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Bretton woods system II- The Risks Of Currency Pegging
Topic: GS-3, Economy
Sub-Topic – Indian Economy and issues related to growth.
Overview – The implications of pegging developing economy’s currency to hard currencies.
Introduction Bretton woods :
In the 1970s, developed nations ended the fixed exchange rate regime which was manifested in 1971 when President Richard Nixon took a unilateral decision to suspend dollar-gold convertibility.
Why dis America suspend the dollar-gold convertibility?
- America was worried about the economic success of its former enemies—Japan and Germanyand feared losing its competitive edge. So it started following an accommodative monetary policy allowing inflation to rise. Real rates in America began to decline from the mid-60s onwards.
- The Vietnam War made the fiscal deficit of America widen, which made the inflation go higher. Thus dollar was overvalued and the European Nations began to demand gold from America.
What happened after the suspension ofdollar-gold convertibility?
Globally, exchange rates began to float in 1973.
- In the developing world, most countries pegged their currencies to the US dollarwhich helped signal their anti-inflation credibility to markets.
- The fixed exchange ratesbecause of the dollar pegging frequently led to surges in capital inflows, overheating, and real exchange rate appreciation and the inflation rates spiked from time to time.
- The trade and current account deficits also widened.
- There was occasional BOP crisisin the emerging economies. That played out vividly during the Asian currency crisis of 1997-98.
Therefore, very few emerging nations could maintain a peg to hard currencies. Most countries have floated their exchange rates. However, they still wish to maintain a stable exchange rate, particularly versus the dollar. Most of them still rely on final demand from American consumers to grow their economies. In other words, although the Bretton Woods system of fixed exchange rates was dismantled in the 70s, there has been a de facto fixed exchange rate regime, with the dollar as the anchor currency. China exemplified this arrangement more than others. This is called Bretton Woods system II. It synchronised global economic cycles.
What are the implications of maintaining a peg with the US dollar?
- When the US lowers interest rates and takes an accommodative policy stance to rejuvenate its economy, other countries follow suit, otherwise their own currencies appreciate too much against the dollar.
- But, their currencies appreciate nonetheless, as a weak dollar spurs global risk appetite and leads to capital flows into emerging economies in search of higher returns.
- When the US monetary policy cycle starts to become more restrictive, risk appetite weakens and the cycle reverses. Capital flows back into America and emerging market currencies depreciate.
America is about to upend Bretton Woods system. That is what Federal Reserve chairman Jerome Powell signalled on 27 August.
What is the US attempting?
- The US attempt is to generate inflation and keep real interest rates as low as they were in the 70s. Real rates will likely be negative for a long time. It would help America whittle down debt.
- Government obligations—real and contingent—have gone up steadily in the last 40 years. But, in the last 12 years, its rate of growth has picked up momentum.
Data from the Bank for International Settlements shows that America’s gross public debt-to-gross domestic product (GDP) ratio was 71% at the end of 2007. By the end of 2011, it had risen to 100.4%. It rose further to 114.6% by mid-2016. Post-pandemic, debt ratios are set to rise very sharply. In its June 2020 update to its World Economic Outlook, the International Monetary Fund projected that the debt ratio for the advanced G-20 nations would jump to 141.4% in 2020 from 113.2% in 2019.
What will the US attempts yield?
It is reminiscent of the 1970s when the inflation rate was in double-digits, real interest rates were persistently negative and debt ratios plunged. America’s general government debt-to-GDP ratio declined from around 55% in 1961 to around 35% by the end of the 70s. In the UK, the decline was dramatic. The net public debt-to-GDP ratio declined from 100% to 40% during the same period.
The unstated objective for the 2020s is stealth inflation, thus inflating away the debt burden. Most advanced nations would be pursuing this goal. For instance, the Bank of England appeared to rule out negative interest rates as a policy tool in August, but ruled it in later in September.
When a system’s anchor country pursues deep and prolonged financial repression, it is near-impossible for emerging economies, including India, to expect that Bretton Woods system II will sustain. It will not. India’s options include matching that repression, pursuing a strong rupee, a re-imagined monetary policy regime, and capital controls. The status quo looks infeasible.
- What are the implications of having a developing economy’s currency pegged to dollar? Discuss in light of the prevailing economic downturn around the world because of COVID-19.