Manas Chakravarty: The unravelling of Bretton Woods - II

Asian central banks are diversifying away from the dollar.

Foreign institutional inflows have risen sharply after the Union Budget. Emerging Portfolio Fund Research says that equity flows to emerging markets in February have been the highest in a month ever since they started tracking fund flows in 1995.

Even among emerging markets, portfolio flows to India have been very high, thanks to large bets being placed on the structural transformation of the Indian economy. That rosy scenario for emerging markets may now be in danger, with rising US interest rates, slowing fund flows and a stronger dollar.

Foreign institutional investor (FII) flows have also had an enormous influence on the debt and currency market. The dollar inflows have resulted in upward pressure on the rupee, and the Reserve Bank of India (RBI) has had to buy dollars hand over fist in an effort to keep the rupee down.

This has in turn led not only to a rapid increase in forex reserves, but also to higher liquidity in the money markets, as the dollar buying by the RBI releases rupees into the system. The upshot has been a cap on interest rates, in spite of record credit offtake.

It is not just the equity markets that will be affected should the foreign inflows slow down. We all know what happened in January, when a sudden strengthening of the dollar was enough to spook the market.

So what can spoil the party? Many economists, Morgan Stanley's Stephen Roach among them, have for long been pointing to the mounting global imbalances, with the bloated US current account deficit being the main point of concern.

The argument is simple "" central banks in Asia, notably those of Japan and China, have been financing the US current account deficit and losing money in the bargain, because the dollar has been falling.

There will come a time, so warn these economists, that Asians will no longer be willing to recycle their dollars to the US. The dollar will then plunge, US interest rates will rise, the overextended mortgage market in the US will collapse, and the US economy will slump.

Needless to say, risky assets like emerging market equity and debt will be dumped. And since America has been the engine of the world's economy, the rest of the world will then follow the US into an economic Armageddon.

Bretton Woods -- II
That argument seemed very logical, but when years passed without the feared meltdown, people started wondering whether things were different this time. In a seminal paper in 2003, economists Michael Dooley, David Folkerts-Landau and Peter Garber said that the present system was a second Bretton Woods, a system that allowed the emerging economies to develop.

They pointed to the parallels with Bretton Woods, when Europe and Japan maintained undervalued currencies and controls on capital movements and built up forex reserves from their exports to the US, while the US maintained open markets.

These economists point out that the Asian central banks, by funding the US current account deficit, are essentially ensuring export markets for their countries.

Of course, Asian central banks may be making losses on their dollar holdings, but, according to Dooley, Landau and Garber, "it has been a successful development strategy to subordinate the objective of maximising the value of reserve assets in order to subsidise and build a domestic capital stock capable of competing in international markets."

If the strategy is so rational, will the limits of such a build up of forex reserves ever be reached? Yes, it will, but far in the future, when these emerging economies are no longer part of the "periphery" but have graduated to the centre, just like Europe and Japan before them. Bretton Woods Two is, according to these economists, a rational development strategy in the age of globalisation.

Dumping the dollar
But the proof of the pudding lies in the eating. Recent data released by the Bank for International Settlements (BIS) point out that deposits placed abroad by Asian banks have been "increasingly denominated in currencies other than the US dollar".

For the region as a whole, the share of dollar-denominated deposits fell from 81 per cent in the third quarter of 2001 to 67 per cent in the third quarter of 2004.

This shift was most evident for Indian banks, whose share of dollar-denominated deposits to their total deposits fell from 68 to 43 per cent in the last three years, while China's share fell from 83 to 68 per cent, remaining more or less around 68 per cent since the third quarter of 2002. An earlier BIS report had pointed out that dollar-denominated deposits of west Asian banks had also declined significantly in the last three years.

Nevertheless, the BIS emphasises that "dollar-denominated deposits placed by banks in the region continue to rise in absolute terms suggesting, at most, that the currency shift described above is taking place at the margin." It's also worth remembering the data doesn't include Japan, which has the world's largest forex reserves. Nor does it include Hong Kong and Singapore.

The BIS report also says that Asian currencies no longer form a dollar bloc. Academics who supported the Bretton Woods Two argument had said that effectively the east Asian currencies constituted a dollar bloc because of their interest in pegging their currencies to the dollar, in order to keep their exports to the US competitive.

The BIS, however, finds that turnover in Asian currencies has been rising in recent years and intra-regional trade too is increasing. Consequently, "a broad-basket effective exchange rate orientation may be gaining prominence". Putting it simply, the dollar is no longer quite as important as it used to be in Asia.

Also, US treasury data for December 2004 showed that official net purchases of US securities fell to a mere $10.3 billion, down from $ 27.9 billion in the previous month. Net private purchases in December, however, at $72.6 billion, were at more or less the same level as in the previous month.

But then, although foreign official (read central bank) purchase of US securities was low in December, it had been even lower in July and had bounced back. One month does not a trend make. What's more, net private foreign purchases were much higher than in most months during 2004. Total net purchases, at $82.9 billion in December, although lower than November's $100.7 billion, were substantially higher than in July, August, September and October.

Moreover, despite a steadily declining dollar, net US securities purchased by foreigners in 2004 amounted to $915.8 billion, well above 2003's $745.9 billion or 2002's $ 547.6 billion. The data, at least, do not show any strong aversion for US assets among foreigners.

That's corroborated by the latest Treasury data for January, which shows foreign purchases of US securities at $92.5 billion, with both private flows as well as official flows well above the December level. While the inflows are more than enough to finance January's $58.3 billion trade deficit, much of the inflows have been by hedge funds, which is no prescription for stability.

While the BIS data show the trend in diversification away from the dollar over the past three years, and explains the fall in the value of the dollar over the period, the numbers from the US Treasury do show a deceleration in the accretion of foreign holdings by Asian central banks. This deceleration has speeded up the dollar decline.

Diversification
That is backed up by plenty of talk by central banking authorities throughout Asia. China has drawn down its forex reserves to recapitalise its banks, Thailand has drawn up a plan to fund infrastructure using forex reserves, as has India.

The South Korean central bank inadvertently made public its plan for diversifying its reserves out of the dollar, a plan which it was, however, quick to deny when the dollar plunged. The Chinese authorities too have frequently said that they need to do the same.

On Thursday, Japanese Prime Minister Koizumi's assertion that Japan will diversify its assets away from the dollar sparked a sell-off in the greenback. What's more, bond yields, and mortgage rates, have started moving up in the US.

Of course, there are also many forces holding up the dollar. The strength of the US economy could once again lure private investors back to the US, and the January Treasury data do in fact show strong private inflows.

Rising US interest rates could also prop up the greenback. And finally, every central bank has a vested interest in a soft landing for the world's reserve currency "" as the Bretton Woods Two proponents point out, Asian countries derive strong benefits from the present system.

Perhaps all that will happen is a gradual depreciation of the dollar, which will continue to be positive for emerging market assets, till higher US interest rates finally bite. But there are now more and more signs that Bretton Woods Two is slowly but surely unravelling.