FRBSF Economic Letter
2005-32; November 25, 2005
The Bretton Woods System: Are We Experiencing a Revival?
Symposium Summary
Pacific Basin Notes. This series appears
on an occasional basis. It is prepared under the auspices of
the Center for Pacific
Basin Studies within the FRBSF's Economic Research Department.
This Economic Letter summarizes the papers
presented at the symposium "Revived Bretton Woods System: A New
Paradigm for Asian Development?" held at the Federal
Reserve Bank of San Francisco on February 4, 2005,
under the joint sponsorship of the Bank's Center for
Pacific
Basin Studies and the University of California at Berkeley's
Clausen Center for International Economics. The papers
are listed at the end and are available at http://www.frbsf.org/economics/conferences/0502/. At the center of this symposium was a presentation by
Michael Dooley (University of California at Santa Cruz
and Deutschebank)
and Peter Garber (Deutschebank) based on their papers
with David Folkerts-Landau (2003a, b, 2004). Dooley and
Garber
presented their views on the current international exchange
rate system, the sustainability of global trade imbalances,
and the implications for development by emerging markets,
such as China. Other participants presented papers that
questioned the bases of their arguments and the extent
to which those arguments account for current developments.
A revival of Bretton Woods?
Dooley, Folkerts-Landau, and Garber (DFG 2003b)
argue that the current international exchange rate
system operates
much like the Bretton Woods system of fixed exchange
rates
that prevailed for nearly a quarter of a century, from
the end of World War II until the early 1970s. Under
Bretton Woods, foreign currencies were pegged to the
dollar at
fixed parities, and the dollar was pegged to gold at
$35 an ounce. The system was abandoned when foreign
governments perceived that guarantees of currency
conversion at fixed
rates were no longer credible.
Although the current
international exchange rate regime carries no guarantees
of fixed parities in terms of
gold or the dollar, DFG argue that many countries,
particularly
those in Asia, do limit exchange rate fluctuations
against the dollar to varying degrees. For example,
Japan often
has conducted foreign exchange intervention—selling
yen for dollars, which pushes the yen down against
the dollar—in
order to maintain its export competitiveness. As a
result, Japan has been a net accumulator of dollar-denominated
assets; indeed, it ranks first among official reserve
holders of U.S. Treasury securities.
China's policy
of keeping exchange rates low relative to the dollar
is also related to a desire to boost
exports. In addition, according to DFG, China has also
been motivated
by a desire to attract foreign direct investment by
multinational firms as well as the technical expertise
that usually
comes
with it. As a result, China also has been a net accumulator
of dollar-denominated assets and is second only to
Japan among official reserve holders of U.S. Treasury
securities.
This result is surprising, however. Given
that China is a rapidly growing developing country,
one might
expect it to be a net international borrower, as capital
presumably
enjoys a higher rate of return there than in the U.S.
Naturally,
this question also arises with other developing economies
that may peg their exchange rates to varying degrees
to the dollar. Whether this issue is a valid point
or not,
DFG (2004) have an answer. They argue that developing
nations like China need to accumulate U.S. Treasury
securities, because they provide a form of "collateral" against
concerns about possible future expropriation of the
assets of U.S. foreign direct investors.
This argument
has implications for the U.S. trade deficit. The exchange
rate policies discussed have been accompanied
by large trade surpluses in most Asian countries vis—vis
the U.S., as well as by a corresponding need by the
U.S. to borrow to finance its purchases of net imports.
This
implies that, insofar as developing countries like
China continue to accumulate these U.S. assets, the
U.S. will
see ongoing trade deficits.
Perhaps the biggest question
facing DFG's world view is whether the current system
is sustainable as the
U.S. current
account deficit continues to grow. DFG (2003a) argue
that the system is sustainable in the near term (though
their
estimates of what the "near term" is varies
from three to ten years or more) as long as Asian countries
are willing to finance the growing U.S. current account
deficit by purchasing additional U.S. securities.
Does
China fit the story?
Several symposium participants
questioned the merits and viability of a strategy
of deliberate currency
undervaluation by developing countries, particularly
in the case of
China.
For example, Nicholas Lardy (Institute of International
Economics), in his paper with Morris Goldstein, pointed
out that more than half of China's exports go to markets
other than the U.S. or to countries with currencies
not pegged to the dollar. Thus, a strategy of undervaluation
by China to boost its exports should depend not just
on the renminbi's exchange rate against the dollar
but
also
on its effective rate against the currencies of all
of its trading partners. In fact, between 1994 and
2001
the renminbi's real trade-weighted exchange rate (adjusted
for inflation differences across countries) appreciated
by 30% before falling by 13% since 2001. Lardy also
disagreed with DFG's argument that the undervaluation
contributed
significantly to increasing foreign direct investment
in
China and the growth of China's capital stock. In his
view, this argument ignores the fact that foreign direct
investment
in China has financed less than 5% of fixed asset investment
over the past few years.
Barry Eichengreen (University
of California at Berkeley) dismissed the purported
role of U.S. assets as collateral
that justify U.S. multinational firms' decisions to
invest in China. For one thing, he argues that the
timing is
wrong: rising U.S. foreign direct investment in China
began around
1992, whereas China's massive reserve accumulation
came a decade later. In addition, he doubts that political
conditions would support U.S. expropriation of Chinese
claims, invalidating
the collateral role these claims are purported to play.
Finally, he points out that in recent years the U.S.
has accounted for less than 10% of China's inward foreign
direct
investment.
Steven Kamin (Board of Governors) agreed
with DFG that the authorities in developing economies
other than
China have been acting to maintain the competitiveness
of their
exports by limiting currency appreciation. However,
he argues that the recent large current account surpluses
in the region mainly reflect the special, ongoing effects
of a decline in investment and domestic demand following
the Asian financial crisis of 1997-1998. He attributes
this fall in investment to factors such as the presence
of considerable excess capacity after the crisis and
the near collapse of domestic banking systems in the
region.
To be sure, immediately after the Asian financial crisis,
the desire to rebuild foreign exchange reserves was
another
reason that authorities in the region intervened in
foreign exchange markets to acquire dollar assets,
but this motive
has diminished in importance as reserves have grown.
He believes that, over time, Asian investment spending
will
revive, that the authorities will be more comfortable
in allowing their currencies to strengthen, and that
their
trade surpluses will narrow.
Will the system last?
Barry Eichengreen and Ted
Truman (Institute of International Economics) argue
that DFG make a false analogy between
the current international foreign exchange system and
Bretton Woods. In particular, they argue that the U.S.
is now no
longer a net saver with current account surpluses,
as it was in the years immediately after World War
II. In
addition,
domestic financial systems are more liberalized, capital
accounts are more open, and exchange rates are more
flexible, for both industrial and emerging market economies.
These
differences make it harder to sustain undervalued exchange
rates indefinitely.
Nouriel Roubini (New York University)
and Brad Setser (Roubini Global International) also
questioned the
sustainability of efforts to limit dollar appreciation,
arguing that
the
scale of the financing required is increasing faster
than the willingness of the world's central banks to
build up
their dollar reserves. In addition, the enormous reserve
growth in these countries has become increasingly harder
to sterilize fully, particularly in China, where the
resulting increase in the money supply is fueling a
lending boom
and an asset-price bubble. Lardy and Roubini both suggest
an earlier rather than a later end of China's peg to
the dollar. Eichengreen argues that China has good
reason to
abandon its peg soon, while confidence is strong, capital
is still flowing in, and reserves are still being accumulated.
DFG
suggest that because the euro area has borne a large
and disproportionate share of the adjustment
of the U.S.
trade imbalance, the European Central Bank will be
compelled to engage in large-scale currency intervention
to resist
further euro appreciation. However, Roubini and Setser
and Truman all argue that the European Central Bank
is unlikely to do so, in part because of its conviction
that the recent massive Japanese intervention had limited
effectiveness.
The implication is that there will be continuing downward
pressure on the dollar against floating currencies
until
the overall adjustment is consistent with a lower U.S.
current account deficit.
Might global imbalances spark
a sharp decline in the dollar? Maurice Obstfeld (University
of California
at Berkeley)
discusses the likelihood that the U.S. might face an
emerging markets-style "sudden stop" crisis.
In his work with Kenneth Rogoff, he questions the sustainability
of
U.S. current account imbalances, and suggests that
a large depreciation of the dollar is indeed very likely.
Ron
McKinnon (Stanford University) agrees with DFG that
it is in China's interest to maintain a dollar
peg, but
his argument is different. He argues that a stable
exchange rate is an important way for China to anchor
low inflation
expectations. Accordingly, he provides three arguments
for why it is not a good idea for China to allow
the renminbi to appreciate. First, an appreciation
of the
renminbi would
not necessarily improve the U.S. trade balance; for
example, it could lead to reduced world demand for
China's exports,
thus slowing China's economic growth, which, in turn,
could lead to significant declines in Chinese demand
for U.S.
products. Second, it may create deflationary pressure
in China. Third, it would encourage more speculative
capital
inflows.
Conclusion
One way to assess the arguments of DFG
and their critics may be to examine the implications
of the
revaluation
of the Chinese renminbi in July 2005, five months
after the
symposium took place. On one hand, it is clear
that the Chinese have adjusted their currency
by revaluing
against
the dollar and announced that they would move
towards more flexibility in the future. These developments
would seem
to portend changes that conflict with the DFG
vision
of Asian countries' ongoing willingness to finance
ever-increasing U.S. deficits in the interest
of maintaining their trade
balance surpluses.
On the other hand, it must
be acknowledged that DFG's first works on this
subject were published
in 2003,
and the imminent
sharp adjustment in the dollar that was predicted
by many has yet to take place. Indeed, so far,
the renminbi
has
adjusted by less than 3%. As such, the DFG
framework has already lasted for a notably long duration
in today's volatile
international financial markets.
Reuven Glick
Group Vice President Mark Spiegel
Vice President and Director, Center for Pacific Basin Studies
Symposium papers
Eichengreen, Barry. "Global
Imbalances and the Lessons of Bretton Woods"
Goldstein, Morris, and Nicholas R. Lardy. "China's
Role in the Revived Bretton Woods System: A Case of Mistaken
Identity."
Kamin, Steven. "The
Revived Bretton Woods System: Does It Explain Developments
in Non-China
Developing
Asia?"
McKinnon, Ronald. "Exchange
Rates, Wages, and International Adjustment: Japan and
China
versus the United States."
Obstfeld, Maurice, and
Kenneth Rogoff. "The
Unsustainable U.S. Current Account Position Revisited."
Roubini,
Nouriel, and Brad Setser. "Will
the Bretton Woods 2 Regime Unravel Soon? The Risk of
a Hard Landing
in 2005-2006."
Truman, Edwin. "The
U.S. Current Account Deficit and the Euro Area."
References
Dooley, Michael, David Folkerts-Landau, and Peter Garber.
2003a. "Dollars and Deficits: Where Do We Go from
Here?" Deutsche Bank Global Markets Research Newsletter,
June 18, 2003.
Dooley, Michael, David Folkerts-Landau, and Peter
Garber. 2003b. "An Essay on the Revived Bretton
Woods System." NBER
Working Paper 9971 (September).
Dooley, Michael, David
Folkerts-Landau, and Peter Garber. 2004. "The
U.S. Current Account Deficit and Economic Development:
Collateral for a Total Return Swap." NBER
Working Paper 10727 (August).
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