GS 3 – ECONOMY: Balance Of Payments, Forex Reserves-Reasons For Accumulation of Forex.
Introduction
The Bretton Woods agreement of 1944 established a new global monetary system. It replaced the gold standard with the U.S. dollar as the global currency.
History:
- In the 1970s, developed nations ended the fixed exchange rate regime when President Richard Nixon took a unilateral decision to suspend dollar-gold convertibility.
- America was worried about the economic success of its former enemies—Japan and Germany(feared losing its competitive edge.)
- It started a monetary policy allowing inflation to rise.
- Real rates in America began to decline from the mid-60s onwards.
- The Vietnam War (1955-1975) made the fiscal deficit of America widen.
- Inflation go higher.
- Dollar was overvalued.
- The European Nations began to demand gold from America.
After suspension of Dollar to Gold Convertibility:
- Exchange rates began to float in 1973.
- Developing countries pegged their currencies to the US dollar.(anti-inflation credibility to markets.)
- Led to surges in capital inflows,overheating, and real exchange rate appreciation.
- Inflation rates spiked from time to time.
- Trade and current account deficits also widened.
- Occasional Balance Of Payment(BOP) crisis in the emerging economies.
- Played out vividly during the Asian currency crisis of 1997-98.
- Very few emerging nations could maintain a peg to hard currencies.
- Others have floated their exchange rates-wish to maintain a stable exchange rate-versus the dollar.
- Still rely on final demand from American consumers to grow their economies.
Bretton Woods system was dismantled in the 70s, there has been a de facto fixed exchange rate regime, with the dollar as the anchor currency.It synchronised global economic cycles.
- China exemplified this arrangement more than others.
Implications of maintaining a peg with the US dollar:
- When the US lowers interest rates and takes an accommodative policy(rejuvenate its economy)other countries follow. (otherwise currencies appreciate too much against the dollar.)
- But, their currencies appreciates leads to capital flows into emerging economies in search of higher returns.
- When US monetary policy become more restrictive– Capital flows back into America and emerging market currencies depreciate.
- America is about to upend Bretton Woods II.
US attempts:
- US attempt is to generate inflation and keep real interest rates as low.
- Real rates will likely be negative for a long time.(help America whittle down debt.)
- Government obligation- have gone up steadily in the last 40 years.
- In the last 12 years, its rate of growth has picked up momentum.
Data:- Bank for International Settlement(BIS):
- America’s gross public debt to GDP ratio was 71% at 2007.
- 2011, it had risen to 100.4%.
- 2016-114.65
- Rise very sharply in 2020(pandemic)
- World Economic Outlook(by International Monetary Fund)- the debt ratio for the advanced G-20 nations-141.4% in 2020 (113.2% in 2019.)
Result:
- 1970s when the inflation rate was in double-digits, real interest rates were negative and debt ratios plunged.
- America’s government debt-to-GDP ratio declined from around 55% in 1961.
- Around 35% by the end of the 70s.
- In UK-The net public debt-to-GDP ratio declined from 100%(1961) to 40% (end of 70s).
- Unstated objective for the 2020s is stealth inflation, thus inflating away the debt burden.
- Advanced nations would be pursuing this goal.(the Bank of England appeared to rule out negative interest rates as a policy tool but ruled it in later.)
Conclusion
When a system’s anchor country pursues deep and prolonged financial repression,near-impossible for emerging economies to expect that Bretton Woods II will sustain.
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.
