With the elections out of the way, attention is now re-focusing on the global financial crisis and the upcoming G20 meeting in Washington on November 15th. In that context much has been written about the need for a “new Bretton Woods” agreement, or at least, the hopes for one.
Martin Wolf makes his case in today’s FT. He outlines four main challenges a new agreement should address:
The first is the inability to gain a purchase on the policies of countries that run huge and persistent current account surpluses.
The second is that of financing countries subject to “sudden stops” in capital inflows of the kind we are seeing, as banks and other foreign-currency lenders cut off financing to a wide range of borrowers, particularly in emerging countries.
The third challenge is that of making the financial system less unstable and, above all, less vulnerable to such huge swings in risk appetite — from financing anything, however ridiculous, to financing nothing, however meritorious
The final challenge is that of making the global institutional architecture less illegitimate than today
He concludes it is not only possible but necessary to change the global architecture to reflect changing economic weights. The world must also give the IMF more financial resources in support of its new short-term lending facility.
In the original Bretton Woods, of course, it was decided member countries keep currency values pegged to the US dollar and, in the case of the United States, the value of the US dollar be pegged to gold. Those rates could be adjusted only to correct a “fundamental disequilibrium” in the balance of payments and only with the IMF’s agreement.
The system broke down when imbalances threatened to eliminate the gold reserves of the US, and Washington was forced to suspended the dollar’s convertibility into gold. So how could it work this time?
Writing in the FT last week, George Soros said it was time to start thinking about creating special drawing rights or some other form of international reserves on a large scale to sort out the crisis. This system should, he said, be subject to an American veto.
By “some other form of international reserves”, was he referring to gold once again?
And as for extending the sums of special drawing rights – how would that actually help or be achieved?
Firstly, how does an SDR – dubbed “paper gold” by some – even work? According to the IMF:
The SDR, or Special Drawing Right, is an international reserve asset that member countries can add to their foreign currency and gold reserves and use for payments requiring foreign exchange.
Its value is set daily using a basket of four major currencies: the euro, Japanese yen, pound sterling, and U.S. dollar. The IMF introduced the SDR in 1969 because of concern that the stock and prospective growth of international reserves might not be sufficient to support the expansion of world trade. (The main reserve assets at the time were gold and U.S. dollars.)
The SDR was introduced as a supplementary reserve asset, which the IMF could “allocate” periodically to members when the need arose, and cancel, as necessary. IMF member countries may use SDRs in transactions among themselves, with 16 “institutional” holders of SDRs, and with the IMF. The SDR is also the IMF’s unit of account. A number of other international and regional organizations and international conventions use it as a unit of account, or as the basis for a unit of account.
The number of SDRs in circulation currently stands at 21.4bn (a value of $31.96bn at today’s rates) with each member country allocated its own quota. That quota is determined according to many variables but very generally, the bigger the GDP and standing of the member country in the fund (in terms of economic weight, voting rights and openness), the bigger the quota.
There are provisions for the number of SDRs in the system to be extended, when needed. Any extensions are supposed to be proportional, impacting every member similarly. That’s not to say allocations for countries don’t change – the IMF reviews the quotas on a case-by-case basis every few years.
According to the IMF: most fund loans are financed out of members’ quotas. The exceptions are loans under the Poverty Reduction and Growth Facility, which are paid out of trust funds administered by the IMF and financed by contributions from the IMF itself and a broad spectrum of its member countries.
So it seems extending the number of SDRs in circulation could go some way to addressing the current liquidity constraints currently plaguing the system.
Jan Randolph, head of Sovereign Risk at Global Insight explains to Alphaville :
George Soros’ latest idea here I think is really all about boosting this SDR currency’s money supply, though still restricted to sovereigns in circulation, to enable them to maintain or raise levels of liquidity and therefore conduct more international trade. It would be of special help to emerging markets that may face liquidity pressures as a result of the credit crunch and unlike an IMF loan, would have few, if any, strings attached.
The reallocation of country quotas in any significant manner could also presumably address the large surpluses built up in countries like China. At the end of the day, the solution to the global financial crisis problem is connected to restoring liquidity and confidence to the financial system. To do so, many say the solution must address the current imbalances which see vast sums of dollars stored-away on some sovereign balance sheets and not on others.
Gordon Brown said Tuesday the surplus-holding Gulf States, many of whom already peg their currencies to the dollar, were ready to extend money to an IMF bailout fund at the G20. The question is could that money be channelled through an SDR framework?
SDRs potentially address another problem facing the system too. As Fred Bergsten, director of the Peterson Institute for International Economics,wrote in the FT a year ago, they could help restore faith in the dollar itself. His argument being, surplus nations in many cases have no choice but to bankroll the US debt, as diversifying into non-dollar denominated assets would have drastic consequences on their own currencies.
Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000bn, even a modest realisation of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy.
He adds the problem is further heightened by the fact that none of the countries into whose currencies the diversification would take place want to receive these inflows either. Through an SDR substitution account though the following could happen:
Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.
Via this system all countries would benefit, he says:
Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 per cent dollars, 34 per cent euros, 11 per cent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimising the loss on their remaining dollar holdings as well as avoiding systemic disruption.
Meanwhile, the US would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. As the cost of protecting against US sovereign default in credit default swaps increases, it’s certainly a case worth considering, especially as a proposal for a special one-time allocation to double the number SDR in the system is already in place. To go through, the proposal needs three fifths of IMF members (111 countries) with 85 per cent of total voting to accept it. As of March 2008, 131 members with 77.68 per cent of voting power had accepted it – reflecting the level of the demand for the measure. Approval by the US would now put the amendment into effect.
Related Links:
How to solve the problem of the dollar – FT.com
America must lead a rescue of emerging economies – FT.com
Why agreeing a new Bretton Woods is vital – FT.com
Copyright The Financial Times Limited . All rights reserved. Please don't copy articles from FT.com and redistribute by email or post to the web.