Saturday, October 25, 2008

Bretton Woods 2....The next Shoe to Drop?

Recently I read Brad Setser's blog "The end of Bretton Woods 2?"( in which he referenced a paper written by himself and Nouriel Roubini in 2004. Bretton Woods 2 refers to the currency exchange rate relationship between industrialized nations that was negotiated and agreed to at the end of World War 2. 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States and agreed upon structures of international finance including the creation of the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF). The original Brenton Woods system sought to take advantage of the Gold standard and developed a system of fixed exchange rates. What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money). A number of economists (e.g. Doole, Folkerts-Landau and Garber) have referred to the system of currency relations which evolved after 2001, in which currencies, particularly the Chinese renminbi (yuan), remained fixed to the U.S. dollar as Bretton Woods II. The argument is that a system of pegged currencies is both stable and desirable, a notion that causes considerable controversy.

According to Wikipedia:
"Bretton Woods II", unlike its predecessor, is not codified and does not represent any kind of a multilateral agreement. It contains the following key elements:

* The United States imports considerable amounts of goods, particularly from East Asian export-oriented economies such as China, Japan and various other Southeast-Asian countries.
* Since China and Japan don't have much demand for U.S.-produced goods, United States runs large trade deficits with both countries.
* Under normal circumstances, trade deficits would correct themselves through depreciation of the dollar and appreciation of the yen and the renminbi. However, the Chinese and Japanese governments are interested in keeping their currencies low with respect to the dollar to keep their products competitive. To achieve that, they are forced to buy large quantities of U.S. treasury securities with freshly-printed money.
* Similar mechanisms work in the Eurozone with the euro and its satellite currency (Swiss franc). The Eurozone is somewhat less coupled to the U.S. economy, so the euro has been allowed to appreciate considerably with respect to the dollar.

What I believe Roubini and Setser are arguing is that the pegged relationship of Asian currencies (primarily Renminbi)to the U.S. Dollar and the required reinvestment of Chinese surpluses into U.S. credit markets to maintain these pegs are inherently, unstable, self-reinforcing, and susceptible to a gross mis-allocation of capital (e.g. the U.S. Credit Bubble). I also think they are both surprised by the inverse nature of the current financial crisis and both believed that a weaker dollar would eventually jeopardize the China / U.S. trade relationship prior to cooling housing prices.

So will a rapid process of de-leveraging amongst financial intermediaries be the tipping point for the end of Bretton Woods 2? There is already very clear evidence that the Chinese and Petro-dollars are no longer chasing agency bonds (quite literally the only source of credit within the real estate market). Instead these funds are being shifted to treasury bonds and financing the TARP program recently put in place by Paulson. I suspect that cash strapped American consumer will continue to cut back on discretionary spending and cut the American lifeline to the Chinese and petro state economies. The wealth effect, permeating from the free fall in asset prices, will force American's to change their previously impenetrable spending patterns. By stopping this flow of funds to the Chinese and severely limiting the revenues of oil based economies the creditors of America's $800 billion current account deficit will be forced to rescind. The symbiotic twin engines of growth have stumbled upon a breaking point in their self reinforcing relationship. All signs point towards asset prices falling far below fundamentals.