Richard H Clarida
Ten years ago, in the aftermath of the Asia-Russia-LTCM1 crisis, I was invited by Paul Volcker to prepare a report for the Group of 30 (which he then chaired) on “G3 Exchange Rate Relationships: A Review of the Record and of Proposals for Change.” Readers will recall that, in that turbulent time, there was widespread (but certainly not unanimous) dissatisfaction with the prevailing status quo regime of managed floating exchange rates among the Group of Three – comprised of the US, Germany (now EMU3), and Japan. It was said by many that G3 exchange rates were not well anchored by fundamentals and were excessively volatile. As a consequence, the critics believed, the post Bretton Woods status quo for G3 exchange rates contributed to the volatility of, rather than stabilized, the global financial system of the late 1990s. Defenders of the status quo did not, in general, suggest that G3 exchange rate relationships were ideal but rather that, leading alternatives – essentially variants of target zones with hard or soft commitment to narrow or wide bands – were likely either to be inferior or, if superior in the abstract, not feasible (or more technically, time inconsistent) in practice.
In this installment of Global Perspectives, I step back and reflect on what has been learned about G3 exchange rate relationships that was not clearly foreseen or fully appreciated 10 years ago. While the reader’s 1998 crystal ball may have been better than mine at the time, here is what I have learned about G3 exchange rate relationships that I did not clearly foresee back then.
Capital Accounts Now Drive Current Accounts – G3 Exchange Rates and the Saving Glut: Some things never change, but our interpretation of them can and should as facts and circumstances change. The US ran large current account deficits in the 1980s, in the 1990s, and in the first decade of the 21st century. In the 1980s and 1990s, large US current account deficits were correlated with high real interest rates in the US Low US saving relative to average or better US investment generated a current account deficit which required a capital inflow attracted by these high real interest rates. The global saving glut brought down global real interest rates, both spot and forward, and this encouraged consumption and residential investment not only in the US, but in other countries as well (think U.K., Spain). Initially the driving source of the global saving glut (more precisely the excess of desired saving relative to desired investment at unchanged global interest rates) was Asia, with China and other emerging Asian countries joining Japan which has had its own, structural saving glut (and the current account surpluses to show for it) since the Carter administration. Notwithstanding all the focus on China, and its BWII development strategy, it is important to remember that as recently as 2003 China’s overall current account surplus was just two percent of GDP. Since 2003, strong global growth in the emerging world has triggered a commodity boom which has become a second source of excess global saving though the channel of petrodollar recycling.
As we look ahead to the next 10 years, is it likely that the euro supplants the dollar as the global vehicle currency? I for one do not think so. By vehicle currency, of course, I mean the role that the dollar plays not just in the reserve holdings of global central banks, but also in the daily trading in the foreign exchange market, the interest rate derivatives markets, and as the currency of invoice for global commodity trade and also much trade in goods and services. To date there is no compelling evidence that the dollar’s market share as a vehicle currency has materially declined, not withstanding a substantial depreciation since 2001 and somewhat higher US inflation as compared with EMU inflation. There is some evidence (for example, the IMF COFER data) that the dollar’s share as a global reserve currency has peaked and is on a path of gradual decline. While I expect this trend in reserve diversification to continue.
The Exorbitant Privilege – $500 Billion a Year and a Source of a Weaker Dollar
Fact 1: Between 2001 and 2006, the US ran cumulative current accounts deficits in excess of 3.1 trillion dollars.
Fact 2: Between 2001 and 2006, the US net international investment position improved, its net foreign liability position fell by more than 200 billion dollars.
How could the US run large current account deficits without running up a commensurate increase in its net foreign liability position? The answer reflects the 21st century exorbitant privilege that accrues to the US as the provider of the global reserve and vehicle currency. As is by now much better understood than it was a decade ago, there are two sources of the privilege. While virtually all of the US gross external liability (which at year end 2006 was in excess of 18 trillion dollars) is US dollar denominated, most of the gross US holdings of foreign assets (which at year end 2006 was in excess of 16 trillion dollars) is denominated in foreign currency. As a consequence of its ability to borrow massive amounts in its own currency, US investors benefit from a capital gain (and European, Japanese, and other investors suffer from a capital loss) when the dollar depreciates against the euro, yen, and other currencies.
The next 10 years: So much has happened in global finance in the past ten years, it would be foolish to forecast with any precision what will happen in the next ten. It would seem, however, that the financial clout of the saving glut countries – China and the commodity exporters – is likely to grow and to shape in important ways the global capital market and G3 exchange rate relationships. While the most likely scenario is for the dollar to remain the global reserve currency, the fate of the dollar will likely rest in part on the geo-financial calculations and policies of these sources of global capital outflows. In recent months, we have seen a flight-to-quality scenario in which Treasury yields fall in tandem with the dollar. In a true dollar crisis, bond yields would have risen to attract the capital inflow in tandem with a sinking dollar.
Source: Daily Times, 7/6/2008