Sunday, February 15

Ducking götterdämmerung: SDR as the means to avert trade wars

In my Feb 8 post I noted that if the USA continued to shove smaller borrowers out of the way to fund massive spending rescues the rest of the world would be "so mad ... that one sure outcome would be IMF-issued SDR (Special Drawing Rights) replacing the U.S. dollar as the world's reserve currency." The observation was behind the curve of events. From Ambrose Evans-Pritchard's column Failure to save East Europe will lead to worldwide meltdown for today's (UK) Telegraph (H/T Naked Capitalism):
[...] It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system.

Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.

The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.
So this is not just a US dollar-borrowing problem; where in Sam Hill are 400 billion euros going to be found on short notice without running the printing presses to such extent that hyperinflation is tripwired?

This is also the problem with the drastic solution of nationalization of the biggest banks in the USA and Europe. In an Feb 9 update to my post, while praising Martin Wolf's analysis and advice, I asked where all the money was to come from for an all-out assault on the crisis that he conceives.

In theory, letting governments handle both sides of bank insolvency via nationalization just might work. In practice, the nationalization proposal runs into the same problem as the patchwork ones:

How do you raise all that paper money without hitting the hyperinflation tripwire? Whether you print the stuff in large enough amounts to stem the crisis or run up its value through fierce borrowing competition, you arrive at the same tripwire.

A workaround could be to take pressure off the most heavily traded currencies, including the world's reserve currency (the USD), by making a market in SDR that is created for the purpose of fooling around with toxic assets.

Because the accounting would be so arcane that nobody but the Lords of the Craps Table could understand it, this would stop the panic about marking down toxic assets to the point where everyone knows how many banks are insolvent.

Would anything but hope back that many SDR? You'd be surprised what the Lords of the Craps Table can think up when called upon to save The Casino -- the global financial system.

SDR are called "paper gold" but adding more gold to the IMF's backup for the SDR basket of currencies (USD, euro and pound) would go a long way to shoring up faith in the accounting unit, which is all the SDR really is.

And averaging in the gold price to the basket would be a clever way to disable the tripwire in the face of heavy borrowing denominated in SDR.

What about paying back the borrowings? Don't worry; the IMF is used to defaults; you just shove it all onto them and one day it's all forgiven with hugs for the cameras and furious snapping of pencils behind closed doors. Hey, if Africa and Latin America can do it, why not the rest of the world?

But if we have no unpleasant words there will be no unpleasant deeds. It would be at least a decade before anyone outside The Casino figured out what was being done, so defaulting on nothing but accounting measures is something we could worry about around 2030.

Would it work? As a short-term fix, as the means to duck trade wars that would lead to the twilight of the global financial system, the SDR could be the best shot. The long-term solution, which I'll begin to discuss tomorrow, is outside the power of financial wizards.

Is the United States ready for the SDR solution, which in effect makes the unit the world's reserve currency, at least temporarily? Let me put it this way: Your food stamps and unemployment insurance won't go far if you have pay $15.00 for a quart of milk. By any which way, you want to avoid the tripwire. However, the measure is not as drastic as might seem at first glance; in fact, it came very close at one point to implementation.

Does the argument hold that it's possible to diversify away from dollars without crashing the greenback's value? Writing for the Financial Times in 2007, Fred Bergsten made a good case for just that argument. He warned that SDR are not a panacea but in coordination with additional measures the solution could be softest landing the world can hope for.

And by the way the plan he lays out is an elegant, backdoor, face-saving way for China and other Asian governments to be -- er, encouraged to stop suppressing their currencies' value.

If Bergsten's name rings a bell, he's director of the Peterson Institute for International Economics. He was assistant secretary of the Treasury for international affairs in 1977-1981 and led the substitution account (SDR) negotiations for the US in 1980.

If anyone understands SDR and can explain in plain English their utility, it's Bergsten. So now's the time to dust off his discussion, which I post here in full:
How to solve the problem of the dollar By Fred Bergsten

Published: December 10 2007 19:24; Last updated: December 10 2007 19:24; Financial Times

The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. 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. Fears of such an outcome have risen sharply in both official circles and the markets.

However, none of the countries into whose currencies the diversification would take place want to receive these inflows. The eurozone, the UK, Canada and Australia among others believe that their exchange rates are already substantially overvalued. But China and most of the other Asian countries continue to intervene heavily to keep their currencies from rising significantly. Hence, further large shifts out of the dollar could indeed push the floating currencies far above their equilibrium levels, generating new imbalances and a possibly severe slowdown in global growth.

There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund through which unwanted dollars could be converted into special drawing rights, the international money created initially by the fund in 1969 and of which $34bn-worth now exists. Such an account was worked out in great detail in 1978-1980 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today’s circumstances.

There was widespread agreement, including from influential private sector groups and congressional leaders as well as the IMF’s governing body, that the initiative would enhance global monetary stability. It failed only because the sharp rise in the dollar that followed the Federal Reserve’s monetary tightening of 1979-1980 obviated much of its rationale, and over disagreement between Europe and the US on how to make up for any nominal losses that the account might suffer as a result of further depreciation of dollars that had been consolidated.

The idea of a substitution account is simple. 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.

The fund’s members would authorise it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80bn would more than suffice.

All countries would benefit. 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.

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. Such consequences would be especially unwelcome today with the prospect of subdued US growth or even recession over the next year or so.

The international financial architecture would be greatly strengthened by a substitution account. In the wake of the dollar crises of the early postwar period, the IMF membership adopted SDR as the centrepiece of a strategy to build an international monetary system that would no longer rely on a single currency.

The move to floating exchange rates by most major countries in the 1970s postponed the need to pursue that strategy to its conclusion but also generated the extreme currency instability that triggered official consideration of an account. The global imbalances and large currency swings in recent years, and the accelerated accumulation of official dollar holdings by countries that have essentially reverted to fixed exchange rates, replicate the conditions that led to both the creation of SDR and the negotiations on an account.

A substitution account would not solve all international monetary problems nor would it suffice to restore a stable global financial system.

The dollar needs to decline further to restore equilibrium in the US external position. China, many other Asian countries and most oil exporters will have to accept substantial increases in their currencies now and much more flexible exchange rates for the long run. But early adoption of a substitution account would minimise the risks of adjustment of the present imbalances and the inevitable structural shift to a bipolar monetary system based on the euro as well as the dollar.
This entry is crossposted at RBO with nifty pix. I especially like the goose-stepping bankers.

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