Positioning the world for a transitional euro reserve system
We missed this earlier this month, but it is worth a reprise.
How do you create a global reserve currency?
Some clues by way of a speech by Benoît Cœuré, ECB board member, earlier this month:
The benefits include:
On which note, do read the FT’s Martin Sandbu review of the latest piece by BP chief economist (and former BoE man) Spencer Dale, which draws attention to the new monetary and energy balance in the world. He who requires the spice, is doomed to pump endless IOUs into the international system.
Dale notes that BP expects the US to become self-sufficient in energy by the early 2020s and in oil by the early 2030s:
To the contrary, China and India are likely to account for around 60 per cent of the global increase in oil demand over the next 20 years:
There are geopolitical consequences of this precisely because it releases the US from its exorbitant duty responsibility:
Rent, as Sandbu explains, is politically potent because it represents a windfall to be distributed or spent at will by those who have economic leverage in the system. For decades sovereign oil producers have benefitted from this extraordinary privilege to charge an essential “tax” on oil consumers.
But shale changes this quite dramatically precisely because it resembles a manufacturing process which increases the elasticity in the oil market and by doing so reduces the ability of large producers to extract undue amounts of rent.
As Sandbu notes:
Going back to Cœuré and the euro, it could well be that because of the manufacturing oil production effect, there simply won’t be a predominantly global reserve currency at all.
Such a framework is known as a multi-polarity system.
On paper of course this sounds great — no exorbitant privilege or duty for anyone!
But as Cœuré observes, be careful what you wish for.
Global imbalances may have caused all sorts of confusion for the system, but they may also have led to a unique period of global cooperation and de-risking thanks to the provision of a financial shock absorbing effect.
Or as Cœuré puts it, some people are worried that a multipolar currency system might increase global financial instability:
As he concludes:
Related links:
New Economics of Oil – BP
Hello world. I’m the PetroEuro! – FT Alphaville
Is the end of the oil era nigh? – FT Alphaville
China’s defence against supply chain disruption - FT Alphaville
On the hypothetical eventuality of no more petrodollars – FT Alphaville
With petrodollars also go global reserves – FT Alphaville
Goldman on the commodity/EM financing negative feedback loop – FT Alphaville
How do you create a global reserve currency?
Some clues by way of a speech by Benoît Cœuré, ECB board member, earlier this month:
At constant exchange rates, the euro’s share of global foreign exchange reserves has remained broadly unchanged since 2007-08. The decline in 2014 in the share of the euro at market exchange rates was a reflection of the depreciation of the euro. There is therefore no evidence that global foreign exchange reserve managers actively rebalanced their portfolios away from the euro in 2014, or in 2011-2012 for that matter. This year the euro has been increasingly used as a funding currency by international borrowers, owing to the historically low interest rates in the euro area. Investment-grade corporations in advanced economies, mainly the United States, were particularly active issuers of international bonds denominated in euro, whose proceeds are swapped back into dollars. In April 2015 Mexico became the first sovereign state to issue a bond denominated in euro with a maturity of 100 years. Moreover, the share of the euro as an invoicing or settlement currency for extra-euro area trade remained broadly stable again last year. Finally, the euro is used as a reference currency for the anchoring of exchange rates, mainly in countries neighbouring the euro area and countries that have established special institutional arrangements with the EU or its Member States.While Cœuré goes on to note that the ECB’s position on the international use of the euro is neutral, the ECB neither hindering nor promoting it, believing that ultimately the scope of any international role is determined by market forces, he does note there are benefits as well as costs associated with reserve status.
The benefits include:
1) Seigniorage: interest-free loans to the issuing central bank from non-residents who hold the international currency. In the current environment of low interest rates, this benefit is arguably very limited.As for the costs:
2) Efficiency gains in financial intermediation and lowers transaction costs (it’s so much cheaper to do business if everyone takes your currency).
3) Exorbitant privilege: International currency issuers can issue debt to non-resident investors at lower interest rates than other issuers (to the extent that the currency is perceived as safe and liquid) and moreover they can invest the proceeds in higher-yielding foreign assets. The magnitude of this differential remains a subject of heated debate, however (says Cœuré).
4) Shock insulation: Recent studies suggest that exchange rate pass-through to import prices and domestic prices declines significantly, even at distant horizons, if a significant share of imports of goods and services is invoiced in the domestic currency.
1) Widens the central bank remit: “It may make monetary developments more difficult to interpret, with shifts in non-resident demand for banknotes and deposits having a direct impact on money aggregates. It may complicate the conduct of monetary policy if money demand and capital flows become unstable as a result of external shocks, as the experiences of the Deutsche Mark and the Swiss franc after the demise of the Bretton Woods system starkly illustrate.”Regarding those responsibilities, Cœuré offers some insight into why the current global reserve provider may be back-peddling from many of these duties (our emphasis):
2) Exorbitant duty: International currency issuers provide insurance to the rest of the world in times of global financial market stress, which gives rise to potentially large financial transfers between economies.
3) With great privilege comes great responsibility: With international currency status come greater responsibilities and challenges at the international and domestic level.
At the international level, one challenge is about global liquidity risk. For instance, central banks in major advanced economies have been called upon by emerging markets to establish a structured network of currency swap agreements to mitigate the risks of international currency liquidity shortages. Such agreements are however possible to the extent that they are in line with the domestic mandate of the central bank of issue, i.e. in case of concerns that liquidity stress in global markets could materially impair the pursuit of domestic policy goals. Further progress in global and regional financial safety nets would help overcome this limitation.That’s important stuff. Why would any sovereign wish to be the global liquidity provider of last resort if it needn’t be? Especially if it no longer has to send out bucket loads of IOUs to cover for its energy deficit?
At the domestic level, another challenge is about foreign exchange risk. In this respect, the marked rise in foreign currency-denominated borrowing since the financial crisis, in particular in US dollars and more recently also in euro, could lead to increased demand for currency swap agreements. Currency mismatches may create financial stability risks in some emerging market economies in the event of a significant appreciation of the international currency, and the central bank of issue may be called to the rescue as “hedger of last resort” of foreign currency risk, which falls clearly outside of its domestic mandate.
On which note, do read the FT’s Martin Sandbu review of the latest piece by BP chief economist (and former BoE man) Spencer Dale, which draws attention to the new monetary and energy balance in the world. He who requires the spice, is doomed to pump endless IOUs into the international system.
Dale notes that BP expects the US to become self-sufficient in energy by the early 2020s and in oil by the early 2030s:
To the contrary, China and India are likely to account for around 60 per cent of the global increase in oil demand over the next 20 years:
This increase in oil demand will far outstrip local supplies, such that by 2035, China looks set to import around three-quarters of the oil it consumes and India almost 90%.What this means is that a key element in the global imbalances has completely changed. And in Dale’s opinion the reduction in the US energy deficit has certainly contributed to the dollar’s appreciation in recent years.
There are geopolitical consequences of this precisely because it releases the US from its exorbitant duty responsibility:
It is inconceivable that the reduced dependency of the US on oil imports won’t affect its relationship with some of the key oil producers. Perhaps even more importantly, China’s increasing reliance on energy imports to fuel its future growth – and the associated concerns this brings about energy security – is likely to have an increasing influence on China’s foreign relations. Indeed, it seems likely that the creation of the Asian Infrastructure Investment Bank (AIIB) – and the associated “one belt, one road” policy which has been a centre piece of President Xi Jingping’s first term – stems in no small measure from these energy security concerns.But, as Martin Sandbu notes, there is another important factor that relates to all of this. The diminishing amount of “rent” making its way into the global system, on account of both the US backing away from its dollar reserve position, but also because of the entry of shale to the market.
Rent, as Sandbu explains, is politically potent because it represents a windfall to be distributed or spent at will by those who have economic leverage in the system. For decades sovereign oil producers have benefitted from this extraordinary privilege to charge an essential “tax” on oil consumers.
But shale changes this quite dramatically precisely because it resembles a manufacturing process which increases the elasticity in the oil market and by doing so reduces the ability of large producers to extract undue amounts of rent.
As Sandbu notes:
…it is harder to sustain economic rent if new production can easily be brought on stream to compete away the profit margin — then the politics of oil may well follow the same course.That disadvantages any country that doesn’t have the capacity or will to indulge in shale production, and makes it the growing target of oil producing rent extractors.
Going back to Cœuré and the euro, it could well be that because of the manufacturing oil production effect, there simply won’t be a predominantly global reserve currency at all.
Such a framework is known as a multi-polarity system.
On paper of course this sounds great — no exorbitant privilege or duty for anyone!
But as Cœuré observes, be careful what you wish for.
Global imbalances may have caused all sorts of confusion for the system, but they may also have led to a unique period of global cooperation and de-risking thanks to the provision of a financial shock absorbing effect.
Or as Cœuré puts it, some people are worried that a multipolar currency system might increase global financial instability:
They argue that the likelihood of self-fulfilling runs on reserve currencies would increase, insofar as investors could switch more easily from one currency to another, seeking to convert their holdings first for fear of suffering losses down the line.Cœuré himself suggests that this fear may be overblown because sovereigns will likely act as countercyclical agents, loading up on inventories in the style of dealer banks before them:
These concerns might be overblown, however. First, the extent of price adjustments would depend significantly on the degree of substitutability between reserve assets and on whether reserve currencies would be seen by investors as substitutes or complements. Second, official reserve managers have a longer time horizon than private market participants and are therefore more likely to act as stabilising rather than destabilising investors. Third, the sub-prime and euro area crises showed that, even when large shocks occur in reserve-issuing countries, rebalancing in reserve portfolios may remain limited.But we’re not there yet. While Cœuré seems confident the global monetary system will evolve towards a multi-polarity system over time, it’s more likely that in the interim the euro crisis has paradoxically improved the euro’s prospects as an international currency.
As he concludes:
In the light of this, a stronger international role for the euro, while not being an objective per se, would be an indicator not only of the continued confidence of the rest of the world in the single currency and in the euro area, but also of the success of the EU in completing EMU. And vis-a -vis the latter outcome the ECB is definitely not neutral.Behold ladies and gentlemen, the upcoming transition towards the PetroEuro.
Related links:
New Economics of Oil – BP
Hello world. I’m the PetroEuro! – FT Alphaville
Is the end of the oil era nigh? – FT Alphaville
China’s defence against supply chain disruption - FT Alphaville
On the hypothetical eventuality of no more petrodollars – FT Alphaville
With petrodollars also go global reserves – FT Alphaville
Goldman on the commodity/EM financing negative feedback loop – FT Alphaville
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