Let me start off by saying that the following article is both speculation on my part and addresses other speculation that I have seen circulating online. Bretton Woods II is a term being used by the media to address the calls by international leaders to revisit the Bretton Woods System. This has led to speculation, in my opinion incorrect speculation, that world leaders want to return to a Bretton Woods System in its classical architecture.
The Problems We Are Facing
The original Bretton Woods laid the groundwork for institutions such as the World Bank and the IMF. Now the feeling is that these institutions are not doing a good job in terms of forecasting risk and should be more active in terms of managing global imbalances.
At the heart of this discussion is the conflict over global regulatory competition that has dominated the financial markets since the move off of the gold standard. Countries seeking to make themselves more competitive have sought policies to devalue their currencies and the buildup of foreign exchange reserves has allowed countries to intervene in their markets. Central to this discussion is likely an attack on China which has amassed FX reserves while keeping its exchange rate artificially low. This has allowed it an advantage in terms of pricing power that has turned the country into a manufacturing behemoth. China's willingness (or lack thereof) to join the international community will have massive implications on the outcome of the meeting.
We have also seen massive currency fluctuations that threaten economic stability. Although I am in the business of speculating on currencies, I recognize how destructive the fluctuations are on companies and economies.
Firstly, managing exchange rates introduces an expense that takes away from a company's core business. An ideal system would have companies focus on producing as many products of the best quality at the best price possible. Exchange rates detract from that goal and shift resources from R&D to management.
Secondly, changes in exchange rates change the competitive edge of a company. Let's say a company has a superior manufacturing process that affords it a 5% edge. If the local currency moves 5% against it, its global edge is reduced to zero and a less efficient company can compete because the value of their currency is weaker.
So the obvious answer is to hedge currency fluctuations but this is not without its risks. There is, of course, the issue of cost but there is a far larger risk that has played out in recent months. Most foreign companies were hedging USD exposure and the world was largely short dollars.
The run up we have seen in the dollar has caused massive losses on hedges world wide, particularly in South America. It now appears that there was a very asymmetrical risk to these hedges as the run up in the dollar has been associated with weakening global fundamentals and lower prices. Either these businesses would continue doing business as normal with no negative dollar effects, or they were destined to take massive losses due to bad hedges at a time when demand for their products is slowing and prices are dropping. Hindsight is 20/20 but the situation that these companies find themselves in today is very serious and the risks were clearly unevenly distributed.
FX Reserve Imbalances
Taking a look at a list of FX Reserves, it's clear to see who the winners are - Asian countries. I have been struggling to think about how this imbalance may play out as the game appears to be unstably one sided. Essentially what we are seeing is ballooning FX reserves backed by U.S. treasuries and the only way I can possibly see this imbalance being fixed is through the crash of treasury values. The reason that I say this is that there is a clear solution to other imbalances such as reserves built up by oil exporters who use their oil income as revenue (Iran, Venezuela, etc). Their reserve balances will shrink due to a lower oil price, and will likely reverse when the world ultimately moves off oil.
The U.S. deficit should be one of the topics discussed at the G-20 meeting and the idea of how other countries are funding U.S. consumption should be addressed. How to resolve the issue is something that I won't even try to tackle, but the long term implications of this problem may be put it on the sidelines for now. It is likely that what they call long term reforms will actually be shorter term confidence boosters for the global economy.
Currency Implications
It is argued that a lot of these problems can be fixed by returning to the gold standard and the words 'Bretton Woods' have definitely increased speculation. I believe that the conference will focus on how the international community can better work together and I wouldn't be surprised if they issue some sort of measure intended to reduce currency volatility. However that will fall short of a gold standard for many reasons:
- At present, countries are looking for a way to expand credit, not limit it. A move to a gold standard at current times would likely prolong the period of lower output and higher unemployment.
- Inflation, or currency debasement, is not the issue at hand. The discussion will focus on how to get credit to the private market and how to restore confidence so that institutions continue to lend.
- Bernanke is considered by many to be an expert on the depression. His studies have led him to believe that countries that remained on the gold standard during the Great Depression took far longer to recover. His remarks from a 2004 speech support the idea that he is against the gold standard.
What I will be watching for is exactly the opposite of a return to the gold standard. What we may see is the groundwork for a system of credit expansion that would be super inflationary once credit starts flowing. The reason that I say this is that government actions usually have unintended consequences. The current fight is one of getting credit to the market and avoiding global deflation. The problem is obvious - how do you get credit to the market, avoid inflation AND re-instill confidence in both banks and sovereign nations (and in turn their currencies)? New tools will be emphasized as interest rate cuts are not addressing the root problem. It should be recognized that low nominal rates, even 0% is not inflationary in a deflationary environment as has been seen in Japan over the past 20 years.
Summary
Calling this summit a G-20 summit is more appropriate than Bretton Woods II. The central focus will likely be China's weak currency, ballooning reserves and aggressive export led growth policies. As pointed out in the WSJ, China will want significant concessions if it decides to play along and Europe would have to concede some of its power to China in the role of international financial relations. How this plays out is anyone's guess, but returning to fixed exchange rates or a gold standard is a very unlikely result.
See Also: Financial Times
Disclosure: Author is invested in TBT, far OTM gold calls and Yen
