During the past couple of years it has been difficult to pick up a newspaper without glimpsing a headline decrying China’s unfair competition, denouncing the undervalued renminbi and thus emboldening yet another expedition of politicians flying to Beijing for a photo op and some great food.
Further, many market pundits have argued that, given America’s economic woes and multiple imbalances, a dramatic decline of the US dollar is once again nigh - especially so against the unambiguously cheap renminbi, as well as the yen and other Asian currencies.
For the dollar to depreciate significantly against a basket of Asian currencies requires a collapse of Bretton Woods II. Under the BW II hypothesis, an informal arrangement exists between the US and several mercantilist Asian countries, which closely manage their currencies against the greenback, with the Asian current account surpluses recycled to provide cheap financing for the structural US current account deficit.
A more succinct interpretation is provided by Paul Krugman: “Americans make a living selling each other houses, paid for with money borrowed from the Chinese.” Given its fundamental flaws, the collapse of BW II is inevitable and will certainly lead to a dramatic decline in the US dollar. However, the timing of this collapse is anything but certain and unlikely to be imminent.
Clearly timing the unraveling of BW II and the accompanying dollar decline will be no easy task. To my eye the best place to look for clues regarding how this plays out are the events that lead inexorably to the demise of its prequel, the BW era. One only has to look at the litany of similarities between then and now (domestic economic weakness, global imbalances and primary trading partners maintaining extremely undervalued currencies).
The Bretton Woods system became operational in 1946, with key features including fixing the US dollar to the price of gold at $35 an ounce and having other countries maintain a fixed and agreed parity vis-à-vis the dollar - ie, gold. However, the BW system was arguably doomed as early as 1958 when the European currencies attained full convertibility and private capital flows began to accelerate. The unravelling reached a tipping point in 1970 when the US economy was suffering from a host of ills: inflation approaching 6%, GDP growth south of 1%, an emerging CA deficit, and gold coverage falling from 55% to 22%.
Soon after came President Richard Nixon’s justifiably infamous ‘new economic policy’, announced on 15 August 1971. The prime architect of the ‘Nixon shock’ was treasury secretary John Connally and included a brazenly unilateral 10% surcharge on all dutiable imports (a powerful bargaining chip), a 10% reduction in foreign assistance expenditures, closing the ‘gold window’ (so the dollar was no longer freely convertible) and 90-day wage and price controls.
If the intent was to shock, trumpet the unacceptability of the status quo, and incentivise its overseas counterparts (including the Germans who only wanted one thing from their currency: stability), few economic policies have been so successful. Financial officials on both sides of the Atlantic (and Pacific) by then recognised that a full-blown dollar crisis could explode at any moment and were rushing to the bargaining table.
‘Typhoon’ Connally (as he was referred to by his Japanese contemporaries) was a force of nature and a heavy-hitter among heavy-hitters. His American colleagues included such luminaries as national security adviser Henry Kissinger, under secretary Paul Volcker and George Shultz (famous in 1971 for his pronouncement that “Santa Claus is Dead”). Even without his stint at the Treasury, Connally would have deserved a prominent place in American political annals - he was governor of Texas from 1963 to 1969 (as a Democrat), and was a passenger in the car when John F Kennedy was assassinated in Dallas (Connally himself was hit by two bullets and seriously injured).
Unencumbered by a deep knowledge of either economics or finance (responding to queries regarding his credentials he quipped, “I can add”), during his tenure Connally consistently and effectively focused the G-10 on three key areas of discussion: exchange rate realignment (long overdue), trade liberalisation (improved opportunities for US exporters) and more equitable burden sharing (of mutual defence expenditures and development assistance, for which the US had long borne the lion’s share).
At the G-10 Rome meetings held in late 1971 Connally proclaimed to his astonished counterparts, “The dollar is our currency, but it’s your problem,” having the intended consequence of driving yet another nail into the coffin of Bretton Woods and leading in short order to a roughly 20% depreciation of the dollar. The key outcome from Rome was broad agreement to achieve immediate settlement of monetary and trade issues (with the US dropping the 10% import surcharge). The G-10 ministers met again three weeks later at the Smithsonian Institute in Washington and came to an essential agreement on exchange rate policies, which Nixon humbly referred to as “the most significant monetary agreement in the history of the world”.
The demise of BW was driven by three key features of the macro backdrop (accelerating private capital flows, burgeoning imbalances, dramatically undervalued currencies) and three crucial catalysts (a sense of economic crisis, fears of a full-blown dollar collapse, several bigger-than-life personalities).
Are these features in place today and are they also prerequisites for BW II to collapse? There are certainly a number of undervalued currencies in Asia and global imbalances are by far the most stretched they have ever been. However, Chinese private capital flows remain highly regulated and controlled and there is not yet a sense of crisis (still, some commentators refer to the US-China negotiations as a ‘nuclear’ stand-off).
Although BW II is already strained, to ultimately break what is inherently a fragile and fundamentally flawed system will require significant erosion of China’s capital controls and regulations, and further development of its domestic financial markets and institutions. This is occurring, but only at a snail’s pace.
It seems safe to conclude that, for better or worse, BW II will be with us for some time yet. In light of this, a sensible investment strategy involves placing a modest structural bet, short the US dollar against a basket of Asian currencies, with a view to increasing the bet’s size dramatically once Chinese private capital flows begin to accelerate, especially if accompanied by a sense of economic crisis in the US. In the meantime Chinese monetary authorities had better get used to hosting a never-ending queue of US politicians and being constantly reminded that “The dollar is our currency, but it’s your problem.”
Kevin Hebner is macro strategist at Third Wave Global Investors based in Greenwich, Connecticut