By Russell Jones (Global Head of Fixed Income and Currency Research for the Royal Bank of Canada Europe Limited)
· The Bretton Woods II thesis of a sustainable symbiosis between a deficit prone core and a capital rich and export focused periphery was always based on questionable history and optimistic assumptions.

· And today, it is clear that the economic costs of this regime are increasingly outweighing the perceived benefits.

· As happened with Bretton Woods I in the late 1960s, inflation risks and worries about the dollar are disrupting the cartel.

· Emerging market currencies are on the move and the risk is of a further down leg for the US currency that could develop into a disorderly crescendo.

· Going long a basket of emerging Asian currencies is an attractive option.


Since 2003, it has regularly been asserted that the tendency of certain countries to tie their currencies formally or informally to the dollar amounted to a new system of international finance. This system has been christened “Bretton Woods II” because of the perceived similarities to the system of fixed exchange rates that prevailed in the initial post-war decades. Just as was the case 40 or 50 years earlier, this new system had the US at its core, with a number of less mature peripheral countries linking their currencies to the dollar at artificially low rates. But this time around, rather than Europe and Japan, the periphery was composed of emerging Asia and additional nations in Latin America and the Middle East.

Nevertheless, it has been stressed that the symbiosis between the core and the periphery operated much as it had done before. The periphery was able to enjoy stable export-led growth via a cheap currency, the corollary of which was the accumulation of low yielding reserves issued and denominated in the currency of the core. The core, for its part, achieved cheap financing for a mounting external deficit and was able to extend the period during which it could live beyond its means.

Such was this mutually satisfactory outcome that it was believed this state of affairs could prevail for an extended period, perhaps even indefinitely.


In reality, the historical similarities between the two periods and systems have frequently been exaggerated, and some of the significant differences all too easily glossed over. For example:

· The peripheral countries are much more numerous and heterogeneous today than in the 50s and 60s, when much of the developing world was not yet fully integrated into the international economy.

· In the prior period, the US current account balance never hit the extreme levels recorded of late. Indeed, the US was actually in surplus, and therefore exporting capital to the rest of the world, until the onset of the Vietnam War.

· The US currency was at the time fixed to gold – a hard currency peg – while it is now freely floating and the US authorities’ commitment to keeping it stable is so limited as to be virtually worthless.

· And the old system was for years only sustained by a complex range of capital and other controls. Indeed, for much of the latter stages of its existence, Bretton Woods I required constant patching up as it lurched from one crisis to another and was increasingly seen as a source of international instability. When it finally broke down in the early 1970s and the US abandoned its gold peg, it left in its wake an unholy mess of sharply rising inflation, exchange rate and interest rate volatility and fractured political relationships.


It is also true that, rather than an exercise in rose-tinted nostalgia for the swinging sixties, Asia’s predilection for export-led growth in the current millennium had rather more practical origins. In short, it grew out of the Asian financial crisis of the late 1990s. At that time, a number of countries with external deficits and limited foreign reserves found themselves at the mercy of sudden shifts in risk appetite and financial flows, and were rapidly forced into gut-wrenching fiscal and monetary adjustments to re-establish confidence in their currencies. Reserves also had to be rebuilt from scratch and what began as an understandable effort to restore a semblance of international credibility subsequently rather developed a life of its own.

But whatever the shortcomings of the historical analysis, the fact is that much of the emerging world has been quite happy over recent years artificially to depress their exchange rates to sustain export growth, improve their current account positions and recycle much of the money earned back into the US via reserve accumulation and the purchase of dollar fixed income securities. The latest IMF Economic Outlook estimates the external surplus of the Asian NIEs in 2007 at 5.4% of GDP, that of the ASEAN 4 at 4.7%, China’s at 11.7%, the Middle East’s at 16.7% and Latin America’s at 0.8%.


However, there are now growing signs that the Bretton Woods II system is breaking down as the economic costs associated with it increasingly outweigh the benefits of stable export-led growth.

Bretton Woods II has generated a perverse constellation of capital flows and a misallocation of resources in both the US and those countries whose currencies are linked to the dollar. Capital, rather than flowing from the relatively mature and low return core to an opportunity rich periphery, as economic theory and common sense would suggest (no jokes please), has been moving in the opposite direction. Meanwhile, in the US, domestic spending, and in particular consumption, is being subsidised at the expense of exporters and those competing with importers, while there is less incentive for the US to adjust its policy-mix in an optimum manner. Interest rates are depressed and lower borrowing costs encourage the government to spend more. Outside the US, the subsidisation of exporters and import substitutes reduces current incomes. Such distortions are bound to encourage a political backlash from affected interest groups, of which US protectionism – which, it should be noted, also often enjoys a new lease of life in election years – is perhaps the most obvious manifestation.

Part and parcel of this process is that those countries adhering to the Bretton Woods II model adopt a cost of capital determined by US monetary policy rather than by their own domestic conditions. With the Fed latterly in easing mode, this has meant that monetary conditions in the periphery have loosened and that they could well get looser still, should, as seems likely, the US central bank deems it necessary to provide further support to a traumatised financial sector and domestic activity in general. In most of these economies, an independent monetary regime would have seen the domestic authorities tightening over recent months rather than loosening and, not surprisingly, we have seen a growing reluctance on the part of some, not least the Saudi Arabian Monetary Authority, to march in lockstep with Dr. Bernanke and his colleagues.

Reserve accumulation has gone well beyond the prudent. China now has more than $1.4tr in fx reserves and, as the table below illustrates, seven of the top ten holders of fx reserves are in Asia, with Russia and Brazil also on the list. Not just in these economies, but in a broader range of emerging market economies, reserves run far in excess of six months of imports and 20% of GDP, which in any context would represent extremely conservative insurance policies against an interruption of international capital flows. In the meantime, the return on these assets, which are typically short term and low risk in nature, is well below the average rate of return available on domestic assets. Former US Treasury Secretary Larry Summers estimated more than a year ago that the opportunity cost of the excessive wealth tied up in reserves was some 2% of those economies’ GDP, or the equivalent of global foreign aid or the next round of gains from global trade liberalisation! And, of course, there is also the threat of major capital losses on these assets should the dollar continue to decline. Ten H

Top Ten Holders of
FX Reserve ($bn, latest)
China 1420
Japan 946
Eurozone 482
Russia 425
Taiwan 267
South Korea 257
India 232
Singapore 153
Brazil 163
Hong Kong 141

The sterilisation of fx reserves is a further problem, especially in countries with relatively underdeveloped money markets. Commercial bank balance sheets can become saturated with sterilisation instruments, forcing interest rates on them higher and adding to the cost of the process. China, for example, is suffering consistent problems in controlling monetary growth and is now seeing rapid asset price inflation spill over into more elevated rates of increase in goods and service prices. An alternative mechanism to limit monetary growth is to raise the reserve requirement ratio, which China has been doing consistently of late. But while this is not costly for the central bank, it does represent a tax on the banking sector and can promote disintermediation as non-banks seek to by-pass the requirements.


It was worries about inflationary policies and the fact that monetary policy in the core was too loose for the periphery that triggered the demise of Bretton Woods I. The late 60s saw first France and then Germany and Britain all start to swap their dollar reserves for gold as they questioned why they should continue to accumulate assets at depressed yields in a currency that was only going to go one way – down. We may well be witnessing a similar situation today, as spare capacity is increasingly exhausted and price pressures in the emerging world build – the greater the instability in prices, the greater the likelihood of currency realignments.

And the members of Bretton Woods II have already begun to adjust their behaviour. For some time now, they have been gradually diversifying their fx reserves away from dollars. The dollar share of global reserves was more than 71% in the late 1990s. It is now under 65%, with the Euro (25.6%) and Sterling (4.7%) the prime beneficiaries of the rebalancing. In addition, a number of countries have set up, or are in the throes of setting up, sovereign wealth funds in an effort to achieve a higher rate of return on their reserve assets by investing in a broader range of assets. Korea and China are just two examples of those choosing to go down this path.


And finally, countries are proving more willing to let their currencies rise. China has widened its intervention band from 0.3-0.5% and officials have talked openly of the pressures building for a faster pace of appreciation. But attitudes to revaluation have evolved right across the emerging world, from Brazil to India, from Russia to Turkey, and from Vietnam to Kuwait.

Although not without some merits – for example, it encouraged us to consider how national balances of payments fit together as interdependent elements of a larger system – the Bretton Woods II thesis was, in truth, always a stretch. It was based on a superficial view of history and encompassed a good deal of complacency about the negative aspects of the regime. It implied the existence of a cohesive bloc of countries happy to act in their collective self-interest for a protracted period – in effect a cartel. But cartels tend to break down under strain. And just as in the late 1960s, it is in the interest of each member to exit the cartel before the dollar collapses.

If Bretton Woods II is, indeed, now unwinding, then there are some clear market implications. First, the dollar is going to fall further, perhaps substantially so, and second, a number of pegs and quasi pegs will be broken, or at the very least evolve in some way, shape or form. Of course, politics will play a part in the precise timing and nature of this evolution, especially in countries like Saudi Arabia or Hong Kong, but generally speaking, the currencies that will probably gain most will be those that have the largest current account surpluses and most dynamic economies – in this sense buying a basket of emerging Asian currencies would appear to be a sensible strategy. In the meantime, asset diversification will provide greater support to equities and remove some support from US Treasuries, although whether this rebalancing of demand will be sufficient to dominate the effects of the underlying cyclical dynamics in the world economy is open to question.