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Is The World Converging?

with Paul Alapat , Visiting Faculty, IIMB and MD, Amba Research

With the turn of events that have precipitated in the last 2 years, the Great Recession, as we know it, has left the world a changed place in its aftermath. The days of looking up to Wall Street as the ultimate authority in all things financial seem to be over and a new paradigm, tinted with caution, is taking shape in the economic world. The US Dollar, which has been the lingua franca of the world currency and reserves markets since the abandonment of the Gold Standard, seems to be fast losing its bastion.
In this interview with Paul Alapat, a former currency researcher himself, we explore the possibility of the dollar losing ground to other currencies and trace the evolution of a new world order in wake of the global downturn and its impact on global currency markets.

    Bretton Woods 2 and Underlying Reasons

    tejas@iimb: Though the gold standard was abandoned four decades ago, do you think the world never really moved away from an overarching fixed exchange rate regime? Was the gold standard just replaced by a dollar standard?

    PA: Not really. Yes, it is true that some of the large economies, China in particular, have been pegged to the USD. To that extent, there is a USD block, including quite a few small economies that have their currencies pegged. That said, if you look at the major currencies: Sterling, Yen, Euro, they do move around with a certain amount of flexibility. The other evidence is the size of forex reserves of most of the developed nations. A good clue to the existence of a fixed exchange rate regime is that reserves start accumulating, as is the case with China. But if you look at the G3, the sizes of reserves are minimal with respect to the size of their economies. There is a dollar block because the small economies have little choice but to peg, but the block, sans China, is pretty small. So, it may not be right to say that the gold standard was replaced by a dollar standard.

    tejas@iimb: The Latin American currency crisis of the 1990s was largely driven by propensity of the region to hold all reserves in one currency: the USD. Do you think this kind of overdependence on the US monetary policy is recipe for disaster?

    PA: In the case of Latin America, economy of the region was, and still is largely driven by the US, due to proximity and historical factors. Consequently, they have been dictated by the US economy as far as monetary policy is concerned. Generally, as a small economy, you have little discretion in terms of monetary policy. The problem with such rigidity is that it leaves few ways to allow for differences in economies. For instance in a large economy like Brazil which has different business cycles from those of the US, pressure points would be at disparate points of the cycle and would not be coincident with those of the US. It is at these disparate pressure points that you need some room to allow for the differences. I guess large economies like Brazil have done that reasonably well but smaller ones like Argentina, lacking credibility on their own, have not and are hence subject to the movements in US monetary policy, especially in times of tightening. On the flip side, this has helped rein in inflation which might not have been possible in the absence of a peg.

    tejas@iimb: How much of the global nature of this crisis can be attributed to the fact that despite having its own international currencies for trade, the currency for reserves for most of the economic engines of the world was the same?

    PA: I believe the speed of transmission was accelerated because of this. Especially, when you are a large economy with different business cycles, you need considerable monetary independence to regulate yourself and the fact that most reserves are in the form of USD, hindered that to some extent. I guess another accelerator was the interlinking of the global financial institutions, who act as the plumbing in a house. Since these institutions were so highly correlated, the crisis crossed borders at a much rapid pace than it would otherwise have.

    Sustainability of USD as the Reserve Currency

    tejas@iimb: Do you think the USD will sustain as the inevitable reserve currency going forward? Why or why not?

    PA: I guess the smaller economies have little by way of option, at least as of now. But if you look at the larger economies like the BRIC countries, there have been moves towards distancing from the USD, to aid their own monetary flexibility. Going forward, the dependence on the USD should climb down and diversification into other currencies like the Swiss Franc might occur. Euro is likely to emerge as a substitute, as can be evidenced from the recent diversification moves of the RBI. Also, gold would gain precedence as diversification of the currency composition of the reserves basket gathers pace.

    tejas@iimb: The USD has been experiencing a free fall over the past few months. Despite this, the US economy has not bounced back to the expected levels of economic activity. What do you think is the reason for this?

    PA: The US is a very domestically driven economy, propelled primarily by domestic investment and very little by way of net exports, which over the years, have been negative. Around 60-70% of the demand comes from domestic consumption and with 10% of the workforce out of jobs; it has been difficult to fill that gap. A weaker USD has stimulated merchandise exports but for an economy of the size of US, the export lever is just too small to drive it. Also, the US has shifted a great deal into service exports like banking, insurance, consulting et al, which are not price sensitive. It is therefore arguable that a weaker USD can lead to an increase in demand for such services. You would not hire more McKinsey consulting just because the dollar is weaker. Hence, I believe the sensitivity of economic growth to USD value would be lesser than what would be conventionally expected.

    tejas@iimb: The pegging of Yuan to USD and massive funding of the US expenditure by China buying treasury securities seems to have created a never ending spiral with China accumulating a reserve mountain. What problems do you see with the sustainability of this, if any?

    PA: For China, the imperative is growth. They need to grow at a 6.5% just to maintain social stability. They need to create 100 million jobs every year just to keep the percentage of working population sustainable. For them, growth is not an option or a luxury. The levers for that as of now are public stimulus and exports. Eventually, they would want to shift to domestic demand, but it is not feasible in the short run. Moreover, the bulk of their exports is in manufacturing, in industries where demand is price sensitive, thus mandating them to keep exchange rates under control if they have to retain competitiveness. Though there would be calls for China to allow the Yuan to appreciate, their domestic compulsions would override them. However, it is likely that they might diversify into Euros and other currencies.

    Global Reserves

    tejas@iimb: What are your views on the newly emerging alternatives to the USD in view of the soaring US debt, such as IMF bonds? Are any of these sustainable in the long run, and why?

    PA: I think it is too early to comment on this. The reason you issue bonds is to meet a deficit in your revenue. To that extent, I am not sure how the IMF balance sheet looks like and what would be the capital budgeting rationale for issuing these bonds. Another issue is that of pricing these bonds, devising their term structures. We might need to come up with supporting mechanisms like the artificial exchange rate for the SDRs. But right now, the details are too sketchy to make an intelligent guess on their long term prospects. However, there would surely be efforts to diversify away from the USD, and a move towards Euro, Sterling, SDRs.

    tejas@iimb: Given the weakness of the USD, anemic recovery of the Eurozone leading to a weak Euro and a dwindling Japanese economy leading to a falling Yen, how do you think the issues of structural currency imbalances likely to be resolved, if at all, through an alternative global reserve currency?

    PA: Eventually, yes. But there are a lot of preconditions to becoming a global currency. Take the Indian rupee for instance. You cannot trade the rupee outside of Bombay. There is no forward market for the rupee. Indian banks are not prepared to handle a lot of outflows and inflows. Unless you have the financial machinery in place to handle the responsibilities expected of a global currency, it is difficult to achieve that status. That is true even for a currency like the Singapore Dollar. Despite Singapore being a regional financial center, there is little acceptance of the Singapore Dollar globally. You need institutions to manage the risks of a currency and transfer them, you need free convertibility of the capital account and a lot of such preconditions to be fulfilled for a currency to become a serious threat to the USD. Right now, the Yuan or the rupee do not fulfill these conditions. Nor are the respective central banks in any hurry to globalize these currencies. But if I had to put a finger on the future, I believe the developments would be in line with sizes of the economy and one of these two currencies may become a substitute at some stage.

    A New World Order

    tejas@iimb: Do you see a supranational currency taking over as the new reserve currency for the world?

    PA: At the end of the day, a currency is an undertaking by a sovereign to own a liability. The obvious candidate for defining a supranational currency, if there is to be one, would be the IMF. There are SDRs but they are used only for pricing. The pertinent question here is: what is the damage caused by having USD as the reserve currency. It has created a certain amount of friction and certain amount of artificial rigidity that is not desirable. But there are more fundamental issues like regulation. Though this topic was of hot debate a few months back, in light of recent events, it has much less priority. It would be much easier to go for Euro, as the Eurozone is a bigger economy than the US. Hence, I see a higher probability of a move towards the Euro rather than the emergence of a supranational currency.

    tejas@iimb: Given the disillusionment that the current crisis has created with the Federal Reserve and its policies, do you see the IMF stepping into a more significant role as an international regulator?

    PA: The disillusionment with Fed is more of that of legacy: in trying to stave off the dot com bubble, they created another asset bubble. But in the current crisis, it is difficult to fault them. They were the fastest to respond and set the lead for Bank of England and the ECB. Because this has been a multilateral and global crisis, they have decided to increase the funding for IMF so that the latter can play a more active role. However, the case for IMF replacing Fed is weak since the IMF does not have authority to enforce measures. It does not print currency, banks are not answerable to it. Therefore it is difficult for it to enforce any regulation. It can arrange bailouts or impart wisdom on how to structure them. It can serve as a platform for sharing of financial wisdom from around the world which can help the newly developing economies in sequencing their reform structure. But it does not have the legitimacy to override domestic jurisdiction. It may play an advisory role for the central banks but is not likely to supplant the Fed.

    tejas@iimb: At the beginning of the 20th century, the United Kingdom was running a huge current account deficit and a country called USA was emerging as a massive exporter to the rest of the world. History is witness to what happened in the next century. Are we seeing an encore now with USA in the shoes of UK shoes and China in those of USA?

    PA: Given the current pace of growth and if things go as history suggests, China would surpass the US in terms of economic size. It is already a manufacturing hub and the question is when it would move to more sophisticated parts of the value chain. However, to become a global power, you need strong economic and political institutions and the general feeling about China is against that. Economic freedom cannot preclude political freedom and in order to become a sustainable global power, democracy will become inevitable. Even if you look at the past, US, Britain or even India, made that transition while Russia faded away because it did not. That is one major roadblock impeding China as of now. Secondly, a lot of Chinese growth is driven by public spending which again is not very sustainable. Thirdly, its demographic dividend is diminishing with a rapidly ageing population. At some stage, this would start impacting factor productivity and consequently, potential for growth. Also, given its centrally planned nature, if China gets a far-sighted leadership at the helm, they might reach there sooner. On the other hand, if the leadership falls into the wrong hands, things might very well slip into reverse. Since the institutions are not rich, every change of leadership has very personality-centred implications. Therefore, there are several challenges that can delay, if not disrupt, the eventual rise of China.


    The interview reflects on the various developments that have taken place on the international economic scene over the last three decades, and more specifically the last few months. While the speed of transmission of the global meltdown was accelerated by the universal dependence on the USD, the replacement of the USD from its bastion is not imminent. There is, however, likely to be greater diversification to other currencies like the Euro or the Yen. The role of the IMF is likely to remain limited, primarily on account of the lack of authority of enforcement and the chances of the emergence of a supranational currency are also little. Countries like China would continue to focus on their domestic goals in the short term but are likely to take up a bigger role on the global stage in the long run.


    Paul Alapat graduated from IIM Calcutta in 1985. Having worked with ANZ Grindlays as a currency trader, he pursued his PhD in finance from UCLA, post which he worked with Lehman Brothers and Nomura Holdings at their Hong Kong office in the fixed income and currency research division. A visiting faculty at IIM Bangalore, he teaches a course on Current Economic Scenarios.


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    Dr.Trilochan Sastry, Professor, IIM Bangalore

    Dr. Padmini Srinivasan, Assistant Professor, IIM Bangalore

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    Dr. Vijaya Marisetty, Associate Professor, IIM Bangalore

    Dr. Rajeev Gowda, Professor, IIM Bangalore
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