Trumping the International Monetary System

HONG KONG – It is difficult to know exactly what US President-elect Donald Trump will do when he takes office in January. But he is all but guaranteed to pursue tax cuts and increased infrastructure spending. As a result, financial markets are anticipating faster growth in the United States – a perception that is boosting the dollar’s exchange rate against most currencies, including the renminbi, and triggering capital flight from emerging economies.

Notwithstanding Trump’s vow to impose tariffs on China, a resurgent dollar will hurt America’s trade competitiveness. After all, according to the International Monetary Fund, the dollar was already about 10-20% overvalued in June.

But that is not all. While trade is supposed to be the primary driver of exchange rates, which should rise or fall to correct countries’ external imbalances, capital flows have grown to the point that their role in guiding exchange rates is now much larger. In this context, market optimism about US growth could lead to ever-larger imbalances and possibly disrupt the international monetary system.

In 2010, former Bank of England Governor Mervyn King famously used the game of Sudoku to depict global savings imbalances, highlighting that the numbers in the table cannot be chosen independently. If, for example, all countries want to achieve full employment, and high-saving countries target a trade surplus, the low-saving countries cannot target a lower trade deficit. So when former US Federal Reserve Chair Ben Bernanke blamed the loss of monetary control in the US on the “surplus saving” countries, he had a point – at least with regard to trade flows.

What is missing from this assessment are investment flows. In fact, we can also fill in a Sudoku table showing the stock of net foreign investment claims by non-reserve-currency countries on reserve-currency countries, mainly the US and the United Kingdom. Some of the relevant investment flows have been funded through surplus credit in international markets.

From 1997 to 2007, the US net investment deficit widened by only $0.3 trillion, while the net investment surpluses of China, Japan, and Germany rose by $1.2 trillion, $1.1 trillion, and $0.8 trillion, respectively. The major investment-deficit players were the eurozone minus Germany, with a deficit of $2.4 trillion during that decade, and the UK, with a deficit of $0.5 trillion.

Over the next seven years, until 2014, America’s net investment position deteriorated by $5.7 trillion, producing a liability of 40.2% of GDP. The net investment position of the eurozone minus Germany hardly changed during this period, due to fiscal retrenchment. Meanwhile, Germany’s net investment surplus increased by $0.8 trillion, Japan’s rose by $1.2 trillion, and China’s was up by $0.7 trillion. The rest of the world’s net investment position strengthened by $3 trillion during this period, owing mainly to the commodity boom, which faded as China slowed.

The rapid growth in America’s gross liabilities to the rest of the world is apparent in US Treasury data on foreign holdings of US securities, which rose from $9.8 trillion in 2007 to $17.1 trillion by June 2015, of which $10.5 trillion was debt and $6.6 trillion equity. Foreign holdings of US securities were equivalent to 95% of US GDP in June 2015.

Against this background, policies that will strengthen the dollar considerably could prove highly problematic. While there are good arguments for higher investment in infrastructure – from employment creation to productivity gains – one cannot ignore the fact that it will likely attract more global savings, pushing the dollar even higher. The Fed’s projected interest-rate hikes to deal with coming inflation would exacerbate this trend.

As the dollar strengthens, the value of US holdings of foreign assets will decline in dollar terms, while the country’s liabilities will continue to grow, owing to sustained fiscal and current-account deficits (now running at around 3-4% of GDP annually). The result will be further deterioration of America’s net investment position, which the IMF has projected will reach -63% of GDP by 2021.

Recent experience suggests that countries with net investment liabilities totaling more than 50% of GDP are at high risk of some form of crisis. While this pattern may not necessarily hold in the country with the dominant global reserve currency, there is a very real risk of capital-flow reversal.

The truth is that it is unlikely that the dollar-induced imbalances will be sustainable. The other reserve-currency countries will probably continue to allow their currencies to depreciate, in order to reflate their economies, and emerging economies will probably continue to use exchange rates to cope with capital-flow volatility. If this continues, the strain on the international monetary system will only intensify.

There is something that can be done to ease the pressure. During the global economic crisis, the Fed eased global liquidity shocks by undertaking currency swaps with other major central banks. Today, it could undertake similar swaps, but with countries facing large capital outflows, thereby slowing the dollar’s appreciation. The question is whether the US under Trump would be willing to develop currency-swap arrangements and other coordination mechanisms for emerging economies such as Russia and China.

Another route Trump could take would be to use the IMF as a proxy instrument to enforce discipline on countries with undervalued exchange rates. He does, after all, seem to view international institutions as little more than mechanisms to extract trade and investment advantages for the US. This approach could put both the dollar and global financial stability at risk.

At a time of far-reaching economic and geopolitical risks, investors view the US dollar as a safe haven. But, in time, they may find that a new Plaza Accord – the 1985 agreement to devalue the dollar and push the Japanese yen and the Deutsche Mark sharply upward – will become necessary. Trump bought the Plaza Hotel three years later, but sold it in 1995. So, this time, it might be called the “Trump Tower Accord.”