Wednesday, April 27, 2005

PIMCO on Bretton Woods II

The "Bretton Woods II" currency arrangement, under which China, Japan and other nations are fixing their currencies at undervalued levels relative to the dollar by funding the U.S. current account deficit, will be a key topic at PIMCO's upcoming 2005 Secular Forum.

Commentary by PIMCO MD Chris Dialynas: It is interesting because the presumption that we have a semi-fixed exchange rate system is a farce because the greater the imbalance, the greater the inclination to speculate against the debtor country in favor of the large creditor countries. This suggests that there will be a lot of speculation in Chinese assets, including property, for purposes of not only the productivity of the asset or property, but to capitalize on the revaluation of the currency as well. That means this presumed stable exchange rate regime has engendered a much riskier financial environment because as the trade imbalances grow and grow, then the risk associated with speculation against the debtor country currency becomes lower and lower.

The recycling of money is in essence providing externalities in the form of a higher U.S. dollar than should otherwise be the case, lower U.S. interest rates than would otherwise be the case, much tighter credit spreads because foreign investors are such huge buyers of U.S. corporate bonds, and lower mortgage rates because they are also investing in U.S. mortgage-backed securities. And they obviously own a lot of Treasury and agency securities. So the U.S. has much lower interest rates generally. This process has led to artificially low interest rates, low inflation rates, and an overvalued currency, and it probably manifests itself in the domestic economy in much higher housing prices, so perhaps a housing bubble as well.

The system that is advertised as Bretton Woods II, a semi-fixed exchange rate stable system, by virtue of the system itself, creates greater imbalances and a much more speculative environment. That takes us to the commodity complex. The natural equilibrating mechanism for trade balance is exchange rate adjustment and under BWI, the transfer of gold from one country to another settled trade imbalances. Gold was the stable value global asset.

If you think the dollar is at some point vulnerable to a decline in purchasing power then you obviously want to purchase hard assets now because those hard assets will retain their value in global terms if they are globally traded assets like gold, diamonds, or oil, among many other commodities. This is particularly true if the yield on dollar denominated bonds is very low.

But just as importantly, if you think that this imbalance leads to the potential for more military action, then there would be a natural tendency, it would seem to me, for leaders of foreign countries to begin stockpiling assets that they might deem valuable in time of war. Just as the U.S., during an election year, refused to open the strategic oil reserve, then you would think there would be copycat countries that, if they had not already, would establish strategic oil reserves and fill them. In that event, you get precautionary demand for oil so that the oil comes out of the ground and goes right back in to the ground. The demand for oil looks very high and prices go up based upon not only commercial demand, but also actual precautionary demand and the speculative demand derived from this BWII system.

The BWII system results in speculation and instability. Importantly, the growth rates of "emerging" economies, like China, are quite high in a BWII system as are the infrastructure requirements. The transformation of growth to newly industrialized areas results in additional demand for commodities that are inputs to the infrastructure development, resulting in a structural demand for particular commodities.

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