International Financial Markets: Asset Trade, World Reserve Currency

By Rajeev Dhawan
Member, Financial Roundtable
Director
Economic Forecasting Center
J. Mack Robinson College of Business
Georgia State University

A Sept. 10 session at the annual meeting featured three presentations that focused on international financial and currency-related developments. In light of the ongoing credit market turmoil the session was a timely one, and not surprisingly, very well attended.

The first presenter was Maurice Obstfeld, professor of economics at the University of California-Berkeley, whose presentation titled “Recent Trends in Financial Globalization: Emerging Markets, Reserves, and Global Imbalances” was in keeping with his reputation as the foremost expert on international issues. His graduate level textbook on this topic is very well regarded, and is a must read in Ph.D. programs all over the world. Obstfeld started by listing the stylized facts on the level of international financial integration that has proceeded very quickly for the emerging markets, notwithstanding the late 1990s Asian financial crisis. Furthermore, he presented a roadmap for a potential crisis that can occur with financial deepening and opening of capital markets. An important lesson learned from Obstfeld’s exercise: the open-economy “trilemma.”  It means that an open economy can enjoy only two of the following three at the same time: exchange stability, capital mobility, and domestic orientation of monetary policy (e.g., an inflation target). Furthermore, for emerging markets, currency mismatch makes it difficult to float a currency as freely as for industrial countries. This usually results in monetary policy getting compromised.  The solution to this problem is to have plenty of international reserves. He had to hurry through his presentation, unlike in an academic seminar where you have an hour plus to prove your point, a business forum gives you only 20 minutes. His last few slides were a treat. He may be a professor but he is a forecaster at heart, as he laid out a roadmap of expected global financial adjustments. I highly recommend checking out his slides on the session page website and spending some time absorbing it.

The second presenter was Heinz Jürgen Büchner, vice president of economics and research from IKB Deutsche Industriebank AG, who discussed “Where Do the Petro-Dollars Go?  The answer, not surprisingly, is to build up dollar reserves first and later towards domestic investment. Thus, even the “rich” oil-producing countries feel the need to have currency reserves as a hedge against future financial crisis. Büchner then presented evidence as to how strongly the imports have grown in the Middle East, with the surprise leader being UAE. Why are UAE imports on a tear? Because it is the conduit to Iran! He then presented evidence on the changing nature of investments in this region that are now concentrated heavily in the area of transportation and logistics (do check out the chart where Dubai is ranked among world’s ports in terms of tonnage), with special emphasis on building cities from scratch in the desert. (His description of this phenomenon and anecdotes was very illuminating.) And like any emerging economy with run-away growth this region will also need to spend massively on meeting its domestic power needs. (It takes a lot of energy to maintain a ski slope in Dubai’s heat!) Lots of charts and useful information were presented about where and how the money is being spent in different industries in the region, and who are the suppliers from the rest of the world. And where there is money there will be hedge funds to manage them. Petro-dollars have definitely flown into them although hard evidence is difficult to come by. However, he made a good case for how these countries are investing in high tech sectors by buying into established marquee firms in Europe and the United States, because at present they lack their own labor force to invest in this sector. By the way, he did finish in his allotted time.

The last presenter in the session was Brian A. Bethune, director of financial economics, Global Insight, who talked about global foreign reserve accumulation and global current account adjustment with a perspective on “How Much Should We Worry?”  He started with listing his four key questions and ended as promised, in time, with his clear answers to those questions. In between, he presented evidence in the form of copious but clear slides, charts, and graphs. First, we don’t need to worry about the reserve accumulation trends as they are in sync with the growth of world exports and include the much-needed precautionary buildup. Second, regional imbalances since the Asian/Russian crisis in 1997/1998 and the 2000 oil price shock can be problematic, but he doesn’t anticipate any major problems. Third, a five percent U.S. current account deficit is sustainable in his view.  This optimistic forecast is ultimately based upon the U.S. dollar being the choice of reserve currency and reserve accumulation in the world. This assertion brings into play a very important issue: How long will this good fortune last if countries have already begun to diversify their foreign reserve holdings in light of the U.S. dollar’s devaluation in the last few years?  Bethune’s strong prediction or assertion: the diversification of reserves by a further five percentage points or so does not pose a serious threat to the role of the U.S. dollar as a major reserve currency or to the financing of the U.S. current account deficit.  I am very sympathetic to this point and my two cents on this issue are in the following sentence. From the drug dealers in the streets of Moscow to the underwriter for exports in Singapore, all these transactions are conducted in dollars! Liquidity motive, although not unlimited, is a very important factor.