to the Euro and as the Yen is getting close to 103, the chances that the BoJ and ECB may start intervening are increasing.
Compared to the first quarter of this year when BoJ aggressively intervened as the Yen was getting close to 105 and when the ECB started its verbal intervention when the Euro was close to 129, the BoJ and ECB may now wait a little longer before moving from verbal to actual intervention. A strong Euro reduces the stagflationary costs of high oil prices in Europe and Japan; also both Europe and Japan economic performance is less tentative today (if a bit shaky) than in Q1 when the economic recovery was starting to get its momentum. So, the ECB and BoJ can wait a little longer but not much longer. With export demand being a major driver of aggregate demand and growth in both regions, Europe and Japan can little afford a much stronger currency. So, expect intervention when the Yen gets close to 103-100 and when the Euro enters in the 130-135 range. Even Trichet who likes a strong Euro for anti-inflation goals had to warn today, as in February, against “brutal” currency movements. So, expect verbal intervention to move soon to actual intervention.
So, will Europe and Japan come to the rescue of the U.S. fiscal and current account deficits? Do not count on it too much. With the U.S. playing its game of reckless and continuous accumulation of public and external debt to be cheaply financed by foreigners, the chances of an eventual hard landing of the dollar are only increasing. And indeed, the Fed has started to express increasing concerns about the sustainability of the US current account deficit: in the last few weeks, Fed Governor Ferguson
, Dallas Fed President McTeer, San Francisco Fed President Janet Yellen and Kansas City Fed President Thomas Hoenig have all signaled increased concern about the current-account deficit and its implications for the US dollar.
Instead, the Bush administration is continuing its ostrich-head-stuck-in-the-ground-”Me Worry?” attitude about the US twin deficits as exemplified by Under Secretary John Taylor’s remarks on the current account deficit last week. His argument that there is no problem in financing the U.S. current account deficit as U.S. residents can reduce their rate of accumulation of foreign assets was specious and self-serving. It hinged on comparing Q2 with Q1 2004 when in Q1 there had been an aberrant increase in US residents accumulation of foreign assets from $ 8 billion in Q3:2003 to $61 billion in Q4:2003 to $307 billion in Q1:2004. Thus, the reduction in this accumulation in Q2:2004 to $118 billion implied a still very large increase in US residents accumulation of foreign assets compared to the values of 2003. And his mantra that the U.S. current account deficit would shrink as the U.S. budget deficit would be cut by half had no basis as the fiscal policy objectives of the administration will lead to a further increase, not a shrinkage, of the U.S. fiscal imbalance.
You can read the details of our arguments for the fragility and unsustainability of the BWII in my recently revised paper with Brad or on my blog.
14 Responses to “Speculative Central Bank Reserve Diversification as the End Game Trigger for BWII?”
UK • November 9th, 2004 at 8:26 pm
Visit my blog, http://www.thecapitalwire.com for more on the dollar adjustment and other econ issues. also, roubini has excellent post today on the prospective end to foreign central bank U.S. subsidization: http://www.roubiniglobal.com/archives/2004/11/speculative_cen.html
calmo • November 10th, 2004 at 1:17 pm
There is the view posted by that other Brad (De Long) that the private investor/speculator has a role to play here and that without that support, the central banks in their intervention in the fx market to support their respective currencies are in a losing battle. The recent numbers in the Treasury auctions indicate that the private interests are still a factor, no? If these private interests are lining up short positions guessing where and when BoJ will wade in (and possibly ECB), it is only a matter of time before we adjust to the new reality of a seriously cheaper dollar. Unless the current efforts to talk the dollar up, (by citing misleading employment gains, falling crude prices, productivity gains, etc) shift the focus away from the deficits which are driving this issue, the private interest/investment is taking the short side on the dollar, no? Are there further ramifications for the status of the senior currency?
Larry • November 10th, 2004 at 2:23 pm
The current situation of Central Banks with respect to the US Dollar more closely resembles the “Prisoners’ Dilemma” than the “Tragedy of the Commons.” It concerns the value and paradoxal outcomes of concerted action, more so than use and overuse of a commonly owned resource.
Nouriel Roubini • November 10th, 2004 at 10:57 pm
Larry, you are indeed right that this free riding game is more of Prisoner’s Dilemma rather than a Tragedy of the Commons.
hbj • November 11th, 2004 at 8:28 pm
It strikes me the dollar is set up for a triple-whammy: 1) The only politically doable way out of our debt situation is to inflate it away by printing more dollars. Who in their right mind would hold dollars against that trend, all else equal? 2) There are already a huge surplus of dollars held by our “investors”. They’re misallocated already, and it would be only sensible for them to look to reallocate to less risky options. 3) Those dollars are only as good as the assets they can purchase. Which means what? Bonds? Headed down as interest rates rise on short-term fed moves and long term risk premium rises. Stocks? American companies are less competitive by the hour. As Bill Gross puts it, we’re gone from being a manufacturing economy to a service economy to a finance economy. We “make” money increasingly by just shifting it around, not doing anything competitively against world manufacturing or services. How can US stocks at these historically high ratios be a good bet under these competetive conditions? Real estate? Look at the values. What sane person would buy real estate denominated in dollars at these levels? 4) With Bush in again, there’s no sanity in sight as far as dealing with any of these issues. Besides currency pegs (the longer they hold, the more power China gets over us) I can’t see any affirmative reason to hold dollars right now. I get the sense China’s quietly pulling the rug out without causing too much of a fuss (loosening gold holding regulations for its citizens, for example). I suspect the way it may play out is at some point the American consumer will be just too underwater to keep up spending at high levels. China will observe this and reason that the peg has lost its effectiveness relatively speaking, as the American consumer will have spent herself under the table. At that moment it may make sense for China to start unloading dollar-denominated assets and release the peg. I’d imagine at that stage all hell breaks loose as bond prices collapse, interest rates go back up to double-digits, and the dollar finds amazing new lows. Does this make sense to anyone else?
dave iverson • November 12th, 2004 at 11:55 am
hbj, Your assessment/prediction makes sense to me with one caveat. There is a small chance that before “all hell breaks loose” (or just as it does) nation states will come together and strike yet-another accord to keep capitalism going for a while longer. But what do I know? I’ve been thinking, rightly or wrongly, that the US was on a wrong track since before the day Paul Volkner performed his magic on high interests rates in an earlier era. Since that time, we’ve squandered our savings (private and public) and thrown ourselves a great party, with Great Gatsby McMansions and all. There was a time when the FED used to step into the middle of speculative frenzies and take the punchbowl away. But given the emergence of derivatives, GSEs (Fannie and Freddie), and more, and the precedent set by Greenspan and Co. in bailing out Long Term Capital Management, I think that those days are over. Instead we now paper-over all problems and pretend that helicopter money will save the day. I don’t believe it, but as I said earlier, what do I know. Thanks Noureil and Brad for these blogs.. dave. PS.. How does one get paragraph breaks into comments?
dave iverson • November 12th, 2004 at 11:57 am
PSS Ignore my last question — about paragraph breaks.. The “preview” didn’t give me the impression that they were there, but I see now that in fact they were.. d.
dave iverson • November 12th, 2004 at 12:11 pm
After this post I’ll quit being a pest here. But forgive me for misspelling your name Nouriel along with Paul Volker’s.. Day after a holiday for some of us, and my morning fog is pretty thick.. d.
Sandra Walker • November 19th, 2004 at 9:00 pm
I am interested in the plans other readers have to protect their financial 401k and IRA’s.
Dwight Cramer • November 21st, 2004 at 5:13 pm
Whoever made the comment that this situation is less Tragedy of the Commons and more Prisoners’ Dilemma was spot on. However, I also think it is worth keeping in mind that the accumulation of dollar reserves in Asia has been a residual effect of other policy actions rather than an objective achieved by concerted action. As long as those other policy objectives remain paramount, BW2 should remain viable, with two caveats. The first is that within the community of central bankers the free riding issue is a very real one. The second is that one should anticipate a great deal of froth and testing in the markets, as various non-trivial speculative positions are taken by private actors.
abu hartal • December 5th, 2004 at 6:32 pm
The tragedy of the commons/prisoners’ dilemma analysis may have it backwards. It would be in the collective economic interest of Asian central banks to diversify their holdings so as not to have to absorb losses from dollar depreciation, but not one can attempt to do so without jeopardizing its state’s security relationship with the US to the benefit of its rivals and its access to the US market. Bretton Woods Two has its basis in the US’ sole status as superpower. It’s a bit troublesome that economists seem to neglect the interpenetration of economics and politics. But this is the price for imagining that the real world is as cleanly divided as university disciplines!
gillies macbain • December 8th, 2004 at 2:38 pm
currencies head for 1914 ? world war III – ‘ the cold war ‘ – was actually won by the u s economy when it vanquished the soviet economy. the american and soviet armies never met, thank god. suppose the fourth world war were fought between the real and effective great powers of the globalised economy – the major currencies and currency blocs ? why would they fight a war ? they would mobilise because other great powers were mobilising, and because it would be folly not to do likewise. and why are other great powers mobilising ? . . . . . .( well, see above.) if all the nuclear weapons are used, that will be the end of not just the men in the trenches – but the generals, and the battlefield as well. so they will try to avoid that. and even a couple of bunker busters might cause as much damage on wall street as in damascus or tehran. let us for a moment imagine the billions in various central banks not just as reserves, but as uniformed military reservists. the biggest of the great powers is the dollar, under general greenspan. he has the ability to call up unlimited reinfocements, he can actually print new soldiers and send them to buy cooking oil. surely no one would dare challenge such a superior force ? but look. the dollar, the financial army of the united states, has gone and done what napoleon did, and what hitler did. it has become overconfident and invaded the vast landmass of asia. can a retreat from moscow, or a stalingrad, now be much longer delayed ? the lesser armies of japan, china, taiwan, and south korea, hold american hostages – 800 billion, 400 billion, 200 billion,and 150 billion respectively. it is in their power to begin shooting them, a billion men here, a billion men there – but why would they do that ? at the present these americans are their allies and do their bidding. start shooting some and all the others would quickly turn useless and uncooperative. wouldn’t you, in the same circumstances ? - and might the americans start shooting their own foreign hostages ? no, the americans, for some unknown reason, do not have many hostages. now the other interesting thing about the hostages is that most of them do not actually live in the far east. the chinese dress them in chinese uniforms ( they are nevertheless still americans underneath ) and send them to work in new york. from there they send home remittances that help the people back home. so what is the problem ? everyone seems happy. the problem is this – that there are too many soldiers in the world and not enough cooking oil to feed them all. saudi arabia has lots of oil but no decent soldiers of its own. japan has the most soldiers but almost no oil, so they are not likely to make the first move either. china has some oil but needs more and more every passing day. no one wants to go hungry, but no one wants its foreign conscripts to turn negative and melt away like iraqi police trainees in the night, either. so who will start a war ? the russians have noticed – ( who can help not noticing ) – that the american soldiers are getting smaller every day, while european soldiers ( who also have to buy their oil ) are nevertheless getting stronger. they want to shoot their american hostages and recruit euro men in their place. they do not intend to shoot them all – they shoot a few million every week, just enough not to start a war, but enough to keep their plan in moving forward. diabolical! are the russians not afraid of having no cooking oil to feed the big euro men ? ha ha. the russians have both their own soldiers – roublemen – and hostages, but not too many – and wait for it. . . . they also have their own oil. warehouses full of it. euromen with their bellies full of russian food. now they could fight . . . . and that is not all. the russian citizens who never trusted the roublemen ( who tended to get smashed on vodka and suffer sudden falls ) actually have american hostages as domestic help! they keep them under their beds. ( 60 billion of them.) the citizens also have noticed that the americans are losing weight and looking sickly, when put to work alongside the sturdy euro men and maids. now this is the danger. the russian households are quietly shooting their domestics one by one. not enough to cause a war ( not yet ) but with much the same long term effect. you are not meant to photograph the body bags, either. so don’t be looking out for this in the ‘ washington post.’ you see. the more hostages you have – the more inconceivable is the final solution of doing away with the lot. so the nations to fear most, are not the greatest powers, nor the virtually powerless, but the private citizens in middle sized countries all over eurasia – long known to be subject to passing fashion. if one gets a phillipino maid – they all want a philippino maid, and so on. you know the scene. once the shooting starts, ( and it has started ) , it can just as easily die down again as if nothing had happened. skirmishes are like that. - or, as in 1914, it can drag in all of the great powers, cause the death of billions of soldiers – dollarmen, yuanmen, yenmen, euromen and sterlingmen – while others will not be shot but sold into slavery for gold, oil, or other commodities, which is actually just as bad. it shrinks the infantrymen. nobody wants them. so we may all lose – but some worse than others. the most scary thing might be the confusion, with soldiers rushing home, rushing abroad, panicking in all directions, fighting over the oil, and causing the domestics of all nations to turn difficult, surly, and wholly undependable. and suppose the americans told the asians in new york that they weren’t allowed to travel – and their remittances would now be taxed at 50 per cent ? then the fat would really be in the fire. you think george wouldn’t dare ? so what do i think about it all ? i think that it is little different from all other wars. if the soldiers had just stayed at home . . . . well they never do. . . o k if the same number of soldiers came home, as went abroad – at least things would not get worse – even if things did not get much better either. but it is too late to be telling the yanks that now . . . . bloody tourists.
jm • December 12th, 2004 at 2:32 pm
You write, “… Individual Asian countries at some point will have an incentive to diversify out of US dollar reserves into Euro reserves, so as to avoid capital losses should their currencies appreciate relative to the US dollar.” But has anyone ever seen any Asian government show any concern about such capital losses? There are very good reasons to believe that, to the elites who control these countries, true wealth and power reside not in paper financial assets but in factories, technical knowhow, and military might. Why should they care about capital losses, as long as they can ensure that those losses come out of the pockets of the common people? Would a rigorous analysis of net present values not find that the losses have in effect already been sustained? (Think of how much more in imported goods and commodities, and in European vacations, the Japanese could have enjoyed had they kept the yen up at its mid-90s peak value!) As long as they can keep their currencies undervalued, the elites of Asia can probably profit enough from selling their subjects’ labor at bargain rates to more than compensate for the losses they themselves may someday suffer from dollar devaluation. Their concern is to keep the masses’ noses to the grindstone, and continually build up concrete capability to make the things that the people from whom they get their raw materials producers will always want to buy. The capital losses Japan has already swept under the rug in its myriad white-elephant public works projects must dwarf the paper losses it will someday have to nominally recognize on its dollar holdings. One could argue that all these losses are the reason that the Japanese have a much lower physical standard of living than Americans, despite their higher average IQ and educational standards. But a majority of the Japanese, and the elite in particular, seem to feel that it’s better to have large stocks of “capability” and money-in-the-bank (regardless of its future value) than to have the lowest possible import and foreign-vacation prices today. If I remember the stats correctly, during Japan’s bubble years about $500 billion worth of land was transferred (net) from individual to corporate hands. And there was much lending with value-inflated land as collateral. Thus actual financial losses from the collapse of real estate prices must have been on the order of $500 billion, and nominal losses must have been in the trillions. But these enormous losses have been papered over to keep the music playing. Why would the Japanese government not accept a 50% loss on their foreign exchange reserves as also just “the cost of keeping the music playing.”
AndrewP • June 2nd, 2005 at 9:31 pm
Not so fast. The Euro isn’t looking so good today after the political cohesion of Europe is revealed as being less than meets the eye. No one will want to invest too much in a currency backed by an entity that is politically unstable and could break up. Even if the odds of breakup seem to be low, they could increase, especially if unempolyment in the EU gets worse. I would expect Chinese central bankers to do some diversification, but not any wholesale dumping of the dollar. The best thing for China would probably be a pegging of the Remnibi to a basket of dollars, euros, and yen, and to gradually increase the proportions of euros and yen over the coming years until the proportions are equally weighted.
