247Bull.com Editor: Special drawing rights, or SDRs, were created by the IMF in 1969 as an international reserve asset that could be held by a member country alongside its official currency reserves. The value of an SDR is currently based on a basket of four key international currencies, the US Dollar (41.9%), the Euro (37.4%), the Japanese Yen (9.4%) and the British Pound (11.3%). However, not only is there a proposal to reweight the basket of to reflect the growing share of economic activity that takes place using Asian currencies such as the Chinese Renminbi. It has also been proposed that the weighting of the British Pound be substantially reduced to reflect its diminished role in world trade. The next official date for a re-evaluation of the basket is in January 2015, though the IMF reserves the right to re-evaluate the basket of currencies that values the SDR sooner than that if it decides that the current basket no longer reflects “the relative importance of currencies in the world’s trading and financial systems”.
On multiple fronts there appears to have been a resumption of hostilities in the global currency wars. A subtle indication of this is the recently released report, Gold, the Renminbi and the Multi-Currency Reserve System, which I believe is highly significant for two reasons: First, it demonstrates that major global actors are now keenly aware and frightened of the possibility of a major breakdown in international monetary relations. Second, it suggests that these same actors are trying to contain the growing demand for gold as an alternative reserve asset and pre-empt an uncontrolled gold remonetisation. These efforts will fail. A collapse of the current, unstable global monetary equilibrium is inevitable. Recent events indicate that the countdown has begun.
BREAKING THE CEASE-FIRE
Curiously, in the second half of 2011 and through most of 2012, notwithstanding the escalating euro-crisis, US ratings downgrade, Japan’s protracted nuclear disaster and sharply divergent global growth rates, there was surprisingly little volatility in foreign exchange markets. EUR/USD traded mostly in the historically narrow range of 1.40-1.25. USD/JPY was in a range of from 76-82. The Chinese renminbi held between 6.4 and 6.2. GBP/USD moved within 1.54-162. The Swiss franc was also steady at around 1.20 versus the euro, although this was the result of an explicit Swiss policy of capping the franc at that level.
In retrospect, it appears that this period was characterised by a general ‘cease-fire’ in the global currency wars ignited by the global financial crisis of 2008.1 Rather than attempt directly to devalue currencies to stimulate exports at trading partners’ expense, the focus during this period was primarily on measures to support domestic demand.
1 In the Amphora Report I have long followed the ‘currency wars’. My first take on the subject, BEGUN, THE CURRENCY WARS HAVE, dates from September 2010. The link is here.
There has now been a resumption of hostilities. The first shots were fired by the Japanese, where national elections were held in December. The victorious LDP party campaigned on a platform that, if elected, they would increase the powers of the Ministry of Finance to force the Bank of Japan into more aggressive monetary easing. The LDP also has voiced support for either a higher BoJ inflation target or a nominal GDP growth target.
Combined with poor economic data, this had a dramatic impact on the yen, which has subsequently declined by about 10% versus the dollar and 15% versus the euro. This is the weakest the yen has been in broad, trade-weighted terms since 2011.
Now it is understandable that Japan should desire a weaker yen. Japan is no longer running a trade surplus, in part because it is importing a record amount of energy following the decision to scale back
the production of nuclear energy. Moreover, demographics are such that the proportion of retired Japanese is growing rapidly. As Japan’s ageing population draws down its savings to fund retirement, this implies that Japan will be saving less and consuming more relative to the rest of the world.
But while Japan has an interest in a weaker yen, many other countries have an interest in weaker currencies too. Much of Asia has been following a classic, mercantilist growth model ever since the Asian credit/currency crises of 1997-98, seeking to export more than they import. They are still inclined to follow this model, as it has succeeded in the past.
Of course it is impossible for all countries to be net exporters. The US is by far the world’s biggest importer. But given structural economic problems and associated high unemployment, US policymakers also have reasons to desire a weaker currency to stimulate exports and jobs. Much the same is true of the UK, arguably the leading candidate for the next big devaluation. Then there is the euro-area, which is suffering under a huge debt burden and desires to stimulate exports abroad to offset ‘austerity’ at home.
The BRICs (Brazil, Russia, India, China, South Africa) and other developing economies are well aware of mature economies’ problems and do not want to be the ones that pay for what they perceive, quite justifiably, as economic hypocrisy. Just who has been living beyond their means? Who has been borrowing and consuming, rather than saving?
It does, of course, take two to tango. The BRICs have been financing mature economies’ largesse—including financial bailouts—with their surpluses. But as the BRICs have stated on multiple occasions, they would far prefer for the developed economies to take their necessary economic medicine at the local, structural, supply-side level rather than to try and pass the pain of adjustment off on them.
A recent sign of such concern includes some rather provocative statements by Russian central banker Alexyi Ulyukayev. Russia is currently the Chair of the G-20 countries who seek to cooperate on global economic matters. Back in 2009 the G-20 agreed not to engage in competitive currency devaluations. Well they’re not exactly cooperating at present according to Mr Ulyukayev, who has specifically accused Japan of breaking the cease-fire: “Japan is weakening the yen and other countries may follow,” he said recently. South Korea, one of Japan’s closest competitors in several major industries, has warned of possible retaliation for the weaker yen and both South Korea’s and Taiwan’s currencies weakened sharply this week. Even Norway, with a healthy economy at present, has recently indicated that it is concerned by the strength of the krone.2
2 These various statements were reported in this Bloomberg News article that can be found here.
The sad fact of the matter is, currency wars (ie competitive devaluations) are ‘zero-sum’ at best. At worst, they severely distort global price signals, thereby misallocating resources, and eventually morph into trade wars, in which economic protectionism destroys the international division of labour and capital, making economic regression all but certain. The 1920s/1930s are a classic case in point but there were similar such episodes in the 18th-19th centuries, the era of mercantilist economic policy debunked by, among others, Adam Smith and David Ricardo. (While the classicists were right about mercantilism, it should be noted that classical economic theory is deeply flawed in key respects.)
Given the destructive power of currency and trade wars, it should come as no surprise that policymakers in the developed economies are increasingly desperate to find a way to de-escalate and contain the conflict. But is this possible?
IS THE OMFIF REPORT AN OLIVE BRANCH TO THE BRICS?
Perhaps the best indication of growing policymaker desperation is a recent report prepared by the Official Monetary and Financial Institutions Forum (OMFIF), on behalf of the World Gold Council. In the report, the OMFIF argues that the international monetary system is approaching a transformation from a mostly ‘unipolar’ system centred around the dollar, to a ‘multipolar’ one of multiple reserve currencies, including the Chinese renminbi, which at present comprises only a tiny fraction of global FX reserves.
Most important, the report recognises that monetary regime change is fraught with uncertainty. History is clear on this point. Also clear is that, historically, periods of global monetary uncertainty have been associated with central bank (and private) accumulation of gold reserves and, by association, a rising price of gold.
According to the OMFIF, this is the explanation for why central banks are accumulating gold today. It boils down to increasing uncertainty or, if you prefer,
decreasing trust between countries, a natural consequence of the currency wars. OMFIF assumes that, in the coming years, uncertainty and associated gold accumulation will continue to increase, placing further upward pressure on the gold price.
It is difficult to argue with any of that. Indeed, in my book, The Golden Revolution (available here), I illustrate how the 2008 global financial crisis critically destabilised the international monetary system. In particular, the dollar is losing its dominant reserve currency status, yet there is no other existing fiat currency that can replace it. The euro has issues, the yen has issues and the renminbi has issues, although it is the ‘rising star’ in this group.
The OMFIF report then makes a recommendation that the best way to reduce the unavoidable monetary uncertainty ahead is to acknowledge that there should be a more formal role for gold to play in the international monetary order, in particular, that it should be included in the Special Drawing Rights (SDR) basket as calculated by the International Monetary Fund (IMF). The SDR is a global reference point for currency valuation and IMF member countries’ capital shares are denominated in SDRs.
This is a formalisation of what was first proposed by World Bank president Robert Zoellick back in 2010. In a Financial Times article that I believe will be noted by monetary historians in future, he wrote that gold was already being treated as an “alternative monetary asset,” and that the international monetary system “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”3
3 Robert Zoellick, “The G20 Must Look Beyond Bretton Woods II,” Financial Times, 7 November 2010.
The OMFIF report also suggests expanding the SDR basket to include all the ‘r’ currencies, not only the renminbi but also the Indian rupee, the Russian rouble, the Brazilian real and the South African rand. This would be a formal recognision of the rising economic power of all the BRICs, not just China, and pave the way for their currencies’ use as reserves.