International currencies and the macroeconomy. Richard Portes London Business School and CEPR

Transcription

1 International currencies and the macroeconomy Richard Portes London Business School and CEPR Ministry of the Economy and Finance Rome July 2009

2 Road map I: the fundamentals Determinants of international currency status - Key role of financial markets: interplay between vehicle currency and asset currency functions - Network externalities International currencies pre-crisis Global imbalances at root of crisis and still threaten dollar dominance But GI were a key feature of consumptionfuelled (US, UK) growth in past decade could multicurrency system be an element of a better balanced growth pattern?

3 Road map II: crisis and change New features: financial markets, capital flows, exchange rates Will crisis be a tipping point? Small currencies squeezed out? Can euro now challenge dollar? Could RMB or SDR become a significant international currency over the next decade? Future of international financial system

4 See Costs and benefits of running an international currency (with Elias Papaioannou), November 2008, European Economy Economic Papers 348, European Commission. The international role of the euro: a status report (with Elias Papaioannou), European Economy Economic Papers 317, European Commission, April Global imbalances, in Macroeconomic Stability and Financial Regulation, eds. Mathias Dewatripont, Xavier Freixas and Richard Portes, CEPR, March 2009

5 Financial globalisation and international currencies Cross-border financial flows up much faster than trade Asset trade (including with emerging markets) dominated by major international currencies FX markets have expanded dramatically, also international use of derivatives etc. Hence international role of a currency today much more related to financial than trade flows (relative to 1990, say)

6 International currency roles are linked Choice of reserve (and invoicing) currency depends on currency stability (store of value, unit of account), size of economy, role in world trade Financial market determinants of vehicle currency Vehicle currency influences composition of reserves for countries that manage exchange rate Size, depth and liquidity of financial markets also key in choice of investment currency

7 Markets choose international currencies, network externalities important But models with network externalities have multiple equilibria (Portes and Rey 1998) Might shift if expectations and transactions costs change and if there are high elasticities of substitution between assets denominated in alternative major currencies

8 Dollar dominance in reserve holding Confirmed by Bretton Woods Maintained/explained by network externalities But does that make sense for central banks? And diversification motive works the other way especially if there are alternative assets tradeable in large, liquid and deep financial markets And increasing use of euro as pegging or anchor currency may change incentives for reserve holders

9 Anchor currency role Switch from $ to basket pegs (Russia, Libya, China, maybe GCC) De facto anchoring some switch towards, comparing with

10 Private use: invoicing Data scant, but gradually rising, especially when one party is an EU country Attractiveness of currency for invoicing affected by ER risk, volatility of inflation, capital market development, absence of capital controls so now attractive alternative Network externalities surely relevant here $ used for reference-priced and exchangetraded goods won t change without a major shock

11 Investment currency Transaction costs now lower for -denominated than for $-denominated corporate bonds, close for government bonds (Biais et al., Dunne et al.) Bid-ask spreads in FX markets similar and very low until crisis -area financial development now comparable to US and UK, superior to Japan Bund is world s most important hedging instrument But euro-area government bond market still has separate issuers, and corporate bond and equity markets much smaller than US (though corporate bond issuance very high in 2009H1)

12 Other private-sector use Optimal hedging strategies (Campbell et al. 2007): bondholders should be in $ (which appreciates when global bond prices fall), equity holders in as well as $ (both negatively correlated with global equity returns) Physical currency use: $ still dominant, usage outside US 3 times greater than outside EMU But -denominated deposits held by non- -area residents growing rapidly

13 Vehicle currency in FX markets BIS (2007) shows $ still dominant (appears in 86.3% of transactions, down from 88.7% in 2004) at 37.0% (37.2% in 2004) $ also dominates OTC FX derivatives But exceeds $ in market for OTC interest rate derivatives

14 US is still world banker with exorbitant privilege US borrows short, lends long, and earns excess returns on all asset classes (Gourinchas-Rey) Since 1999, euro zone investors have not earned consistent excess returns Like the US, the euro zone obtains a positive valuation effect when euro depreciates and suffers a valuation loss when it appreciates (assets in foreign currencies, most liabilities in euro) Euro area assets and liabilities are a higher percentage of GDP than for US more highly leveraged But US does more maturity transformation

15 Global imbalances at root of crisis and threaten dollar s dominance Unprecedented that main international currency is issued by country in substantial, continuing CA deficit, with NIIP << 0 UK pre-1914 also borrowed short and lent long, but it ran a large CA surplus and was big net creditor In recent period, US deficits created international liquidity on unprecedented scale, led to low interest rates, search for yield,

16 Crisis and change Fall in perceived advantages of US financial markets and instruments (but Gruber and Kamin (2008) say no previous evidence for superior US assets story) Exchange rate showed no significant safe haven effect in August 2007 a 3% appreciation of $ wrt over 10 days, then rise resumed nor after Lehman ( rose 6% during Sept) But down from $1.60 to $1.42 since 15 July 2008 Still, this is more likely due to deleveraging and unwinding of carry trades than safe haven response

17 Will crisis be a tipping point? Some evidence from a century ago that network externalities didn t fully dominate even in vehicle currency role, inertia not as great as previously believed (Eichengreen-Flandreau 2008a) And in interwar period, network effects didn t apply in reserve currency role (E-F 2008b) Indeed, during that last period of financial crisis, there was switching: $ overtook in mid-1920s, then with $ devaluation of 1933, regained dominance! then came war, the greatest shock So no big obstacle to tipping after all?

18 Will small currencies be squeezed out? As in interwar period, we have two highly liquid financial markets without capital controls reserve holders split between them Smaller currencies offer less stability, can t compete (even if, as for, financial markets are highly developed) Examples: French franc interwar, yen in 1990s, Swiss franc and sterling now, RMB now and in future Indeed, serious threats to international currencies that are small compared to the size of their international financial sectors (sterling, Swiss franc)

19 Can now challenge $? structural factors Financial stability and regulation fragmentation of regulatory authority current proposals won t fix this Unclear LLR authority and no ex ante burden sharing rules to deal with distressed institutions But crisis may yet force more clarity, closer coordination, more common policies And ECB has handled market liquidity problems at least as well as Fed But ECB policy cool to internationalisation

20 Dollar vulnerabilities High foreign ownership of Treasurys both central banks and private sector US reliance on foreign financing is a strategic (geopolitical) weakness that there now exists a serious alternative to dollar gives creditors leverage Interdependence ( balance of financial terror ) is not necessarily stabilising if creditors and debtor have different interests (i.e. not the common interest of avoiding MAD) Central banks and private sector might move in parallel ( herding ), rather than one substituting for the other

21 Threats to dollar dominance China, Japan (DPJ), smaller players that might break ranks Financial deglobalisation since autumn 2008: foreign central banks avoiding Treasurys, Fed lending abroad (swaps), foreign private sector not investing in US

22 US residents repatriate capital while foreigners pull out Source: B Setser

23 How would unwinding work? Some countries abandon dollar pegs (they are importing inflation) Quality of US assets more doubtful, US long-term growth slowing, US inflation may rise So lower private flows into US assets (already seen) Central banks and SWFs diversify (they have already taken large capital losses from dollar depreciation) High US inflation or serious dollar depreciation would threaten dollar s global status conversely, switch out of dollars would accelerate depreciation So a possible self-reinforcing process away from dollar, probably towards euro But implies euro appreciation against dollar

24 Alternative to dollar and euro: SDR At end-1960s, SDR a response to doubts about dollar and perceived need for more international liquidity Floating hit SDR it became a basket currency (rather than fixed to gold), and its role has been not much more than as a unit of account e.g., trivial share of global reserves (< 1%) Compare ECU, which never had much traction, although there were ECU-denominated bonds To become a major international currency, SDR would face same obstacles as euro (overcoming network externalities), but hasn t the advantages of being currency of major trading and financial region, with central bank issuer (LLR), physical notes,

25 Another alternative: renminbi (yuan) China concerned about dollar exchange rate, US monetary policy, role of dollar key currency status in creating global imbalances China would like to be lending to US in RMB but would it want foreign holdings of RMB? Recall Buba-ECB concerns about internationalisation of currency Would need capital account convertibility, no capital controls, developed financial markets decades away

26 Systemic issues Can US continue to act as financial hegemon can major debtor supply public good of international financial stability? What is a stable financial order? Global imbalances (BW II)? Current architecture assumes US and Europe are creditors who lend through IMF, giving them leverage Why shouldn t major reserve holders lend bilaterally rather than through IMF? Or form regional reserve pools? What incentives for them to lend to IMF?

27 Summing up Network externalities are important but not decisive no big obstacle to tipping point Euro clearly gaining ground, except in vehicle currency role US is still the world banker, but on an increasingly precarious base Global imbalances at root of crisis, still threaten dollar dominance Fall in perceived advantages of US financial markets and instruments

28 Little evidence of safe haven effects in crisis Small currencies are threatened The supposed structural weaknesses of the euro area are overstated as impediments to international currency role Overall, the crisis may have strengthened the euro s challenge to the dollar s dominant international status Major changes to international financial system likely in next decade possibly including move to two equally important international currencies Will this be part of a better balanced growth path? Or is multipolarity unstable?