Up to 60 percent of global transactions are conducted in U.S. dollars, more than one-third of world economic output is produced in dollar bloc economies, and an even greater share of global assets are priced in the currency, or linked currencies. This role as the de facto global currency for more than six decades has made the Federal Reserve’s monetary policy one of the U.S.’s greatest exports.
As we have observed recently in southern Europe, or in Asia during the 1997 financial crisis, importing monetary policy can be dangerous. It is surprising then that the Fed’s dominance hasn’t caused even deeper problems over the decades.
The relative lack of trouble may be because, for the bulk of the past 60 years, the U.S. has been the world’s largest economy, and other mature economies have accounted for the much of the rest of global output. This has meant that monetary policy settings in the U.S. have usually been in tune with the global cycle. An acceleration of U.S. growth was likely to be mirrored in similar economies, or the better conditions in the United States were pulling along the rest of the world through enhanced trade links.
But this is changing.
The U.S.’s diminishing contribution to global growth means that economic cycles around the world are becoming both less synchronized and more divergent. As a result, Fed policies are proving increasingly inappropriate for most of the rest of the world.
Consider the past three years. In 2010, emerging markets such as Brazil and China were battling rising inflation and overheating economies even as the Fed was engaging in quantitative easing, forcing even more capital toward those markets. Now, with the U.S. in the midst of a sustainable economic recovery driven by domestic causes such as cheap energy and rising house prices, the Fed appears to be signaling that it may tighten policy. Yet the euro area remains in, or close to, recession, and growth in emerging markets is slowing drastically.
This points to a fundamental problem in the monetary system: the Fed’s monetary-policy settings are becoming incongruous with the economic environment of much of the rest of the world.
To be sure, the U.S. is entitled to adjust its monetary policies in response to changes in domestic demand. Indeed, it would be politically unacceptable for the U.S. taxpayer-funded Fed to base its decisions on considerations such as unemployment in Spain or house prices in Hong Kong. Theoretically, countries that experience swings in exchange rates or capital flow as a result of Fed decisions should accept these as a normal part of a global rebalancing, whatever the cost, or benefit, to their international competitiveness. That is what Jeffrey Frankel and others have argued.
But this isn’t realistic, because sovereign nations will instinctively seek to protect their own national interests above the common good.
For years, China has sought to boost its international competitiveness through capital controls and/or foreign exchange intervention. And the quantitative easing era has encouraged many other countries, from Switzerland to Brazil, to do the same.
However, the real effect of such intervention has been to create an overreliance on credit along with significant internal imbalances.
As a recent International Monetary Fund working paper illustrates, countries that attempt to control exchange rates are more likely to experience credit booms, because of the added incentive for companies to take on foreign currency debt and the reality that foreign exchange reserve sterilization is usually only partial. This dynamic is evident in the more than 20 percent annual credit growth in Brazil, or the overstatement of Chinese export data attributable to domestic companies’ attempts to access cheap U.S. dollar funding in Hong Kong.
With investors now convinced that the Fed is on the tightening path, a withdrawal of capital from emerging markets threatens to expose these imbalances. Last week, in an attempt to attract back capital, Brazil increased interest rates by 50 basis points, to 8.5 percent. It is expected to increase rates by an additional 75 basis points by year-end. These are necessary, but hardly helpful, steps in an economy where growth has been driven by credit-backed consumption and where expansion already slowed to 0.9 percent in 2012.
Meanwhile, the recent surge in Chinese interbank rates is being attributed to an unwinding of a U.S. dollar carry trade.
Unfortunately, there is little that can be done at this stage to make the process of rebalancing away from credit-dependent expansion easy. In the near-term, it will mean higher nonperforming loans, liquidity shortages and slower growth.
Ultimately, emerging markets in particular need to resist the temptation to link their currencies to the dollar by intervening in foreign-exchange markets for extended periods of time; such measures may support short-term competitiveness, but do more harm than good in the long run. Unfortunately, the temptation for short-term gains is likely to prove too great, and without more meaningful international pressure, such boom- and-bust credit cycles will become more frequent.
Therefore, in the future, rather than offering tacit support to capital controls and currency intervention, international institutions should take a tough line on countries building significant foreign exchange reserves, all the more so if interventions are associated with a sharp increase in credit.
The coming years will probably show that such interventions are neither in the common nor the national good.
Alexander Friedman is global chief investment officer at UBS and Kiran Ganesh is a cross-asset strategist for UBS Wealth Management, overseeing $1.6 trillion.