The annual meetings of the IMF and World Bank will be dominated by the economic consequences of the shock generated by Covid-19. Generally, these have tended to be an amplification of challenges that were present before the emergence of the virus.
At their heart is an international payments system that does not reflect the structure of international economic activity and the flows of trade that it generates. Since the collapse of the Bretton Woods system fifty years ago, the relative importance of the US economy has diminished massively. Yet the dollar and its markets are as important as ever. Since the end of Bretton Woods’ fixed parity regime central banks, led by the Federal Reserve, have responded to every adverse economic shock with injections of liquidity to remedy the financial consequences of those shocks. The result has been the creation of a financial cycle that overlays and amplifies the real economic or business cycle.
In purchasing parity terms, the Chinese economy is bigger than the US economy. Emerging market economies now make around 60 per cent of world GDP. Yet the dollar accounts for over half of all world trade invoices – some five times greater than the volume of US economy’s share of imports. In addition to being the dominant currency for trade invoices and international settlement, the US dollar is the principal currency used for issuing securities, recording financial holdings and used to hold reserves of the official central bank sector. The dollar accounts for two thirds of the both world’s securities and its foreign-exchange reserves.
The high volume of trade transacted in dollars generates an incentive to hold dollar assets. That lowers returns on dollar assets offering an incentive for firms to borrow in dollars, which encourages firms with dollar liabilities to reduce the currency risk arising from their revenues not matching their debt service liabilities. The increasingly dominant role of the dollar in international transactions has resulted in central banks and governments raising their holding of dollars as a form of self-insurance against risk. This further contributes to the global savings glut identified by Ben Bernanke and to lowering dollar interest rates and aggravating the secular trend to lower rates.
This has effects on the scope of domestic and external monetary management. The received policy consensus has been that governments best manage their economies in terms of macro-economic stability with flexible inflation targets and flexible exchange rates that enable adverse balance of payments shocks to be dealt with by exchange rate adjustment. The increased role of the dollar, the savings glut and attempts at self-insurance by holding dollar reserves creates a deflationary bias that countries with inflation targets find difficult to correct. Lower interest rates aggravate the constraints that make domestic monetary policy a less effective source of macro-economic stimulus. While the effect of dollar invoicing makes an exchange rate devaluation less effective as a means of dealing with balance of payments adjustment.
The dependence of the world economy on the central role played by the dollar was powerfully demonstrated in March when the Covid crisis was getting under way. Market liquidity froze. Long standing concerns about the amount of bank capital devoted to making markets in government bonds, following the framework of regulation put in place after 2009, were realised. The US Treasury market became illiquid. Everyone wanted cash and they wanted in only one currency: the dollar. Emerging market economies were used to having their currencies abandoned for the dollar but other currencies that would normally be considered safe havens such as the Swiss franc were abandoned for the dollar. It required decisive and effect action by the Federal Reserve Board to stabilise both the US Treasury market and the international currency markets by the creation of very generous swap lines to other central banks similar to the actions it took in 2008.
International financial flows play a critical role in determining the prices of financial assets such as bonds and equities. It is changes in huge flows of liquidity that are the keys to a security’s price in the context of an international economy where at any one time there is over $180 trillion of so-called footloose or hot money on the move and engaged in portfolio investment in relation to a world GDP of $80 trillion. Financial crises arise when there is an interruption to funding liquidity available in markets that prevent projects and asset holdings from being refinanced.
In modern money and capital markets the process of refinancing the stock of existing economic projects is as, if not more, important than financing new initiatives. Over the past twenty the financial system has changed from a retail bank-based credit system to one based on wholesale market-based provision. The source of liquidity is the repo not a bank deposit. Repos require a stable collateral base. This has normally been provided by a ‘safe’ asset such as government bonds. In relation to the demand for such safe assets the supply has been insufficient to meet demand. The result is over $16 trillion of sovereign debt that now trades at a negative interest rate.
The world economy, in practice, has only two potential sources of liquidity on the scale that is needed to manage its crises and in normal conditions to maintain international liquidity: the USA and China. China despite having a central bank balance sheet that is bigger than that of the Federal Reserve and the world’s largest foreign exchange reserves, remains cautious about the international use of its currency. China has not so far allowed its capital account to be liberalised, so that the renminbi can play a full and constructive role in the international payments system.
There is plainly an international appetite among investors to hold Chinese financial assets. This reflects China’s strong recovery from the Covid crisis and the relatively attractive yields on its bonds. The People’s Bank of China has avoided much of the monetary easing that the rest of the world has had to engage in and has maintained a steeper yield curve. Instead of cutting interest rates China has made greater use of fiscal policy. Ten-year Chinese sovereign debt, for example yields 2.7 per cent compared to 0.8 per cent in the US Treasury market.
In 2016 the IMF added the renminbi to its Special Drawing Rights Basket. This September FTSE Russell announced it would add Chinese government debt to its World Government Bind Index. This means that renminbi sovereign debt is in now in all the major international bond indices, such as Bloomberg LP and JPMorgan Chase & Co. Foreign investors now hold around 2.8 billion worth of renminbi bonds ( $413 billion) about 2.5 per cent of 110 trillion renminbi market composed of central government, local government, financial and corporate bonds. The decision by FTSE Russell to include Chinese debt in its index reflects growing market liquidity, the growth of a more reliable secondary market and greater confidence about price discovery in Chinese bond markets.
The international financial system at present is lopsided in terms both of economic activity and its payments systems and reserve holdings. It is further complicated by the direct geopolitical conflict between China and the US about its future evolution.
China is clear it wants to replace the dollar and obtain the advantages of a full reserve currency. Dislodging even an anachronistic reserve currency, as the replacement of sterling by the dollar illustrates, can take decades. It may even require the disruption of wars and several international debt and currency crises to fully bring it about. The US, moreover, is responding to that direct challenge and not just in relation to trade policy. When the Federal Reserve, makes central bank swap lines available to ease liquidity strains in the international economy, China is expressly excluded. This saga will run for a long time and will both increase international risk and will make the management of the world economy more unstable.