Tuesday, February 28, 2017

In the Shadow of the Hegemon

David Beckworth thinks the Fed is the global central bank (excerpt):

The Monetary Superpower: As Strong As Ever

[A] defining feature of the US financial system is that its central bank, the Federal Reserve, has inordinate influence over global monetary conditions. Because of this influence, it shapes the growth path of global aggregate demand more than any other central bank does. This global reach of the Federal Reserve arises for three reasons.

First, many emerging and some advanced economies either explicitly or implicitly peg their currency to the US dollar given its reserve currency status. Doing so, as first noted by Mundell (1963), implies these countries have delegated their monetary policy to the Federal Reserve as they have moved towards open capital markets over the past few decades.

These “dollar bloc” countries, in other words, have effectively set their monetary policies on autopilot, exposed to the machinations of US monetary policy. Consequently, when the Federal Reserve adjusts its target interest rate or engages in quantitative easing, the periphery economies pegging to the dollar mostly follow suit with similar adjustments to their own monetary conditions.


The second reason for the global reach of US monetary policy is that a large and growing share of global credit is denominated in dollars. That means the Federal Reserve’s influence over the dollar’s value gives it influence over the external debt burdens of many countries.


The third reason for the extended reach of US monetary policy is that other advanced- economy central banks are likely to be mindful of, and respond to, Federal Reserve policy given the large size of the dollar bloc... These findings imply that even inflation- targeting central banks in advanced economies with developed financial markets are not immune from the influence of Federal Reserve policy. This has led Rey (2013, 2015) to argue that the standard macroeconomic trilemma view is incomplete.

He also points us to a new working paper that shows that US Dollar use has in fact expanded over the past few decades, despite the breakdown of the Bretton Woods system in the early 1970s.

Why is this important, and why should it matter to us in Malaysia?

Consider the standard macroeconomic trilemma. A country can only control 2 out of these 3 variables:

  1. The capital account
  2. The exchange rate
  3. Domestic interest rates

For a small open economy (i.e. an open capital account), you can control either the exchange rate, or domestic interest rates. Controlling one means automatically giving up control of the other, because of the way the two interact. For example, trying to sustain a particular exchange rate value under capital mobility means that you have to also match interest rate differentials with that of the anchor currency (i.e. the USD). Otherwise there will be pressure on the exchange rate to move. The opposite is true: controlling interest rates means having to allow the currency to float, because by definition, allowing interest rate differentials to converge or diverge also implies an exchange rate that MUST vary.

Actually, it’s a whole lot more complicated than that, but this will serve for the sake of simplifying the exposition.

Trying to control both, while simultaneously allowing the free flow of capital, leads to things like the Tequila crisis, or the Asian Financial Crisis. The problem with the exchange rate anchor is that while you gain the credibility (inflation credentials) of the anchor currency, you fall mercy to the business cycle of that anchor currency, which might not match your own. The problem with the interest rate anchor is that you face the problem of potentially large swings in the exchange rate, which could have real (and not just nominal) effects on your economy.

But what Professor Beckworth is essentially pointing out is that even this story is incomplete. The pervasiveness of US Dollar use means that even large economies have to be wary of the Fed and USD movements, what more small open economies like Malaysia.

The situation we’ve seen over the past decade shows some of the problems. The Fed, being focused on domestic recovery, followed expansionary monetary policy including unconventional quantitative easing. This is right and proper for the US and means the Fed is responding to its mandate; but its not so great for the rest of the world. The wave of liquidity flowing out of the US boosted asset prices around the world, even in those countries nominally independent from US monetary policy (i.e. they had floating exchange rates). In fact it created a dilemma for other central banks – accelerating economic activity called for higher real interest rates, but higher real interest rates would boost expectations of exchange rate appreciation, drawing in even more capital which would boost asset prices even further.

Now that the tide has turned, we’re running up against the opposite problem – the US needs to tighten monetary policy, whereas the rest of the world really doesn’t. Yet Fed tightening, manifesting itself in a stronger USD and a drying up of offshore USD liquidity, is causing difficulties. We now have the central bank dilemma in reverse – sustaining economic conditions (or equivalently, avoiding an asset price crash) means loosening monetary conditions. But this means cutting interest rates (or devaluing exchange rates), expectations of which draw even more capital out, and creating ever tighter monetary conditions.

The (perfectly rational) response of companies and individuals, isn’t helping. Seeing a stronger USD, many would prefer to keep their money in USD rather than in local currencies. This is especially true of those involved in exports and imports, or have commitments overseas. But this makes the central bank dilemma even worse as it reduces the traction monetary policy has on the domestic economy, and potentially destabilises the banking system from asset-liability mismatches either within the banks themselves or among their customers.

The trade-offs from dollarisation might be worthwhile in a less developed economy with synchronised business cycles and still trying to establish credible institutions; it doesn’t make sense for an emerging market with diversified trade and already solid institutions.

Which brings us to the measures BNM took last December. While the main aim was to reduce the volatility of the USDMYR exchange rate, in a very real sense it was also about maintaining the effectiveness of domestic monetary policy. Just as an example, less than 1% of export proceeds from Malaysia’s sustained trade surplus since 2010 was converted into Ringgit.  That seriously complicates the central bank’s ability to lean against the wind, as the impact of central bank policy measures falls mainly on holders of domestic currency, while those holding foreign currency are insulated (and thus aren’t affected).

Mexico is a great example of what happens when you have that imbalance – over the past year and a half, the Banco de Mexico has doubled their benchmark interest rate, from 3% in November 2015 to 6.25% this month. This is in the context of an economy barely growing by 2%-3%, and heavily exposed to the drop in oil prices.

So what to do? For the past 3 years, since the beginning of Fed tapering, we’ve been holding on to the proverbial Tiger’s tail – we can neither let go, nor can we get off. Given Malaysia’s exposure to international trade, we’ll always have some degree of risk from dollarisation – not completely as the economy is more than just exporters and importers – but enough that it mutes the ability of monetary policy to manage economic growth and price stability domestically.

The long term solution is to move to a multiple reserve currency world, but we’re far from an end game here. Despite central banks globally diversifying their reserves, use of the USD in capital flows and trade settlement have not really fallen. In any case, none of the other major contenders (like Europre or China) have anything like the unique set of characteristics that the US offers. Another solution is to give it all up and cede monetary sovereignty to the US, like those who peg their currencies to the USD, or allow full dollasrisation, like Zimbabwe. But this is only workable and sustainable if you heed the lessons of the Euro and also cede fiscal sovereignty as well, and hoping the Americans play ball – uh, not going to happen, especially in the Age of Trump.

So in the meantime, in this struggle to retain control over our own destiny, we’ll be like a surfer riding a big wave – on the fine line between staying upright and wiping out.

[Bonus points to whoever gets the Sci-Fi reference in the post title without resorting to Google]


  1. I have always been in the opinion that one of BNM's mandate to "maintain the stability of the ringgit" was a dangerous line to maintain. It leaves room for BNM to intervene in the market to "control" the ringgit trend, even though its supposed to be leaning towards free capital mobility and an independent central bank. BNM has to decide soon on what kind of monetary conditions it wants to keep to. While a multiple reserve currency world would ease the problems of dollarisation, why not a currency or monetary union for ASEAN as a whole? There were a number of economists in the early 2000s who saw the benefit of such a union to ease trade flows between countries though noted the impossibility of political integration (the EU is an example of this failure in political integration).

    1. @ho

      Actually, BNM's monetary policy mandate is for growth and price stability. The exchange rate isn't mentioned.

      But the problem here is that the problem outlined here (trend towards dollarisation) directly impacts the channels by which monetary policy operates on the domestic economy, although considerations of financial stability are also relevant.

  2. Bonus points to me!

    Good read (had to reread to make sure I understood it)