At $47tn, the gross international investment position of the US is 20 times bigger than Brazil’s, 51 times bigger than India’s. Any movement into and out of US assets is sizeable relative to other and may translate into sharp asset price and exchange rate movements

October 2, 2013 10:03 am

Dollar-based system is inherently unstable

By Ousmène Mandeng

The international economy needs more currencies

The international monetary system does not work as intended. An international economy relying predominantly on one currency is inherently unstable. This is amply demonstrated by the recent turbulence in foreign exchange markets. Over the summer, several emerging markets faced sudden reversals in capital flows. Blaming economic fundamentals to explain such shifts misses the point. There are none sufficiently important.Only a few months ago there was heightened concern about too much capital flowing into emerging markets. In recent weeks, emerging market currencies have been roiled due to investors’ concerns about the direction of US monetary policy. Earlier this year, theyen was under pressure due to expected changes in Japan’s economic policies; and before that it was sterling, because of acute bank funding constraints.

They all illustrate one point: that the international monetary system is out of order. The rules and regulations that guide foreign exchange regimes and international liquidity to foster orderly exchange rate adjustments do not function adequately.

The culprit is the dollar

The international economy relies overwhelmingly on the dollar to manage international liquidity, trade and investments. This has provided many advantages. Yet, the asymmetry between the stock of internationally tradable, fungible, relatively safe and liquid dollar assets and other currencies represents a fundamental source of instability.

At $47tn, the gross international investment position of the US is 20 times bigger than Brazil’s, 51 times bigger than India’s and 74 times bigger than South Africa’s. Any movement into and out of US assets is sizeable relative to others and may translate into sharp asset price and exchange rate movements. There is little that small open economies can do about it over a given time horizon.

The relationship between the dollar and the international importance of US assets implies that the spillovers of US monetary policy are unmatched. Yet, the dollar is a national currency and the Federal Reserve is unlikely to subordinate its national policy objectives to the needs of the international economy.

For a system to rest on a dominant or key national currency there needs to be a considerable degree of convergence between the core (issuer) and the periphery (rest of the world). This is simply not the case.

The currency jitters will undoubtedly reinvigorate a debate about the need for bigger safeguards. Yet, it seems reasonable to assume there is no amount of International Monetary Fund resources large enough to fend off possible currency attacks; and there are no international reserves plenty enough to sustain foreign exchange interventions for long.

At the same time, little use is made of existing central bank reserves or of schemes such as central bank swap arrangements to signal forcefully that critical exchange market liquidity will be provided.

Advances on macroprudential measures may help but at the same time risk stifling cross-border capital flows.

Capital controls may come up for discussion, but their imposition would move the international economy away from vital further integration. Any such development would need to be accompanied by a debate about the trade-offs between liberalisation, growth and stability. As an example, take China’s closed, though increasingly leaky, capital account, which constitutes a key source of international instability.

Policy makers appear to lack the courage to reform the foundations of the system and are more inclined to fiddle at the margins.

The IMF, supposedly at the centre of the system, shows little interest. The last meaningful reform goes back to the 1970s. Recent attempts by the G20 in 2011 failed.

For the international economy to work better, dependence on the dollar will need to be reduced. Recurrent exchange crises and high asset price volatility are otherwise likely to remain the norm. More diversification in currency use would help put the international economy on a broader footing and shield it against the vicissitudes of US national policies.

The most important lesson from the recent jitters, therefore, is that the international economy needs more currencies, to allow orderly adjustments. Financial safeguards or significant economic policy adjustments, though warranted in select cases, are not the answer. But any change requires some vision about the future of the international monetary system. The upcoming IMF annual meetings would provide a good starting point to develop such vision.

Ousmène Mandeng is managing director of the global institutional relations group at Pramerica Investment Management