The Existing International Monetary System: Vulnerabilities and Reformation

HongCai-Xu ([email protected])

 Professor of China center for international exchanges

【Abstract】The current international monetary system is basically a “3-ring structure” dominated by the US dollar which does not only fail to resolve the “Triffin dilemma”, but also causes cyclical depreciation of the US dollar and current account deficits of its own. Each cycle is more or less reflected by global economic imbalances. However, the United States has a unique “Wealth-generating mechanism” that benefits itself from the cyclical depreciation at the expense of other countries. There are six major dilemmas in current international monetary system. It is necessary to establish the three pillars for the new system, and it is a general trend that RMB will be internationalized and become one of the three pillars.

Key word: international monetary system, six dilemmas, three pillars for new system, RMB internationalization

Part one: The US Dollar-dominated International Monetary System Leads to Global Economic Imbalances

Ⅰ The fundamental features of the current international monetary system

ⅰ The US dollar is the core of the current international monetary system

In 1973, the United States unilaterally abandoned the Bretton Woods system. After A few years of the market turmoil, the international monetary system gradually returned to the dollar-dominated system. After the mid-1970s, there were only a few international currencies such as German Mark (later the Euro), Japanese Yen, British Pound, and Swiss Franc that keep floating against the US dollar. However, currencies of emerging countries were not internationalized, and they were forced to peg to the US dollar. After the Asian financial crisis in 1997, the East Asian countries restored the exchange rate policy of pegging to the dollar, and hence strengthened the central status of the dollar.

ⅱ The current USA-dominated international monetary system is basically a “3-ring structure”

 The United States is the “core country” as it is located in the center of the ring structure. To some extent, the US Fed acts as the “global central bank” because its monetary policies have dominant power and the privilege to artificially export the US dollar. Countries that adopt floating exchange rate regime, known as intermediate floating exchange rate, are located in the middle of the ring structure, including the European Union, Japan, Canada, Australia and some other Latin American countries, which rarely intervene in the foreign exchange market. The last group is called “peripheral pegging countries”, which adopts fixed exchange rate regime and locates in the outer layer of the ring structure, including China, South Korea, Hong Kong, Taiwan and Southeast Asian countries. These countries hold a large amount of foreign exchange reserves. The structure of the current international monetary system is shown in Figure-1.

Figure-1: Current international monetary system a three-layer “ring structure”

ⅲ Multi-level and multilateral coordination is needed to adjust the interests of the three groups.

In the international monetary system illustrated as the Figure 1, the three groups are in unequal positions, and the relationships between them are also different. Specifically speaking, “Core countries” and “intermediate floating countries” interact with each other mainly through capital account, while “core countries” and “peripheral pegging countries” interact with each other through current account. Consequently, the US and Europe become financial partners while the US and Asia become trading partners. To change the pattern of global economic imbalances, we must enhance multilateral coordination and give full play to the role of the Group 20 (G20), International Monetary Fund (IMF), World Bank and World Trade Organization (WTO), etc. Bilateral games between China and US will not be able to effectively balance the interests of the three groups in the “ring structure”.

Ⅱ The US dollar serves as international currency and causes cyclical depreciation and US current account deficits

Since the establishment of Bretton Woods system in 1944, the US has acted as the “core country” in the international monetary system. As an international currency, the US dollar is not only unable to resolve the “Triffin dilemma”, but also causes US current account to vary cyclically. United States export dollars through trade deficits and force its currency to depreciate against other currencies when trade deficits accumulate to certain level. Because of the depreciation, US current account returns to balance and the US starts to export dollars through trade deficits again. As a result, a peculiar periodic cycle that can be presented as “trade deficits (imbalance) → depreciation (balance) → repeated deficits (repeated imbalance) → repeated depreciation (repeated balance)”has been formed: Each cycle is reflected by periodic imbalances. Since the mid-1960s, the dollar has experienced three periodic cycles. More details can be described as follows.

The first periodic cycle occurred between the mid-1960s and the late 1970’s. At that time the US trade surplus was decreasing continuously. By 1971, the US current account balance to GDP ratio dropped below zero for the first time. The US exported dollars mainly through foreign investments to other countries and large trade surpluses was accumulated in Western Europe. In the 1970s, the Bretton Woods system collapsed amid the oil crisis which led to substantial depreciation of the dollar and relieved the US current account deficits. The average ratio of current account balance to GDP remained at zero with slight fluctuations.

The second periodic cycle occurred between the 1980s and the mid-1990s. The US current account balance dropped again to the level of -3%~-4%. Japan and some major European countries in this cycle became the largest surplus countries. However, the “Plaza Accord” in 1985 made the dollar depreciated sharply against Japanese Yen and German Mark and other currencies. In the early 1990s, the US current account was rebalanced again.

The third periodic cycle started from the mid-1990s and it has not been ended yet. Especially after the Asian financial crisis, the US current balance to GDP ratio dropped all the way down: -1.6% in 1997, -3.2% in 1999, -4.5% in 2002, then -5.7% at the end of 2004. The US current account deficits accounted for 75% of the global current account surpluses and China has become the country with the largest trade surpluses in this cycle.

In the most recent periodic cycle, the scale of trade imbalances has become larger that covered more regions and countries. The new characteristics led to severe global economic imbalances, particularly the China-US economic imbalances, which resulted in financial instability on a world-wide basis, especially in emerging markets, and has sowed the seeds of global financial and economic crises.

Ⅲ The United States successively “generates” wealth in mysterious ways by taking advantage of the dollar’s status

ⅰ The United States has a unique “wealth-generating mechanism”

Americans are used to consume and are reluctant to save. The US household saving rate has remained around zero or even negative for years. However, US investors received unprecedented returns and risks were hidden by the cycle of “financing → purchasing financial assets (assets accretion) → more financing → purchasing new financial assets (assets accretion again)”. Since 1990, the wealth accumulation of rising US stock prices and house prices has created a “wealth effect” which boosted US consumption and economic growth. Besides, the US has the privilege to distribute US banknotes to the rest of world without restraint. In the past 10 years, with China’s integration into globalization, China has not only become a production base for the US manufacturing sector, but has become a de facto US bank. The US uses dollars to purchase cheap goods from China, and then China exchanges these US dollars with US Treasury bills. This process forms an excellent bilateral circulation of commodities and currencies.

ⅱ US huge external debt strangely disappeared

The circulation of goods and currencies between China and the United States is well operated through the US developed financial system. A large amount of China’s savings is transferred to United States through China’s investment on US T-bills, part of which is used to support US to successively purchase products from China; and part of which flows back to China in the form of FDI and hot money. By this means, the United States not only suppresses domestic inflation but obtains high returns on investments in China. The United States is a country of borrowing to live that experiences fiscal deficits and current account deficits almost every year and keeps running the “double deficits” policy. In recent years, the United States has large current account deficits with a rising trend. In theory, the total amount of US gross external debt should increase gradually. However, it has de facto unusually remained stable at between 2.2 and 2.4 trillion US dollar. In the past four years, the annual increase in the amount of US current account deficits was about 400 to 600 billion. Since 2005, this number has increased to more than 700 billion and in 2008 after the financial crisis it has surpassed 1 trillion US dollars. However, the total amount of US external debt declined instead of increase. In other words, the huge US external debt strangely disappeared.

ⅲ Three channels to make the US external debt disappeared strangely

The first channel is the dollar depreciation. As a result of the unfettered printing of the dollar by the Fed, the dollar comes to state of long-term depreciation, which is de facto debt repudiation. The second channel is the accretion of the US assets through high returns from the US foreign investments. For example, the United States borrows dollars from China through issuing treasure bills at little cost, and then invests the dollar in highly profitable sectors in China in the form of FDI, which rewards them more than 10% return. The third channel is the depreciation of the US external debt. When the dollar depreciates, the dollar assets held by foreign governments is about to shrink values. This is how the United States engages in capital operation on global basis, very “impressive” indeed!