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:
- Beefing up the IMF, with more funds and extra seats on the board for developing economies, notably China.
- 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:
- 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.
- 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.
- 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:
- 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.
- The evident difficulties of transition – a collapse in the U.S. dollar would hurt everyone.
- 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.