Last week, I had argued that “If there are problems in managing the exchange rate … because of capital inflows, the correct course is to curtail the latter: Too many countries have suffered by allowing the currency to appreciate because of capital inflows, and the current account deficit to become unsustainable (Mexico 1994-95, East Asia 1997-98, Argentina 2001)”. I had not imagined that another BRIC member would act on the point so soon. On Tuesday, October 20, Brazil imposed a tax of 2 per cent on all inflows of portfolio capital to stem the rise of its currency. (Earlier Brazil had imposed a tax on inflows in the debt market but that was withdrawn last year.) The overheated stock market promptly fell, and so did the real. The Financial Times carried an editorial on October 22, that the tax was “a good choice by the government”. It remains to be seen whether the move will work and one wonders whether an interest free margin as a percentage of the inflows, to be kept with the central bank by the investors, which worked so well in Chile earlier, would not have been better. It is for the first time since Malaysia in 1998 that a developing country has taken such step to control capital flows. One compliments the Brazilian authorities who put the needs of the real economy before the commands of the Chicago School, market-fundamentalist theology.
Interestingly, on the subject of capital flows, in a speech delivered on October 19 in Washington, Chairman of the Federal Reserve Ben Bernanke compared the 2007-08 financial crisis “with past emerging market crises fuelled by giant capital inflows that overwhelmed both market discipline and regulatory safeguards against the mispricing of risk”. That’s quite a change from the push to capital account liberalisation for developing countries, so fashionable in Washington less than two decades ago! And, in an embarrassing U-turn, the IMF may now need to help developing countries to manage capital flows, as recommended not only in the draft report of the UN Commission on Reforms of the International Monetary and Financial System (‘Full convertibility-II’, September 28), but also by the G20! To quote from the communiqué at the end of the Pittsburg Summit, “The IMF should ….strengthen its capacity to help its members cope with financial volatility, reducing the economic disruption from sudden swings in capital flows and the perceived need for excessive reserve accumulation.”
Dollar’s reserve currency role
As early as 2006, Avinash Persaud had argued that, by 2050, China and India were likely to be bigger economies than the US, EU or Japan, and that “In the case of the US today, the process (of US decline) is also being accelerated by wars where the end is as elusive as the enemy and by a consumerism built on a property bubble. Perhaps we will not have to wait until 2050. In my lifetime, the dollar will start to lose its reserve currency status, not to the euro, but to the renminbi or the rupee. The loss of reserve currency status, for the US will bring economic and political crisis. If it was economically and politically painful for the UK (to lose its reserve currency status), even though its international financial position did not begin from a position of heavy deficit, what will it be for the US which has become the world’s largest debtor?”
Persaud is by no means alone in expecting a change in the status of the dollar as a reserve currency. Earlier, I had quoted The Economist on the issue (‘Balancing exchange rates’, October 12). World Bank President Robert Zoellick, in an address to the School of Advanced Studies just before the last Fund Bank meeting, echoed the same thought, arguing that “The United States would be mistaken, to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar”. UNCTAD, in its Trade and Development Report 2009, has claimed that “In the discussion about necessary reforms of the international monetary and financial system, the problem of the United States dollar serving as the main international reserve asset has received renewed attention. Central banks, motivated by the desire to reduce exchange-rate risk in a world of financial and currency instability, have been increasingly diversifying their reserve holdings into other currencies, in particular the euro”.
Over the last decade, the proportion of dollars in global reserves has gone down from 72/73 per cent to 62/63 per cent with a corresponding rise in the euro’s proportion to 27/28 per cent (balance is sterling and yen). Recent research by Barclays Capital suggests that during Q2 of this year 63 per cent of fresh reserves were placed in the euro and the yen, neatly reversing the proportions. Meantime, nine leftist countries in South America have agreed on the creation of a new currency, the sucre, for regional trade.
To me, the dollar’s days as the world’s sole reserve currency are numbered — whether in years or in decades, whether in a sudden collapse or a gradual transition. But more on this next week.
