The Multi-polar Reserve Currency System and its Inherent Stabilizing Mechanism

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1 The Multi-polar Reserve Currency System and its Inherent Stabilizing Mechanism Pan Yingli Shanghai Director of the Research Center for Modern Finance, Shanghai Jiao Tong University Professor of Antai College of Economy and Management, Shanghai Jiao Tong University

2 Outline 1. The instability of the current IMS 2. The key point of today s IMS reform: to build the stabilizing mechanism for the international currencies 3. Build the 5+1 international currencies cooperation and coordination mechanism 4. Impose Tobin tax under the UN framework to support the supply of international public products

3 1. Flaws of the IMS Mundell (1971) held that an effective IMS has to address three key questions: an adjustment mechanism for the balance of payments(bop); liquidity; and confidence in the international reserve currency. (1) The conflict between the multi-polar world economy and the single reserve currency Triffin s dilemma (1960): Bretton Woods system faces a dilemma between meeting the demand for dollars and maintaining the dollar-gold fixed correlation. Triffin identified the conflict between the liquidity supply and the confidence in international reserve currency, and forecasted the breakdown of Bretton Woods system. Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey (2011) put forward the modern version of Triffin s dilemma: the overseas reserve assets (US government debts) are getting increasingly deviated from the US fiscal performance (US government s ability to redeem the bond). If the situation continues, this could potentially lead to a systemic collapse of the current IMS.

4 Future of the multi-polar world economy Figure 1:growth forecast by OECD

5 Distinguish the transaction demand and the reserve demand for USD As long as the trade between two countries is well balanced, the demand for currency for payment and settlement does not have to be proportional to the growth of international trade volume, given that goods can in theory be exchanged for other goods. The transaction demand can be abated by strengthening the financing capacity of IMS, expanding SDR applications and establishing bilateral and multi-lateral settlement and clearing systems and currency swap networks. Current reform schemes are basically limited in this area. The biggest challenge of today s economic globalization is the international division of labor has shifted from the horizontal style (wine in France exchange for fabric in Britain) to the vertical style (ipod), leading to the structural imbalance in the world distribution of the production capacity of the tradable goods and the final demand. More and more emerging countries redeem their demographic dividend by trade. Due to the overreliance of IMS on the USD, these countries have to hold larger investment position on US assets for storing their newly-created wealth. This is the root of global economic imbalance.

6 Figure2: China s foreign exchange reserve as China s national wealth 外储存形式存在的

7 Multi-polarization of world economy requires expanding supply of international reserve assets Early studies indicate the amount of foreign exchange reserve should equal to the amount of 3-month import. But China s foreign exchange reserve was more than 9.5 times its 3-month import in 2009 and this ratio maintained larger than 7. We regard 85% of China s foreign exchange reserve as the oversea storage of national wealth instead of the capability of international payment and settlement. While the focus of global economy shifts toward Asian emerging markets, the multi-polarization of economy requires the multi-polarization of international reserve currencies, in order to meet the demand of international reserve currencies stemming from the global division of labor. This requires the development of European official bond market supported by European fiscal integration. It also requires RMB internationalization and the corresponding capital market opening. Involving the supply of international reserve asset, SDR cannot help.

8 (2) Floating exchange rate regime and short-term capital flow lead to huge instability of international financial system Fritz Machlup and the Bellagio Group (1960s) put forward the floating exchange rate regime in order to adjust the BOP imbalance and hoped to reduce the demand for reserve currency. Neither of the goals has been achieved. The market environment has changed and it is hard for exchange rate to adjust the BOP balance. The industrial chain division makes the domestic GDP from the processing industry translate into the trade surplus. Pankj Ghemawat (2010), professor of Harvard Business School, gives the case study: China imports more than 400 spare parts for processing and exporting ipod, which is sold at 299 dollar in the US. The US trade deficit to China is 150 dollar but the China s revenue accounts for only 1-2% of the price. In 2005, China s processing export accounts for 57% of the total export. The self-fulfilling mechanism or positive feedback mechanism of the speculative capital s expectation: the volatility of exchange rate increases the instability of capital flow, triggering larger demand for self-insurance of developing countries and expanding global economic imbalance.

9 (3) Global financial cycle driven by systemically important central banks Figure 3: Policy rates of advanced countries and QE

10 Figure 5:NYSE composite index grows by more than 10 thousand points (CEIC database) The amount of domestic listed companies in the US has shrunk by 14% from 1975 to Graig Doidge, G. Andrew Karolyi & Rene M.Stulz, 2015.

11 Financial added value accounts for 20% of GDP in the US.

12 Figure 5: the substitution effect of the global liquidity after the crisis (Unit: bn USD) Advanced Economy A Emerging Economies Advanced Economy B

13 Figure 6: In spite of the capital control, the capital inflow plays a leading role in China s stock bubble and crash. Quarterly data from the 1 st quarter of 2011 to the 3 rd quarter of 2015 Data source: State Administration of Foreign Exchange

14 2. The key point of current IMS reform (1) Create condition for transition from the unipolar system to the multipolar system. (2) To build the inherent stabilizing mechanism for the coming multipolar system, we need: i. to reinforce the international monetary cooperation and implement the managed floating exchange rate regime with a wide target zone; ii. to reinforce the short-term capital flow management.

15 3. Build the 5+1 international currencies cooperation and coordination mechanism (1) Based on SDR currency basket, the 5+IMF International Monetary Management Committee should be established to focus on the regular dialog and coordination on monetary policies. A target zones regime should be put in place, which restricts the international exchange rate fluctuation within a range of 10%-15% on each side around the central rates (CFR report, 1999). The international exchange rates fluctuation with a wide range has already lost its legitimacy in reality. i. abandon the original intention of the regime design: not decrease the demand for reserve but expand the BOP imbalance. ii. The free floating exchange rate and the cross-border arbitrage increase the instability of the international financial market. The turnover of the global exchange market has reached 2000 trillion USD, but only 1% of the transactions are based on trade. iii. The finance develops excessively and grabs the harvest from the real economy.

16 4. Impose the global Tobin tax under the UN framework The United Nation has the function of global legislation; take the procedure and induce the global Tobin tax; impose the Tobin tax on all of the short-term FX transactions with a tax rate of 0.5%. Three benefits: (1) reduce the exchange rate fluctuation and stimulate the trade and real investment; (2) the tax revenue can be used to establish funds for financial stabilization (managed by IMF after the reform), global peace (managed by UN) and development (managed by social organization mandated) so that the problem of supply of international public goods can be solved; (3) it contributes to the U.S dollar stability, the smooth transition from the unipolar reserve currency system to the multipolar system, and future building of the inherent stability mechanism.