How dollar became king of global finance

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India and Japan have agreed to raise the value of currency swap from the $50 billion (agreed in 2013) to $75 billion during Prime Minister Narendra Modi’s two-day visit to Japan on October 28-29. This means India can now readily borrow up to $75 billion from Japan in exchange for rupees. This was the latest measure taken by the government to dampen the rupee’s slide against the dollar.

But India is not the only country taking measures to reduce dependence on the dollar. Many countries have started settling trade transactions in local currencies.

Germany and France are setting up a Euro based trading system to continue trading with Iran in the wake of the US call to punish countries having any trade relation with Iran.

Every few years local currencies across the world face intense pressure in the forex market. This pressure has a direct link to the US-controlled global financial system. As if connected through an umbilical cord, countries prosper and decline in sync with the US Federal Reserve’s actions. But how did the dollar become the centre of global finance? And, what does it mean for India and the world?

The roots

Since the early 19th century, countries struggled to find the best way to settle trade balance. It was not easy as each had its currency with no check on more printing. Finally, most countries agreed to settle trade deficits through the exchange of gold. This system continued up to Word War I.

Then many countries stopped their currencies’ convertibility to gold so they could print more money to finance the war effort. Disappearance of gold as a common anchor led to the collapse of the global financial system and became one of the reasons leading to great depression in the early 1930s.

Bretton Woods

Realising the importance of an anchor like gold for promoting stable trade and finance, countries on the winning side of Word War II agreed to establish a robust global financial system. They considered many options.

John Maynard Keynes on behalf of Britain proposed creating an International Clearing Union (ICU) to keep account of countries’ exports and imports. The unit of account for such transactions would be Bancor (French for Bank Gold).

Exports would add Bancors while imports would subtract these in a country’s ICU account. Limits were proposed on the amount of deficit, and if it exceeded, the country’s currency was allowed to depreciate. It was a currency neutral system.

But the US rejected Keynes’ proposal and proposed that the new system should rest on both gold and the US dollar.

No one liked this idea as this would make the dollar the supreme currency of the world. But the US, the principal financier of the victorious side of the war prevailed. And except for the Soviet Union, all 44 participating nations signed the Bretton Woods agreement in 1944 at Bretton Woods, New Hampshire, US.

The member-countries agreed to maintain a fixed exchange rate which could be adjusted if deficits or surpluses persisted. The International Monetary Fund (IMF) was created to lend to member-countries in need of foreign exchange.

The price of gold was fixed at $35 per ounce. The US agreed to supply gold at this price in the exchange with dollars held by other countries.

De-linking of gold and dollar

The gold for dollar system worked during 1950-70. But it came under strain as the US started printing and spending a large value of dollars on post-war reconstruction efforts. When countries holding these dollars went for exchange with gold, the US gold reserves started vanishing.

Gold supply was finite, but the dollar printing knew no limits. The story came to an end in August 1971 when the US reneged from its commitment to convert the US dollar to gold.

De-linking gold with dollar made the US the linchpin of global finance. Other countries need to earn foreign exchange by exporting; the US Fed has just to hit the print button. Fed has almost become the central bank of the world. Central banks all over the world must calibrate their policies to be in sync with the Fed’s.

It could print dollars without bothering about domestic inflation or balance-of-payments as over two-thirds of all dollars in circulation are held outside the US. It could carry out massive expenditures on military activities and foreign aid to achieve its political objectives.

The Soviet Union was the only major country opposing the dollar’s status, and that was the main reason for the Cold War. Europe and Japan reluctantly joined the US political and military umbrella, and accepted dollar as the de facto world currency.

Impact of $-centric system

A country’s economy is ransom to Fed’s actions. If Fed increases the interest rate, dollars flow back to the US, and if it lowers rates, dollars move to the world to take advantage of growth stories or interest rate arbitrage of individual countries.

Trillions of dollars loaned to corporates at near zero interest rate transfer wealth from the people to corporates, a key reason for the concentration of wealth in the top one per cent of the population.

US actions are being emulated by China and other countries which have also printed and offloaded large volume of money in the past 10 years. Awash with cheap loans, Chinese firms export subsidised goods with no relation between cost and price. This has distorted the world trading pattern.

India’s options

The key to managing the rupee are: One, avoid the lure of hot money that comes for investment in debt market and shares. It leaves the economy devastated while leaving.

Two, reduce our $90-billion annual crude oil import bill. This is possible through transparent regulation, investment in domestic oil exploration and switching to green energy options. Many countries, including the US, have turned from energy importers to net energy exporters using these strategies.

And, three, India is batting far below its potential in exports. Make export a national do-or-die priority.

The writer is from the Indian Trade Service. The views are personal.



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