G20 Could Surprise Currency, Gold and Bond Markets

Don’t write off the London G20 meeting. It could lay the foundations for fundamental global change, impacting currencies, gold and bond markets. Understandably, most commentators are cynical about the April 2 meeting in London achieving anything major and British newspapers mostly enjoy mocking Gordon Brown’s hopes for the meeting. But take two of the expected outcomes from the meeting and then look at some other developments afoot and we could be facing a momentous shift.

The two expected outcomes to note are:

1. Beefing up the IMF, with more funds and extra seats on the board for developing economies, notably China.
2. Agreement to regulate global financial markets and institutions more closely.

Not exactly Bretton Woods II (the original 1948 Bretton Woods conference gave birth to the post WWII financial system) but these two outcomes are building blocks.

Now, consider three other developments:

1. The major central banks have been cooperating to an unprecedented extent in soothing currency markets and global flows of capital. Their (quiet) harmony is all the more striking compared to the disagreements and brawls amongst political leaders.
2. The U.S. government – as many others – is in need of large scale bond sales to fund growing fiscal deficits, leading to some nervousness in markets about the future paths of interest rates, exchange rates and inflation. It’s very hard to assess risk and pick winners and losers amidst current volatility and faced with the coming wall of government debt.
3. Global concern over the soundness and role of the U.S. dollar. China has been pressing the U.S. to ensure the soundness of the U.S. dollar. As I've illustrated before, China is signaling its expectations to the U.S.

Put those five forces for change together and you have the basis for Bretton Woods II. China has signaled the shape of this. The Chinese have weight as lender of first and last resort to the U.S. and the rest of the world have no interest in seeing available resources continually sucked in to feed U.S. debt habits.China suggests building the IMF’s special drawing rights into a viable reserve currency for international trade. The statement a few days ago by Zhou Xiaochuan, Governor of China's Central Bank, can be seen here. This is not seeking to dethrone the role of the U.S. dollar as the world’s reserve currency. This would be unwelcome to both the U.S. and to China as the biggest foreign holder of U.S. dollars. Rather, China is asking the U.S. to take a demotion by sharing its throne with other currencies.

The idea of a basket is not new. In 1948, Keynes suggested the bancor, based on a basket of commodities The path to the Euro was paved by the ECU, a basket of European currencies. From 2005 to 2008, the Chinese ran their currency against a basket of the currencies of their main trade partners. Russia has similar views to China about a basket of currencies or regionally based funds providing a global reserve fund, and been arguing the case for some time. From media reports poorly covered in the U.S., the four BRIC countries (Brazil, Russia, India and China) are aligning their agenda for the London G20 on this. They also appear to have gained the support of South Korea, South Africa and Indonesia – that is, at least seven of the G20 look likely to support this route. The U.S. has said a clear “no” to the Chinese idea, but we have lately seen the U.S. backtrack before Chinese pressure. At the London G20, they could well find themselves in the minority, depending on the position of the Europeans. The Eurozone countries might well find the BRIC proposal attractive as it would be liable to further boost the role of the Euro.

If so, a clear majority of the G20 (and of the world economy) would favor the Chinese suggestion. Indeed, the basket of currencies could probably be tailored to remove upward pressure on the Japanese Yen and to recognize Arab oil interests (who have been favoring the Euro over the U.S. dollar).

The main beneficiary of the current role of the U.S. dollar as global reserve currency is the U.S. The crisis exported from the U.S. has left the rest of the world experiencing significant costs – both directly from the crisis and from the sucking in of available funds to service America’s problems. Potentially, the U.S. could find itself isolated at the G20.

The brakes on replacing the U.S. dollar as the international reserve currency have hitherto been:

1. The lack of a suitable replacement, as the Euro and Yen have their own problems and all other currencies (including China’s) are insignificant in international finance and trade.
2. The evident difficulties of transition – a collapse in the U.S. dollar would hurt everyone.
3. The determination of the U.S. to retain the global role of the U.S. dollar.

The Chinese approach overcomes (a) as a basket of currencies is used. On any basis of calculation, the two main currencies would still be the US dollar and the Euro but with others – and notably the Chinese Yuan - given some weighting. Transition to a basket of currencies still looks tricky, but if central bankers cooperated, such a shift could be accomplished without massive disruption of trade or currency relativities. The G20 central banks could agree to hold their currencies within set bands in relation to each other and to ban various forms of speculative currency trading. This would damp down market movements and give time for the details of a currency basket to be thrashed out. The mechanisms of the 1960s and 70s - with currency bands and crawling pegs for exchange rates - could return. Provided the big central banks remained united, they could quash any Soros style attempt to break the emerging system. In short, problem (b) can be dealt with.

This leaves us with problem (c). In the 1990s, the U.S. fiercely opposed the setting up of the Euro – for the same reason - but failed. Now, a weakened U.S., dependent on Chinese and Arab funding for its debt, would find it a very risky strategy to refuse to cooperate with a G20 majority. The Fed cannot defend the dollar or U.S. financial markets without the cooperation of other major central banks, as the events of last September and October demonstrate. If and how quickly all this plays out is hard to say, but the London G20 on April 2 could hold some surprises. To the extent the China-Russia idea emerges as a runner, the impact on currency, gold and bond markets could be profound.

Comments

[ZigZag]

Simon Smelt would please help us by spelling out exactly what impacts a basket of currencies would have on the Euro and gold.

2009 Mar 30 06:57 AM

[socrateazz]

One of the problems looming on the horizon for the US is their currency being the world's reserve currency. The US balance of trade has been negative for so long because everybody wanted more dollars to spend. I think a real intenational money should be developed denominated in $1,000, 000 actual dollar chunks accepted by all leading nations. and released into the economy in large chunks, say 100 billion (maybe a different level would be good) a month! It would be acceptd as reserve currency and smaller chunks would have to trade between current monies. Any money devauation or revalation would have to be supported by their previous three months balance of trade. and all would be reevaluated relative to the reserve currency. If the money value is great enough then every unit can be followed and accounted for under some kind of system and counterfieting would be minimal

2009 Mar 30 07:06 AM

[DONE_SONZ]

Any currency not backed by gold is just paper.The more printing of it just lowers its supposed value even more and buys even less.

2009 Mar 30 08:13 AM

[morph366]

Interesting points but I think that a slow transitional process towards fixing cross rates for a new currency based on the SDR or a new basket would not be the way to go. It would need to be a one time decision as happened with the establishment of the Euro at the end of 1998 where conversion rates were fixed irrevocably by the EU parliament even though there was a period during which the old currencies were still accepted as legal tender.
For one thing central banks are not good at managing currencies within bands - the ERM illustrated that.
At present It would be a horrendously tough negotiation to fix the rates and for that reason - amongst others (i.e. the US will fight the proposal tooth and nail) - it will almost certainly be kicked into the long grass at the G20 meeting this week.
If there is to be a replacement for the USD (and perhaps Keynes was on the right track with the bancor) one suspects that it may have to wait until there is another super critical event before the politicians will, in moments of panic induced epiphany, see the wisdom of it.
Also just as a matter of fact the first Bretton Woods Conference was held in 1944 and not 1948 as the article cites.

2009 Mar 30 08:44 AM

[dybydx]

The US can choose to enforce the USD role as reserve currency (by dictating its terms at the IMF), in which case the world (including China) has few choices but to keep buying up USD.

OR

The US can allow the USD to lose its role as reserve currency in which case the world (including China) will buy alot less USD and more of other currencies.

2009 Mar 30 09:53 AM

[doubleguns]

If a reserve currency other than the dollar is established there will be less demand for the dollar and dollar holders will see thier holdings begin a downward slide. I would think that this is what they would want to keep to a minimum but possibly all countries holding dollars would throw them into the basket immediatly to "purchase" this new currency and thus get rid of the dollars that are going to begin a downhiill slide. This would leave the US suffering the impact and remove this risk from those holding dollars in hugh quantities.

Looks bad for the US if this happens. Hyper inflation becomes more probable in the future unless we get our debt in check and the present 3.7 trillion budget is a big giant nail in our coffin.

2009 Mar 30 10:38 AM

[dybydx]

I would support the 3.7T spending spree if the result is a more competitive economy. But right now, most of that money went to deadweight assets which should have been a sunk cost. Not a prudent investment plan in my opnion.

2009 Mar 30 03:21 PM

[overtaxed42long]

The only way to fix the illegal use of the banking communities manipulations of currency is to use currency based on something that has its own value. Gold, silver, copper, platinum are the only ones that fit the bill. Each has different value levels and each has been held through history as money. The way these banks use interest rates to hold us hostage is shameful to everyone not a banker. We let them dictate to us how much our money is worth and how much interest we pay to borrow it and then how much they will pay, if any, for us letting them borrow it. With real currency, no one would have to worry about their dollars being stolen through interest rate hikes and the unstoppable printing press. Support the effort to make the Fed Reserve accountable by supporting the law they be audited. Bet you didn't know they are never audited did you? They are accountable to no one. Particularly unaccountable to the US or its citizens. This audit would be a start in the right direction of ending the Fed. So if your tired of worrying about wether or not the money you've worked your whole life for is worth anything tommorrow, call your congressional and senatorial elected thieves. Tell them to make the Fed accountable. It is your money and your future at stake. End the Fed. Use something worth something for money just like it mandates in the Constitution. Only Congress has the authority to coin money and is required to use only gold and silver. Paper will always only be one thing. Paper.

2009 Mar 30 06:57 PM

[change is the only constant]

Much ado about nothing. Stock Market decoupling has to succeed first before the US the dollar would be either slowly or quickly replaced by a basket or another country's fiat paper as reserve currency.

The G19 is waiting for the US to recover and biding time until that happens. Oil is falling and gold is rising (or at least stable). Globally, for most commodites and maufactured goods, demand is falling and suppliers are reducing the fat in inventories.

There won't be any surprises. And that is a good thing.

2009 Mar 30 08:08 PM

[The Geoffster]

Buy gold and short treasuries but don't short the USA for the long count unless Obama really is a socialist in which case learn Mandarin.

2009 Mar 30 08:10 PM

[Mr. Ed, Jr.]

Not the sort of thing that is likely in the midst of a global crisis, with some currencies and economies hanging by a thread, since it would just create more uncertainty. Down the road a bit, perhaps. For now, this is just talk.

2009 Mar 30 09:37 PM

[@TexasER]

Good article. But I have a beef.

Quite a popular opinion you have, "The crisis exported from the U.S. has left the rest of the world experiencing significant costs "

The entire world was complicit in this mess, gladly making money hand over fist until the music stopped. Not complaining one bit about their artificially weak currencies.

That being said, it is a popular opinion and perception is reality.

2009 Mar 30 10:30 PM

[Panda@War]

I don't think China could gain the majority on the issue this round in G20. US at least got half of them in the pocket: Canada, Mexico, EU, Turkey, Japan, Saudi.

So the shocks Mr. Smelt suggests are unlikely to happen.

However, SDR or similar form of reserved currency will be well on its way. Anyone with basic intuition and honesty will tell you that USD is on the mid-term and long-term devaluation trend, which gives the world no other options, since at the end of the road even EU can not afford to help US defending the dollar when the time is due. Another reserve currency is just a matter of time. China's remark makes a LOT of sense! To be a responsible leader, US should seriously consider it!

2009 Mar 31 04:46 PM