Time to Reform the Global Monetary System?

This month marked the 50th anniversary since Richard Nixon suspended the US dollar’s convertibility to gold, effectively putting an end to the Bretton Woods System that had underpinned international currency stability since the end of World War 2. That system had fixed the exchange rates of all currencies to the dollar, which in turn was fixed to gold. Nixon’s move unleashed unprecedented volatility in global currency markets.

Currency volatility was a godsend to the financial services industry. Suddenly, there was huge demand for hedging foreign exchange risks, and speculators jumped at the opportunity to profit from currency swings. This spurred the development of an enormous market in financial derivatives, which has grown continuously since. However, the impact on other sectors and the wider economy has been decidedly mixed.

Nixon’s Treasury Secretary, John Connally, famously told a meeting of G-10 finance ministers: “The dollar is our currency, but it’s your problem.” Certainly, the dollar’s role in financial markets has created problems for many emerging markets, whose governments and businesses need to borrow in the US currency. Periodic bouts of dollar volatility caused a wave of emerging market financial crises across Asia and Latin America. However, it might be argued that the dollar has now become an even bigger problem for the US.

Bretton Woods’ demise did not end the dollar’s centrality in the global monetary system. It continued to serve as the key reference in foreign exchange markets. If anything, the growth of financial derivatives referencing the greenback further cemented the dollar’s global role. Therefore, while Nixon’s move to a free-floating currency saw a brief downward adjustment in the dollar’s exchange rate, demand for the US currency to support activity in global financial markets has led to a persistent structural overvaluation of the dollar. This has contributed to reduced US export competitiveness, for which American workers have paid a high price.

In the wake of the Asian financial crisis, many countries built up large dollar reserves to insulate themselves from capital markets volatility. This further compounded problems for US industry and indirectly contributed to the subprime mortgage crisis (along with a host of regulatory and policy failings, admittedly).

The dollar’s role has become something of a quagmire for America. On the one hand, it has been a source of considerable international influence and enabled the US government to access plentiful cheap funding; on the other, it has undermined American manufacturing competitiveness and required the Federal Reserve to step in to support global market liquidity in times of crisis. This has denied America the benefit of a critical exchange rate rebalancing mechanism in response to faster productivity growth in other countries and has been a significant source of rising wealth inequality.

The cracks in the dollar-centric global monetary system are starting to show. The March 2020 dislocation in US Treasury markets was a warning sign, highlighting the strains in the market for US government financing. The surge in the popularity and value of cryptocurrencies is another clear symptom. A disorderly unravelling of the dollar’s international role would pose huge risks, extending well beyond the realm of financial markets.

China, in particular, has much at stake. This is not just due to its $1.1 trillion in US Treasury holdings, but also because it is now highly integrated with the global economy through the channels of trade and, increasingly, financial markets. Further, China’s international commerce continues to be primarily settled in dollars. The impact of a shaky dollar on US and, indeed, global trade and finance is therefore likely to have serious repercussions for China.

As the second largest economy in the world, China is uniquely positioned to expand the international role of its currency to help rebalance the global monetary system. Increasing the amount of trade and investment around the world settled in renminbi could also have considerable benefits for China. Nevertheless, while Chinese policymakers have been gradually expanding the international use of their currency, notably in financial markets through the Stock and Bond Connect programmes via Hong Kong, they have been wary about promoting the renminbi as a usurper to the dollar’s role. This is evidenced by former PBOC Governor Zhou Xiaochuan’s call in 2009 to promote greater use of the IMF’s Special Drawing Rights (rather than the renminbi), which was echoed by his successor Yi Gang in mid-2020. 

Like Britain at the end of World War 2, the US cannot go on absorbing the world’s financial imbalances. Notwithstanding today’s tense geopolitical backdrop, it is in both China and America’s self-interest to find a solution to this dollar problem. Policymakers on both sides should therefore work together proactively to reform the global monetary system.