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The New Global Balance

Jim Rogers

Brazils Concerns

QFINANCE

Sir Howard DaviA Reserve CurrencyCorporate GovernanceChina and the United StatesWilliam Keega

QUANTUMF i n a n c e i n P e r s P e c t i v e Issue 15 July 20


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Contents

24

QUANTUM FINANCE IN PERSPECTIVE

Aice f QFINANCE

UNINtENdEd CoNsEQUENCEs/30

Paul Wharton

HoldINg tHE CUrvE/45Andrew Milligan

doNt blAmE tHE Fog/58Justin Fox

QFINANCE is a fnancial knowledge base and reerence

source created by the QFC Authority and Bloomsbury

Publishing PLC. See www.qfinance.com

1Quantum - Finance In Perspective - Issue 15

lEssoNs to bE lEArNEd/4The fnancial crisis was the nadir o the WashingtonConsensus, but the speculative culture is still very much

with us, says William Keegan.

rollEr CoAstEr/8Jim Rogers, one o the worlds shrewdest investors,graphically lays out his view o the new global economic

order in a special interview with David Smith.

AmErICAN Hot/12Conrad de Aenlle insists that the United States hasthe underlying strengths to resist the challenge to its

supremacy rom rapidly developing rivals.

tAlkINg rEvolUtIoN/18China may be slowly moving towards greater

international participation but, says David Smith,it will insist on doing so on its own terms.

rEsErvE posItIoN/24Bretton Woods may fnally have had its day, arguesBrandon Davies, and the reserve currency system urgentlyneeds modernising.

mEEtINg oF mINds/34The recent economic meltdown has led to irresistible

demands or broader participation in the regulatoryprocess, says Sir Howard Davies.

sEttINg tHE stANdArd/39International Financial Reporting Standards arespreading round the world but at a comparatively

slow pace. Victor Smart reports.

CorporAtE powErs/52As ownership models become increasingly diverse, FahadToonsi analyses the strengths and weaknesses o diering

methods o corporate governance.

ANotHEr CUp oF CoFFEE/62In a letter rom Brazil, Brian Caplen says the nationsnew status as a world power has led to a major spending

spree that may not be sustainable.


4/682 Quantum - Finance In Perspective - Issue 15

Contributors

Brandon Davies is senior non-executive director o Gatehouse Bank

plc and Premier European Capital

Limited, a private capital company,

as well as chie executive o his owncompany dRisk.biz Limited. He has

more than 35 years o experience in the

banking sector.

Sir Howard Davies has beenthe Director o the London School o

Economics since September 2003.

From 1997-2003 he was the frst

Chairman o the Financial Services

Authority, and rom 1995-97 Deputy

Governor o the Bank o England.

Justin Fox is editorial director othe Harvard Business Review Group

and author oThe Myth of the Rational

Market: A History of Risk, Reward, and

Delusion on Wall Street. He also writes

a blog or hbr.org and is a contributor to

Timemagazine.

Paul Wharton is chie investmentstrategist or Deutsche Bank Private

Wealth Management UK. He is

responsible or economic and market

strategy and the income-orientedportolios, and serves on the UK and

the global investment committees

o Deutsche Bank Private Wealth

Management.

Brian Caplen has been editor oThe Banker since 2003. He joined

the Financial Times Group in 2000

rom Euromoney, where he had been

executive editor or fve years. He

also worked as a business editor and

journalist in Hong Kong and the Middle

East or 10 years.

QUANTUM FINANCE IN PERSPECTIVE. TRADEMARK REGISTRATION IN PROGRESS. QATAR FINANCIAL CENTRE AUTHORITY 2011.

All rights reserved. No part o this publication may be reproduced, stored in a retrieval system, or transmitted in any orm or by any means, electronic or otherwise, without the prior permission o the copyright holder.

Quantum magazine is published quarterly by Camel5 Publishing o London (the Company) on behal o the Qatar Financial Centre Authority (QFC Authority). Whilst the Company makes all reasonable eort to

ensure that inormation contained in articles (inormation) is accurate, complete and not misleading, no warranty, representation or undertaking o any kind whatsoever is given by the Company or QFC Authority. The

Company, QFC Authority and its representatives shall not be liable, directly, indirectly or howsoever or any loss or damage suered or incurred by any party using or relying upon the inormation. Further, no liability

whatsoever is accepted or any er rors, omissions or statements contained in the inormation. Accordingly, all third parties accessing, using and/or relying upon the inormation expressly undertake to car ry out their own

due diligence and independent verifcation o the accuracy and completeness o the inormation.

Contributors

Fahad Toonsi is a manager in theRisk Assurance Services department

o PwC, specialising in corporate

governance and the measurement

o perormance and efciency levels

o frms, boards o directors and

governance systems.

Andrew Milligan is head o global strategy at StandardLie Investments, having worked previously at the British

Treasury, Lloyds Bank, and Smith New Court as an international

economist. He was chie economist at New Japan Securities

Europe, and director o economic research and business risk

at Morley Fund Management.

Conrad de Aenlle writes investment columns and eaturesor The New York Times and International Herald Tribune among

other publications.

William Keegan is the senior economics commentatoro the London Observer, with more than 25 years experience

covering international business and fnance.

Victor Smart is a communications specialist in thebusiness, fnancial and accounting sectors. He is a contributor

to the Economist and Financial Times.

David Smith has been Economics Editor o the London

Sunday Times since 1989, where he writes a weekly column.He is the author o several books.


5/683Quantum - Finance In Perspective - Issue 15

QUANTUM

Editorial

Editorial

The days when the United States and Europe dominated the globaleconomy and set the rules or how the fnancial system operated are

gone, almost certainly or ever. But it is ar rom clear how those

demanding a place at the top table, including India, China, Brazil and

Russia, intend to exercise their power.

In this issue o Quantum Finance in Perspective, a quarterly

magazine published on behal o the Qatar Financial Centre Authority,

we examine this New Global Balance.

In the United States, says Conrad de Aenlle, many bankers and gurus

still believe that the countrys undamental strengths give it a strong

chance o remaining economically supreme and playing the leading role

is setting the rules or international markets.

This view is orceully rejected by Jim Rogers, one o the worlds

shrewdest global investors. In an exclusive interview, he argues that there

is now a huge historic move (in economic power) rom the United

States to Asia, exacerbated by a fnancial crisis and the mistakes made

by politicians.

Rogers has no doubt that fnancial power has already shited

away rom Washington and that, while the fnancial crisis has accelerated

the process, the prime cause has been the Wests slide into

indebtedness.

That debt has been fnanced by creditor nations, headed by China and the extent to which Beijing wishes to exercise its economic power

will be critical to the development o the new global balance.

David Smith says there has been a recent change in attitude. Two

years ago, China appeared to be backing calls or the IMFs Special

Drawing Right (SDR) to replace the dollar as the worlds pre-eminent

currency. Today, says Smith, the enthusiasm or reorm appears to have

cooled, perhaps because analysts have pointed out that a gradual

approach is the best way o preserving the value o its huge and growing

dollar reserves.

The advocates o change to the SDR, headed by Frances President

Sarkozy, remain as loud as ever. The banker Brandon Davies argues that

the fnancial architecture designed at Bretton Woods has now passed its

sell-by date and the reserve currency system may need to be resdesigned

rom scratch.

Chinas current stance suggests that this is unlikely to happen in

the short term but the act that Beijing can now tip the balance either

way shows just how ar and how ast real power is shiting away rom

the West.Q

The New Global Balance

EDITORIAL BOARDSir Graham Boyce

Rajat Gupta

Lord Jacob Rothschild

Sheikha Hanadi Nasser Bin Khaled Al-Thani

Sir Kenneth Warren

Sir John Stuttard

PUBLISHERSarah MacInnes

[email protected]

+44 7879 473 221

EDITORNigel Dudley

[email protected]

+44 208 670 1922

DEPUTY EDITORSStephen Carriere

[email protected]

+974 496 7784

Akshay [email protected]

+974 496 7783

DESIGN/PICTURE RESEARCHMarcus Baron

PRODUCTION MANAGERHannah Martin

F I N A N C E I N P E R S P E C T I V E

z

For subscription please visit our website

www.quantummagazine.com



Historyis BackThe changing balance of global economic power should not come as

a surprise to economic historians. But although it is a fundamental

shift, the speed of the transformation should not be exaggerated,

saysWilliam Keegan.

At the same time, even those

members o older generations who

ought to have known better seemed

to be too wedded to the amiliar, and

resistant to the idea that we had by no

means witnessed the end o history.

Certainly, the Bretton Woods system

had broken down in the early 1970s,

and the prevailing view was now that

markets knew best, and that there was a

limit to the desirability o intervention

by governments.

Western economies have not always

dominated the global economy. Indeed,

at one time China and India dwared

the economies we are accustomed to

describe as advanced. Thus, in the

late Angus Maddisons remarkable

workThe World Economy A Millennial

One o the more interesting and

benecial consequences o the 2007-

2009 nancial crisis and its atermath

is the rediscovery o economic and

nancial history. With the rise o

mathematical economics and the so-

called ecient markets hypothesis,

the study and practice o economics

became divorced rom its historical

roots.

There was a generation o university

graduates, alumni o business schools

and trading practitioners who had

never lived through a recession,

let alone had any knowledge o a

Depression, and who genuinely

seemed to think that the nancial

markets had discovered the economic

philosophers stone.

Perspective, it was estimated that in

1820, shortly ater the Napoleonic

Wars, China accounted or a third

o world GDP, Europe a quarter and

the United States less than 2 per cent.

Indias share was 16 per cent.

The proportions changed

dramatically in the course o the 19th

and 20th centuries. There were trade

cycles, banking crises and periods

o very sharp decline but on average

world GDP grew year by year. The

really interesting contrasts were

between the periods 1913-50 and

1950-73, when average annual growth

o output went up rom 1.85 per cent

to 4.91 per cent.

This latter, largely Bretton Woods,

period was truly the nearest we got

Commentary

z



to a golden age o growth. And, as

Keyness biographer Robert Skidelsky

pointed out in Keynes, The Return o

the Master, there was a sharp decline

in economic growth rates between the

Bretton Woods period almost 5 per

cent a year and the post-1980 period(1980-2009) when average growth

was 3.2 per cent.

It is noteworthy that there were

no global recessions during the

Bretton Woods period, and no ewer

than ve during the so-called (post-

1980) Washington Consensus years.

These ve included the big one

the recession caused by the nancial

crisis o 2007-08, the consequences

o which are still with us. This is

important when assessing possible

uture economic trends, because there

can be little doubt that policymakers

in the rising economic powers

headed by China, India and Brazil

have ully taken on board the deects

o the Washington Consensuss

emphasis on the putative wonders o

deregulation and maximum reedom

or nancial markets.Two events stand out as reasons

why the emerging economic powers

can be orgiven or concluding that

the western emperor has no clothes

the Asian nancial crisis o 1997

and the more recent Great Recession.

Washington was still triumphally

imperialist in international monetary

matters in 1997, and eectively vetoed

a proposal or an Asian Monetary

Fund.

As a result the Chinese and other

Asian countries, having seen what had

happened to deenceless developing

nations in the ace o volcanic capital

fows, decided that this should never

happen again. They built up their own

reserves, giving them not only ample

ammunition to deend themselves

against speculative raids on their

Commentary



currencies, but also massive sovereign

wealth unds, which enabled them to

invest abroad in both nancial and

physical assets, including supplies o

raw materials.

The nancial crisis was the nadir

o the Washington Consensus. Theemphasis had been on price stability

rather than control o credit creation.

The boom in asset prices was noted,

but policymakers reused to take any

responsibility. Financial markets were

allowed to speculate themselves out o

any trust in one another.

The western-dominated G7 and

International Monetary Fund went

along with all this indeed became

vocierous cheerleaders. Meanwhile

China adopted a cautious approach,

picking and choosing what it regarded

as the more useul aspects o market

capitalism, but remaining a lot

more communist than all those

western commentators celebrating

the collapse o communism seemed

to notice.

What has become increasingly

obvious is the sheer economic clouto China, whose economy has grown

by some 10 per cent a year on average

or the last two decades, while nal

domestic demand in the advanced

economies (broadly the OECD area)

grew at 2.9 per cent a year rom 1992

to 2001, and 1.5 per cent a year rom

2002-2011.

But we still lived in the world

where the economic clout o the G7

mattered most. People talked about

the rise o China; but, or all its

ormidable size, it was in global terms

a relatively small economy. I shall

never orget, or instance, a senior

Japanese policymaker telling me in

1997 just what a small proportion

average Chinese living standards were

o Japans. And they still are, although

the gap has narrowed.

There should o course be nothing

surprising about a large gap between

the growth rates o advanced and

developing economies. Indeed, some

analysts can be disingenuous, i not

naive, in contrasting such growth

rates. But the interesting thing is that,

with its maniestly mercantilist trading

policies, its nancial power as a result

o the accumulation o all those

currency reserves and its increasing

demands on world resources, China

has become a major some would say

the major infuence on the course o

the entire world economy.

Thus China may still be only hal

the size o the US when it comes to

economic output less than hal by

ordinary measures o GDP, more than

hal when measured by purchasing

power parity. Nevertheless, at the

margin and economists love talking

about the margin it is enormously

important, with hardly a day going by

when its infuence on the course o

commodity prices is not being cited in

the nancial press.

Some lessons have been learned;

but only some. As I write, the top

bankers are still awarding themselves

massive bonuses despite the act

that they have been bailed out by the

taxpayers. The speculative culture is

still very much with us, not least in the

commodity markets.

One ashionable theory is that

or a decade there was a Faustian

bargain between China and the West

Commentary



The nancial crisis was the nadir o the

Washington Consensus. The emphasis had beenon price stability rather than control o creditcreation. The boom in asset prices was noted, butpolicymakers reused to take any responsibility.

Financial markets were allowed to speculatethemselves out o any trust in one another.

(still dominated by the US), with the

West enjoying cheap goods (with

employment suering at home), but

ailing to realise that demand rom

the Asian manuacturing powerhouse

would drive up the price of commodities

and threaten stagfation slowgrowth but imported infation.

So ar there has been nothing

remotely resembling the stagfation

o the 1970s. The US Federal

Reserve has remained haunted by

the spectre o defation. Meanwhile

the new British coalition government

has superimposed a defationary

programme on an economy that has

shown ew signs o recovery rom

recession.

The eurozone too is in serious

trouble that is to say, peripheral

economies such as Greece and Ireland

are on the edge, while Germany, with

its strength in manuacturing and

exports, prospers. Germanys happy

secret is that other members o the

eurozone, such as Italy, can no longer,

within a single currency, devalue their

currencies to boost competitiveness.

The political will behind the

eurozone project is not to be

underestimated, even i membership

eventually proves too much o a strain

or some o the peripheral nations. It is

also interesting that, as China watches

developments, its policymakers give

the impression o wanting to assist

the eurozone by investing in it asa counterweight to all the nancial

investment they have made in the US.

But, in international economic

governance, the time has surely

come or the heavy presence o the

European Union on the IMF Board to

be reduced, and ar greater weight to

be given to the likes o China, India

and Brazil.

Few would have expected, back

in the early 1980s, that in 2011 the

eurozone would be by ar the IMFs

biggest customer or unds. It is ironic

that Dominique Strauss-Kahn, the

now-departed managing director o

the IMF, was able to play a crucial

role in assisting the eurozone, while

encouraging those who believed that

the structure o the IMF and World

Bank ought to refect the undamental

shits in economic power.

Strauss-Kahn recognised that the

limits o the Washington Consensus

placed more emphasis on the

importance o employment, and

acknowledged the need at times or

capital controls. Moreover, his was a

powerul voice in supporting the scal

and monetary stimulus o 2009. But

whether the Fund itsel will have learntits lesson remains an open question,

given the strict conditions being

applied to the eurozone bailouts.

For economic historians the

changing balance o economic power

in the world should not come as a

surprise. But an historical perspective

also suggests that one should not

exaggerate the speed o change. The

US, notwithstanding the re-emergence

o China, will remain a ormidable

orce in the world economy or decades

to come. Its policymakers leaving to

one side those who support the Tea

Party have been right to concentrate

on warding o a Depression. In the

longer run, the decit, which is seen

as a sign o weakness, can in theory

be xed by a combination o

renewed economic growth and scal

adjustments. Whether the US has the

political will to hold to such a strategy

is an open question. Q

Commentary



Global investor par excellence Jim Rogers

believes that the 30-year boom in fnance

is over, but that new opportunities beckon

elsewhere. In this special interview orQuantum, he explains his vision o the

uture to Daid Smih.

Rider onthe StormI anybody should know about the

new world order, it is international

investment guru Jim Rogers. Hisconversation is littered with historical

reerences. Everything he says is

jargon-ree, though there is a weight

o accumulated investment knowledge

behind it. It is hard not to come away

convinced.

Interviewing Rogers, now 68, is

an exhilarating roller-coaster ride.

Speaking rom his oce in Singapore,

he doesnt mince his words. Wheres

the world going? The worlds going to

hell, isnt it? Yet minutes later he will

say: Im wildly excited about some

things I cant tell you how excited

I am. But Im very pessimistic about

others, Were in a period o great

historic change.

He explains: In the 1920s and

1930s there was a huge historic move

rom the UK to the US, exacerbated by

a nancial crisis and mistakes made by

politicians. Most o them didnt notice

it at the time. Now were in anotherhuge historic move rom the United

States to Asia exacerbated by a

nancial crisis and the mistakes made

by politicians and again, most o them

dont notice it.

Financial power has already shited

away rom America, rom Washington,

not as a result o the nancial crisis

though that has accelerated the process

but o the Wests long-run slide into

indebtedness. Debt and credit are

central to the way Rogers views the

world.

The large creditor nations in the

world are China, Korea, Japan, Hong

Kong, Taiwan and Singapore. Sure,

people see that something is happening

in China and in Asia. But look at the

whole thing thats been going on at the

IMF, he says, reerring to the upheaval

Iriw

z



Iriw



Through history weve had long

periods when the nancial types were

in charge, and weve had long periods

when the producers o real goods were

in charge. In the 50s, 60s and 70s

Wall Street and the City o London

were backwaters. Virtually nobody

went there or cared about them.

I was at Oxord in the 50s and

my dons used to say: We dont have

anybody like you here. Nobody cares

about the City. The City is irrelevant to

the world, irrelevant to the economy.

That was the status o the City and Wall

Street. Believe it or not. when I rst

went to Wall Street in the 60s, a big

day on the New York Stock Exchange

was three million shares. These days

they trade three million shares beore

people get up or breakast.

leading to the departure o Dominique

Strauss-Kahn. The question has been:

Which Frenchman or Frenchwoman

will head the IMF? The world is

moving to Asia, quickly, and people

dont understand it, he says.

I wrote recently that the Nobel

Prize or economics was established

in 1969 and in that time nobody rom

Asia has ever won it. The West has gone

down the tubes in that time. The world

is heading east. Go east young man, go

east young woman.

That is a theme we will return to

in the conversation, but Rogers has

another story central to his view o the

world. The 30-year boom in nance is

over, he argues, particularly as far as Wall

Street is concerned. Making things and

growing things will make a comeback.

But not, he suggests, or long.

The nancial community is going

into decline, he says. Let me give

you some statistics. In 1958 America

produced 5,000 MBAs per year.

Nobody else produced any. Last year

America produced over 200,000

MBAs as well as the tens o thousands

in the rest o the world.

That kind o competition in

nance, at a time when debts are

staggering and when governments are

coming down very hard on bankers

and investment bankers the laws, the

taxes, the regulations means nance

is going to be a terrible business over

the next 30 years.

Finance is now the wrong place to

be, he insists, and agriculture is the

new growth area. But in his view the

Iriw

JIM RogeRS, InveStMent bIkeR

Jim Rogers co-ounded the Quantum Fund

with George Soros as long ago as 1973,

making enough money by 1980 to take time

out to travel the world on his motorcycle.

Thus was born the investment biker.

Over many years he travelled the world on

two wheels, riding through six continents

including Arica. When China was still highly

suspicious o oreign visitors, he rode through

it more than once on his trusty bike.

In the late 1990s and early 2000s, he

entered the Guinness Book o World Recordsor a journey o more than 150,000 miles in

a specially-built Mercedes in the company o

his wie.

So Rogers has seen the world as well as

invested all around it. Today he is chairman

o Rogers Holdings and Beeland Interests.

He is known as a raging commodity bull, his

own Rogers International Commodities Index

monitoring the ups and downs mainly ups in

recent years o global commodity prices.

Famously, Rogers voted with his eet our

years ago, selling his mansion in New York

and moving to Singapore. Even beore the

fnancial crisis had done maximum damage

to America, he was convinced the worlds

centre o gravity was shiting rapidly away

rom his own country (he is a native o

Baltimore).

His book, A Gift to My Children, publishedtwo years ago, written or his two young

daughters, contains lessons on lie and

investing. He advises his daughters to learn

Chinese and beware o boys. He also advises

them not to ollow the crowd. Following the

crowd is not something you could ever accuse

Jim Rogers o doing.



Iriw

that I can oresee in the longer term

replacing the dollar on a permanent

basis. But it is a blocked currency, so

it is almost absurd to bring it up right

now.

Jim Rogerss views can seem

pessimistic, particularly to Americans,most o whom do not share his view

o their countrys decline. Maybe, as

he would say, they just have not yet

got the message. He insists he is not

downbeat. Indeed, his voice sings with

enthusiasm about what he sees are the

opportunities that will open up in the

coming years.

In 1807 i youd moved to London

youd have had a wildly exciting lie

while other parts o the world collapsed

the Austro-Hungarian Empire was in

serious decline, France was in serious

decline. I you had moved to New York

in 1907 you would have seen some

phenomenal opportunities.

There are great opportunities

now, but you are going to see some

institutions that have been around or

a long time declining just as always

happens in periods o great change.Lehman Brothers had been around or

150 years its gone. Bear Stearns had

been around 80-90 years its gone.

Harvard is essentially bankrupt. Who

was it who said: The old order changes,

bring on the new? I youre in the new

youre going to make some staggering

ortunes.

I suggest to him that it eels like the

creative destruction coined by Joseph

Schumpeter, the Austrian economist;

the radical changes that breathe new lie

into capitalism. He agrees. In China

theres the concept o Yin and Yang

disaster and opportunity are two aces

o the same coin. In a catastrophe there

are always opportunities or those who

adapt and who are alert. Thats why Im

wildly optimistic about some things

and I hope I can adapt to them.Q

and it cuts demand. I suspect it will

with this one too.

The long-term trend, however,

is up. The commodity super-cycle,

identied early by Rogers, is intact.

His belie in China is well known.

More surprising perhaps is that, unlikemost commentators, he does not see

India in the same light. Having visited

India many times on his travels

and or proessional reasons he is

unconvinced. I urge people to fy to

India and drive across it a couple o

times, he says. I dont think they

would be quite so enthused. I you

could only visit one country in your

lie you should go to India man-

made and natural sights, ethnic groups

and religions, women winning beauty

contests and men who are incredibly

smart. But they are incredibly

chauvinistic, they are anti-capitalist. I

youre not in bed with the right people

youre not going to do well. It is a

bureaucratic nightmare.

Rogers is also worried about Indias

debt. Historically, i you have 90

per cent debt to GDP, thats a pointater which it is very dicult to grow

dynamically.

As or China, the Peoples Republic

is in the vanguard o the huge shit

towards Asia that he expects. The

uture shape o the international

monetary system is a key actor.

China, like a lot o other people, is

worried about the dollar, he says. I

dont have much condence in SDRs

(IMF Special Drawing Rights) because

paper money is bad enough, much less

ctitious paper money. Who knows i

the world collapsed tomorrow, thats

probably what they would use out o

desperation. I the US ell into the sea

tomorrow they would use the euro, but

I dont expect the euro to be around or

too many more years either.

China has got the only currency

US is ill-prepared. In America the

average age o a armer is 58. America

produces virtually no agricultural or

mining graduates every year. Theyre

all studying or MBAs to go into

nance.

One o Rogerss central investmentthemes is that commodities are a buy.

The other side o that is that bonds,

and in particular Western government

bonds, are to be avoided. He scos at

the idea that bonds should be seen as a

sae haven in the coming years.

We have a bull market or

commodities, no matter what happens

to governments, because supply issues

are problematical and demand is up,

he says. The US is now the largest

debtor nation in the history o the

world, and you have the debt sky-

rocketing at the same time as the US

and others are printing huge amounts

o money. This kind o thing has always

led to problems in bond markets and

higher interest rates. So were going

to have higher infation and higher

interest rates.

What about commodity-basedeconomies? Is he as bullish on those

as he is on commodity prices? And

are not commodities always hugely

cyclical: prone to booms but also

spectacular busts? It depends on how

commodity countries are managed,

he says. Canada has been much better

managed than the United States or

the past couple o decades. Congo,

however, has lots o natural resources

but Im not putting a lot o money into

Congo. But even the badly-managed

ones are going to be doing better.

Weve had many long bull markets

in commodities in the past, ollowed by

bear markets. I would have to examine

my own head i I said it (the bull

market) was permanent. It could be.

Always in the past, as prices go high,

it brings in new supply, or substitution,



Stateso

Flux

Some ear that the United Statess status as

global economic leader may be in jeopardy as

developing nations expand rapidly. But those

in the know insist that Americas undamentalstrengths mean it will remain economically

supreme. Ca All weighs the

evidence.

Mark Twain amously said that

reports o his death were greatly

exaggerated. That was in 1897, just

beore the arrival o what became

known as the American Century. As

observers around the world in 2011

ponder whose century the next one

will be, the perceived odds against a

second coming or the United States

appear to be lengthening so much so

that Uncle Sam might be inclined to

invoke the authors remark, albeit out

o exasperation.

But just how accurate are

the metaphorical obituaries? The

commentators who view American

leadership in the past tense point to

numerous signs o waning power

and inuence in global economic,

fnancial and political aairs. The rise

o emerging economies and other

examples o rapid expansion have been

making news while in the US, fscal

and current account defcits and the

nations obligations to oreign creditors

are predominant.

Looking at just the last three or our

years, the naysayers have plenty to say

nay about. American banks did not

corner the market in stupidity, but the

worldwide fnancial crisis and recession

were largely made in the USA. Perhaps

more importantly, critics argue, the

economy does not have much to show

USA

z


15/68

USA



In terms of American dominance ofglobal affairs, I think it passed in 2007. Thats

my estimate of when leadership switched toAsia. It would have happened graduallyover ten to 20 years, but the crisis and our

handling of it hastened it. Kal S-Kua, TCW, a Aca subsay f t Fc bak Sct Gal.

or the various measures used to try

to revive it, most notably quantitative

easing, the Federal Reserve programme

to buy Treasury bonds with reshly

printed cash. The result, they say, is

a shrivelling o American leadership

abroad.In terms o American dominance o

global aairs, I think it passed in 2007,

said Komal Sri-Kumar, a strategist at

TCW, an American subsidiary o the

French bank Socit Gnrale. Thats

my estimate of when leadership switched

to Asia. It would have happened

gradually over ten to 20 years, but the

crisis and our handling o it hastened it.

and resentment and a source o

potential fnancial calamity in part

because o its impact on the dollar and

the act that the US Treasury and others

are on opposite sides o the mother o

all oreign exchange trades.

The US needs to make sure thebanks are OK and (authorities) want to

export more through a cheaper currency,

but they dont want it to happen all at

once, observed Jerome Booth, research

director o Ashmore Group, a London

und manager. Emerging market

central banks bee is that the dollar is

going to depreciate quickly. They would

be OK with (urther quantitative easing)

However even those like Paul

Bracken, a proessor o management and

political science at Yale, who accept that

US power and inuence has diminished

as rivals in the developing world get

stronger, question whether American

economic might has diminished asmuch as others think. No question,

compared to the 1990s, US political

inuence in the world is lower, he said,

but with the economy its much less

clear.

Long-term economic data compiled

by Haver Analytics and Citigroup

Investment Research highlight one

clear loser, and it is not the United

USA

US inuence appears to be moving

in an inverse relationship with the fscal

defcit. The need to borrow trillions o

dollars has reduced Americas economic

power, Sri-Kumar believes, and also its

power o persuasion. We had the moral

authority to advise Latin American

countries in the 80s and 90s, and we

advised Asia in 97 and Russia ater the

deault o 98, he recalled. Every time

we said what the correct policy was

to get out o a crisis. Everywhere I go

today, Im asked why the US doesnt

ollow the advice they gave us.

The defcit is a ocal point o doubt

i there were a big fscal adjustment at

the same time, but i not theres a risk

that theyll stop buying Treasuries.

Sri-Kumar expresses similar

disdain or Washingtons currency

management. A decade o debasement

o the dollar and no policy on the

currency has made the rest o the world

look urgently or a replacement, he

remarked. That has gathered more

strength than I had anticipated. When it

speeds up, it will increase interest rates

and reduce our dominance over the rest

o the world because we wont be able

to print our way out o a crisis.

States. The 15 countries that made up

the European Union ater the 1995

enlargement accounted or 31 per cent

o global output in 1970, the same as

the United States, their fgures show.

The American proportion dipped to

28 per cent in 1982 and held steady

through 2009, the last year in the study.

Europes share o the pie declined

steadily and markedly, to 22 per cent,

while mainland Asias share quadruped

to 12 per cent.

The US economy has held up

well because it has many undamental

strengths the ones that helped it



become so dominant in the frst place

to accompany its shortcomings.

The latest edition o the World

Competitiveness Yearbook, compiled

by the International Institute or

Management Development, a Swiss

business school, ranked the UnitedStates third, pipped by Singapore and

Hong Kong but well ahead o such

pretenders to the role o global leader

as China, ranked 18th, India (31st) and

Brazil (38th).

The US has weathered the risks

o the fnancial and economic crisis

thanks to the sheer size o its economy,

a strong leadership in business and an

unmatched supremacy in technology,

a study detailing the results said.

Also working in Americas avour are

such actors as a wealth o raw materials,

a socially and geographically mobile

society and a culture o risk-taking that

produces continual innovation, both

the technological sort alluded to in the

competitiveness study and others that

enhance commercial and industrial

productivity. Observers who believe

that the US has not lost its mojo arguethat short-term negatives are obscuring

these long-term positives.

It is certainly true that the

scope o the fnancial crisis and our

policy responses havent engendered

overwhelming confdence in our

national judgment, acknowledged

Kori Schake, an associate proessor

o international security at Stanord

University. The same is true o our

debt and defcit spending. But I think

the people arguing that America is in

decline dramatically underestimate

the resilience o our economy.

That resilience and the qualities

underpinning it engender a sense o

trust and security throughout the world,

in her view, that will outlive present

misgivings. The dollar is the paramount

reserve currency because people have

aith in the continued growth and

innovation and transparency o the

American economy, she said.

Schake would eel more comortable

i she could add fscal rectitude to the

list. She hopes that Washington will get

its house in order. We should come up

with a credible plan to pay down our

debt and spend less than we owe, she

counsels. Thatll do more to restore

the vitality o the American economy

and prestige o American power than

any other policy choice, oreign or

domestic.

That is a major part o Sri-Kumars

prescription, too, but hes not holding

his breath with the presidential election

less than 18 months away. Necessary

fscal changes might cause a steep

recession and hit the stock market, he

said. That might be political suicide,

but it would help the economy, and

thereore American stature, in the

long run. You have to pay the piper,

he said. The more we keep (the

economy) going through temporary

stimulus, the more well have to pay a

price or it.

One way or US authorities to

obtain a discount is to be more gracious

USA



One act o 21st-century economic lie

could limit a decline in US supremacy over

the very long haul and possibly even reverse it

at some point: persistently rising commodity

prices. Thats what Jeremy Grantham, chie

investment strategist

o the Boston und

manager GMO and

a widely respected

fgure in investment

circles, believes is

occurring.Grantham contends

that we now live

in a dierent, more

constrained, world in

which prices o raw

materials will rise

and shortages will be

common. He points

out that more than a

century o decliningi n l a t i o n - ad j us ted

commodity prices has

been undone in just

the last decade.

He attributes the

strong, abrupt course

correction to accel-

erated demand rom

developing countries, especially China, and

fnds that the level o price rises makes itextremely unlikely that the old trend is still

in place. In what could be the makings o

an economic Greek tragedy, Grantham warns

that these conditions will retard long-term

growth rates in the developing world.

Mature countries are bound to suer as

The CommodiTieS ConUndrUm

well, but less so, in his view, and the US

economy could be particularly resilient. One

point in its avour, perhaps paradoxically,

is that Americans are wasteul; that leaves

plenty o scope to conserve and to adjust

demand as prices

rise. The US has

plenty going or it on

the supply side, too,

he points out.

The US is, o

course, very wellpositioned to deal

with the constraints,

Grantham explains.

First, it starts rich,

both in wealth and

income per capita,

and also in resources,

particularly the two

that in the long run

will turn out to be themost precious: great

agricultural land and

a pretty good water

supply. The US is

also well endowed

with hydrocarbons. All

other countries should

be so lucky.

Americas status as global economic leader

may be in jeopardy, but how much progressare the would-be usurpers making? Growth in

developing countries has been impressive, but

some authorities on international relations

point out that it comes o a very low base

and warn that maintaining the momentum will

be no mean eat. They havent yet made the

USA



in dealing with allies and adversaries and accept

a more even distribution o power within global

organisations, notably the International Monetary

Fund, a body where they have the power, i not

necessarily the right, to veto any decision.

Who is going to ask us to shape up, Sri-

Kumar said. The IMF cannot. Emergingeconomies have capital surpluses. Are we going

to ask China and Brazil to fnance the US defcit

when they essentially have no seat at the table at

the IMF?

The indications are that the US is more willing

to listen more careully to the views and demands

o the newly powerul economies o Asia. The

US government is trying to adapt the post-war

system to accommodate the rise o new powers,

he said. Its now working through the G20, not

just the G7. US authorities are also in avour o

UN Security Council seats or India and Japan, he

noted, although not straight away.

Booth, at Ashmore, expects the developing

world to be more orceul in global policy arenas.

The G13 countries are starting to become more

assertive, pressing their agendas on currency

and global monetary system reorm, he observed.

Emerging economies have been pushing or voting

reorm at the IMF too.

How should American ofcials respond?One view is that Washington will be in a better

bargaining position i it recognises that the US

is in a worse position than beore. The US has

the most bargaining power, but or the frst time

China has some too, Booth argues. Better to

sit down and negotiate with China than get

completely worked up and do something stupid.

I Im the US, I need to realise I can no longer

dictate what I want and have (other countries) all

over to do it.

By going with the ow and settling into a sedate

middle age, Booth believes, the US should continue

to thrive and to play the leading role in setting the

rules or international markets and organisations,

despite all the reports to the contrary. The US

is discovering the way the rest o the world has to

deal with problems, he said. Its not the end o

the world. Were all gaining; its just that emerging

markets are gaining aster. The US remains the

most powerul country on earth.Q

tricky transition to idea-generating economies,

says Kori Schake, an associate proessor o

international security at Stanord. Theyre still

manuacturing predominantly.

Paul Bracken, a specialist in global business

strategy at Yale, agrees. He sees the rapid

development in some countries as being

achieved by emphasising quantity over quality.

He wonders how sustainable it will be. China

has had a relatively easy problem in economic

We now live in

a different, more

constrained, world

in which prices of

raw materials will

rise and shortageswill be common.

management so ar because the sources o

growth are manuacturing and moving people

rom the countryside to the cities, he explained.

Even the Soviets were growing under those

conditions in the 1930s.

Growth rates in emerging economies aremuch higher than growth rates in the West

during the Industrial Revolution, he adds, so

theyre going to hit social and environmental

limits a lot aster. What they do with that

depends on a lot o actors in the uture that I

dont know.

USA



ProceedwithCautionHopes that China may be prepared to

countenance liberalisation and the opening up

o its fnancial sector are likely to be dashed,

says David Smith. Risk aversion and caution

will remain its watchwords as it defnes its new

global role.

A couple o years ago, it all seemed

airly clear. At a time when the world

economy was teetering on the brink

o collapse as a result o the global

nancial crisis, Beijing appeared to

be taking the lead on reorm o the

international monetary system.

Ater years in which calls or

reorm usually rom France had

allen on dea ears, suddenly the

worlds second largest economy was

in the vanguard o the demand or

change. Zhou Xiaochuan, governor

o the Peoples Bank, the Chinese

central bank, set out a vision o

reorm very much along the lines

proposed more than 60 years earlier

by John Maynard Keynes at the

Bretton Woods conerence in 1944.

Instead o an international

monetary system based on the dollar

the model chosen at Bretton Woods

in preerence to Keyness version

the Peoples Bank governor gave a

powerul hint that Beijing preerred

to shit the ocus on to the Special

Drawing Right (SDR), the IMFs

currency basket. Just as America

was on course to be replaced as the

worlds biggest economy by China,

so the dollar would lose its global

pre-eminence. That, it seemed, was

Chinas vision and it was dramatic.

Fast orward to late March 2011

and the scene was set or a specially

convened G20 high-level seminar

China

z



China



China doesnt think that theres

really much room or progress in the

G20 under France, said Zhang Ming,

an economist at the Chinese Academy

o Social Sciences. The government

has become more realistic in pushing

instead or yuan internationalisation,

something it can achieve itsel. It is

not as enthusiastic as beore about

getting into the currency reorm

issue.

Chinas approach to international

monetary reorm will exasperate those

who think it is time the country adopted

a more aggressive international role

Flying metaphorical kites is not (Chinas)style. Something has changed. Its enthusiasm

for reform has cooled, perhaps because analystshave pointed out that a gradual approach is

the best way of preserving the value of its hugeand growing dollar reserves.

long-term and complex, he said.

Ocial guidance was that the

Peoples Bank governors analysis two

years earlier had been exploratory,

even academic, rather than a

programme or action. It may even

have been deliberately provocative

in the ace o Washingtons criticism

o Beijings currency policy, with the

aim o showing that the world may

not be as permanently dependent on

the dollar as America likes to think.

That, however, is not the way China

operates. Flying metaphorical kites is

not its style. Something has changed.

managed should be included in

the SDR.

Chinas unwillingness to see the

renminbi attain reserve currency

status, and certainly Beijings

unwillingness to promote it as in any

way a rival to the dollar, remains. So

what does China want?

The current ocial ocus is on

the gradual internationalisation o

the renminbi, by which it is meant its

greater use in commercial transactions

and in some third party activity.

Chinas Ministry o Finance has been

actively promoting the currencys

in Nanjing, China, to discuss

international monetary reorm. While

China was host, the French president

Nicolas Sarkozy was in the chair as

president also o the G20. Sarkozy

was maintaining the Elyse Palace

tradition o wanting a shake-up o thesystem and an end to its dominance

by the dollar.

I he was expecting Chinas

wholehearted support, however, he

was disappointed. Wang Qishan,

the Chinese vice-premier, did his

best to correct the impression that

his country was pressing or rapid

reorm. The reorm process will be

Its enthusiasm or reorm has cooled,

perhaps because analysts have pointed

out that a gradual approach is the best

way o preserving the value o its huge

and growing dollar reserves. Even

on the narrow question o including

Chinas currency, the renminbi, in theSDR basket, no progress was made

in Nanjing.

The Chinese authorities,

having appeared at one stage to be

enthusiastic, pulled back rom even

that, not least because Timothy

Geithner, the US Treasury Secretary,

said only currencies that were truly

fexible in other words not tightly

use in regional trade transactions,

not least by oering tax rebates, and

recently issued an RMB6-billion

bond in Hong Kong to promote its

use in settlements.

The lesson, i it were needed, is

that China will proceed with caution.What China wants when it comes

to international monetary reorm is

not to rock the boat too much, while

heading o external criticism o the

undervaluation o her currency. That

means Frances hopes o a strong ally

or reorm in the remaining months

o her G20 presidency will almost

inevitably come to nothing.

China



to go with her increasing economic

clout. That, however, is the Chinese

way. Gradualism is the watchword.

Change will occur, but rushing it will

benet nobody; neither China nor her

international partners.

As always with China, reading

between the lines o the ocial ve-

year plans can be useul. The latest,

the 12th, presented by Premier

Wen Jiabao in his state o the nation

address in March 2011, was notable

or two things. The rst was the

explicit setting o a lower target or

growth, averaging 7 per cent over

the ve-years (2011-15) o the plan.

The second was the pledge to make

that growth more equitable and

sustainable.

The growth target can be taken

with a pinch o salt. The 7.5 per cent

annual growth target or the 11th ve-

year plan (2006-10) was comortably

exceeded, despite the global nancial

crisis and recession. Successive

Chinese leaders have learned to

promise less than they deliver.

The other aims are more

interesting. In theory Chinese

growth, driven more by domestic

consumption, should also be more

balanced. A promise to raise the

minimum wage by 13 per cent a

year 84 per cent over the period o

the plan will spread the benets o

growth more widely.

Again, however, Chinas

approach is evolutionary rather than

revolutionary. Stephen Green, an

economist with Standard Chartered

in Shanghai, said there was nothing

in the plan to suggest a big shit in

the structure o the economy or a

signicant narrowing o Chinas

current account surplus. Theres

China



absolutely no sign that the percentage

o investment in GDP is slowing. And

there are no signs o liberalisation o

the service sector to allow the private

sector to take a bigger share o the

economy, he said.

Indeed, one eect o the globalnancial crisis may have been to

make the Chinese authorities even

more cautious about aspects o

liberalisation. Hopes among Western

banks o an opening-up o Chinas

nancial sector and an end to the

dominance o state-controlled or

semi-state banks were disappointed

by the ve-year plan, which set out

no such prospect. From Chinas

perspective, the crisis demonstrated

the advantages o having built-in

checks and balances in the banking

system. While the rest o the world

was reeling, China was relatively

immune.

Late last year, China hosted

another high-level meeting, this time

on macro-prudential regulation in

Shanghai, which was attended by

representatives o the IMF and mostleading economies. Zhou Xiaochuan,

the Peoples Bank governor, this time

on less controversial ground, oered

his diagnosis o why China had come

through the crisis successully.

The Chinese nancial system

has basically withstood the shocks

o the recent crisis because rst,

continued economic growth has

created a benign environment, he

said. Second, ater the Asian nancial

crisis, joint stock reorm o state-

owned commercial banks enhanced

their overall strength and resilience

and strengthened the oundation or

nancial stability. Third, the nancial

legislation system and supervision

ability has improved. Fourth, the

nancial market, including delivery

o services and product innovation,

was not sophisticated, and this helped

ward o crisis.

The last point, and the implied

criticism o over-sophisticated

nancial products as a source o

instability in the West, is particularly

interesting. Liberalisation will occur

at a pace o Chinas choosing. There

is a parallel with Japan in the 1980s,

which came under heavy international

pressure to open up nancial services

to outsiders. China is likely to take

even longer. On this, as on so many

other matters, China will do things

her own way. And that may not be the

way the rest o the world wants.

Even then, the Chinese authorities

are aware o the dangers, which range

rom global economic imbalances

to asset bubbles and excess liquidity

including in China itsel and

potentially destabilising structures

and products within the banking and

nancial system.

In the past ew years, many

nancial institutions are oering

China

TRADE SURPLUS ($bn)

Source: Capital Economics.

Unadjusted

Seasonally-adjusted (including

for Chinese New Year)

50

40

30

20

10

0

-10

50

40

30

20

10

0

-10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

CONSUMER PRICES (% y/y)


Headline

Core (excl. food & energy, excl.

food only before Jan. 2006)

9

8

7

6

5

4

3

2

1

0

-1

-2

9

8

7

6

5

4

3

2

1

0

-1

-2

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011



cross-sector and cross-market

products; nancial share-holding

companies have established complex

internal structures and moved into

diversied businesses; new types

o nancial institutions are heavily

involved in the nancial market

activities, said Zhou Xiaochuan.

Banks and other nancial

institutions will be even more closely

monitored than in the past. China is

also ully committed to introducing

a macro-prudential regime

supplementing the regulation o

individual institutions with system-

wide counter-cyclical rules on capital

and credit supply.

The recent history o China,

certainly since the Asian nancial

crisis o 1997-98, has been one o risk

aversion. The global nancial crisis

threw up the threat o systemic risk.

The message rom the authorities

is that every action will be taken to

counter that threat in the uture.

That means regulating more strictly

an already tightly regulated nancial

system. China is determined to move

slowly on big-picture reorm, and to

keep things rmly under control.

That applies to the nancial

system and it applies more generally.

The investment banking communityis going to have to get used to the rise

o Chinese rms with both domestic

and global ambitions. Some o that will

be achieved by acquisition Lenovos

acquisition o IBMs personal

computer division a ew years ago

was a pioneer in that respect and

some by other means.

For years, China has been accused

o stealing technology rom the West.

Now the process is being ormalised.

An aspect o the previous ve-year

plan that is only now coming to

ruition has excited much comment

and concern, the intention being

to substitute indigenous sources o

supply or imported technology.

With the aim o doubling research

and development spending to 2.5 per

cent o GDP over the next decade,

the plan identied 11 key sectorsand 27 breakthrough technologies,

including coal liqueaction,

genetically modied crops, deep-

sea mining, quantum physics and

stem cell research. The rst 16

mega projects are now taking

shape, intended to replace imports

with indigenous innovation,

though innovation based on oreign

technology. They will, according to

Xi Heping, an ocial at the Ministry

o Science and Technology, reorm

traditional industries and develop

high technology manuacturing.

China is moving into a new

phase o economic development. No

longer will it be a branch economy

or Western multinationals. Quietly,

without anare, China is changing

her role.Q

China

RENMINBI/DOLLAR EXCHANGE RATE


Renminbi stronger

G20 Summit

Hu visiting US

US-China dialogue6.45

6.50

6.55

6.60

6.65

6.70

6.75

6.80

6.85

6.45

6.50

6.55

6.60

6.65

6.70

6.75

6.80

6.85

Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11

POLICY RATES (%)


Required Reserve Ratio (major banks)

12m Benchmark Lending Rate

12m Benchmark Deposit Rate

24

20

16

12

8

4

0

24

20

16

12

8

4

0

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


26/68

Lqudt



The Bretton Woods global nancial architecture

has been remarkably long-lived and its demise

has requently been orecast. This time though,

argues Bd Dv, the reserve currency

system may nally need to be redesigned rom

scratch.

Lost inthe Woods

The international currency system

is a product o the past, says Hu

Jintao, Chinas president. And itis hard to argue that it is up to the

challenge o dealing with the current

nancial situation. Today the size

o a number o countries surpluses

and decits on their oreign trade

accounts and associated unding

issues has become an additional

source o potential instability in

nancial markets.

There is, though, little consensus

about the causes o the continuing

banking crisis and the degree o

responsibility attributable to the

dollar-based reserve currency system.

The conventional wisdom that poor

incentives in banks encouraged

excessive leverage and risk-taking,

along with the creation o complex

products that no one really understood,

does not tell the whole story.

This explanation relies on the idea

that supply creates its own demand,

whereas any economist holds tothe belie that supply responds to

demand. Why then was there such a

broad-based global demand or US

dollar-based assets that appeared

to oer low risk and relatively high

returns, certainly when compared to

US Treasuries.

The build-up o excessive

surpluses as a number o countries

seek to gain rom the current reserve

currency system means that these

countries need to purchase US dollar

assets to und the US decit the

counterpoint to their surpluses or

investment purposes and to nance

growing levels o world trade.

The incentives or innovative

bankers to create and or many

global nancial institutions to buy

such assets are obvious, as the US

Lqudt

z



The BreTTon WooDs sysTem

The World War II allied powers wanted to

create the oundations or post-war prosperity.

They assembled in Bretton Woods or a

conerence dominated by the US Treasurys

representative, Harry Dexter White, and

the British Treasurys representative, John

Maynard Keynes.

Dexter White proposed a system o

exchange rates semi-xed against the US

dollar, which itsel would be convertible into

gold. The establishment o an International

Stabilisation Fund to manage the systemwas executed in a way that placed the entire

burden o maintaining the balance o trade on

the decit nations. It would impose no limits

on the surplus that successul exporters

could accumulate. The eventual outcome,

which was very close to the US position,

was the establishment o the International

Monetary Fund and The World Bank.

The proposal or an international

organisation to encourage ree trade wasblocked by the US, but eventually the General

Agreement on Taris and Trade (GATT) treaty

and the World Trade Organisation (WTO)

achieved the same objective. Much o the

system still survives, though the system o

semi-xed exchange rates did not.

Under pressure rom nancing the war in

Vietnam, the US abandoned gold convertibility

in 1971. As a result the semi-xed exchange

rate system became a semi-foating ratesystem, though a number o emerging market

countries eectively xed their currencies

exchange rates to the US dollar, while a

number o European Union member countries

created a single currency area with the euro.

The British backed a very dierent model

to the American system that was eventually

adopted. Keynes proposed a system that

would encourage both debtor and creditor

nations to take action to adjust their

economies. A global bank, called the

International Clearing Union (ICU), would issue

its own currency (the Bancor), which would

be exchangeable with national currencies at

xed exchange rates; it would become the unit

o account between nations, which means it

would measure a countrys trading position.

Keynes proposed a

system that would

encourage both debtor

and creditor nations to

take action to adjust

their economies.

The aim was to secure creditor adjustment

and debtor discipline. All international

transactions giving rise to surpluses or

decits in the balance o payments would

be settled through clearing accounts at the

ICU, while countries central banks would buy

and sell their currencies against debits and

credits with the bank.

Each country would have an overdrat

acility in its ICU Bancor account equivalentto hal the average value o its trade over a

ve-year period. Countries should clear their

Bancor accounts at the end o each year so

that they had neither a trade decit nor a

surplus.

To achieve this, any country with a trade

decit equating to more than hal o its

Lqudt



trade decit must be balanced by US dollar

investments. Triple A-rated bonds that pay well

above US Treasuries have obvious attractions in

these circumstances.

I this argument is valid, then the incentives

that created the current crisis will not go away

just because the capital or the liquidity o banksis being increased. Banks are not the cause o

the crisis but bit-part players in a much bigger

global currency game driven by the perverse

incentives built into it and seen to have been

built into it 70 years ago.

Moreover the need to change the global

currency system is ar more pressing than

anyone is willing to admit, as unless this happens

the orces that created the nancial crisis are

going to re-emerge. The only conclusion one

can draw is that the underlying cause o the

nancial crisis is the global reserve currency

system, which was based on the Bretton Woods

agreement in 1944 (see box).

While it is clear today that Bretton Woods is

no longer t or purpose, the same could not

be said in the atermath o World War II when

its deciencies were to a great extent disguised.

The underunded International Monetary Fund

placed ar too much emphasis on orcing decit

countries to devalue and rapidly defate theireconomies. The World Bank, similarly short o

unds, was unable to ulll its role as a signicant

source o capital injection or countries requiring

reconstruction and development.

However these problems were masked, rst

by the massive injection o investment rom the

US Marshall Plan and the willingness o US

companies to invest abroad (in the ace o ull

employment in the US), and then by the move

to foating exchange rates. Today the US has

moved rom being the worlds biggest creditor

nation to the worlds biggest debtor, and it no

longer has ull employment.

The systemic deciencies became clear

during the emerging market crisis in 1982 in

Latin America and 1997 in Asia. The emerging

market economies responded by xing their

exchange rates to the US dollar at levels that

ensured their competitiveness and consequently

they have amassed very high levels o reserves.

Bancor overdrat allowance would be charged

interest on its account, be obliged to reduce

the value o its currency and to prevent the

export o capital.

There would be similar pressures on

surplus nations, as any country with a Bancor

credit balance o more than hal its overdrat

acility would also be charged interest, be

obliged to increase the value o its currency

and to permit the export o capital. I, by the

end o the year, its credit balance exceeded

the total value o its permitted overdrat, thesurplus would be conscated.

In Keyness ICU-based system, any nation

with a surplus would thus be incentivised to

eliminate its surplus by exporting capital to

decit countries, thus reducing their decit.

Keynes believed that the system proposed by

White would lead to countries attempting to

create a currency surplus through competitive

devaluations, and to the hoarding o oreign

exchange reserves by surplus countries.

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The SDR was created by the IMF in 1969 to support

the Bretton Woods xed exchange rate system by creating

a supplemental reserve asset. Subsequently US dollar-

to-gold convertibility ended in 1971. Two years later the

Bretton Woods system was altered signicantly, and

the major currencies shited to a foating exchange rate

regime; the SDR became a potential claim on the reely

usable currencies o IMF members.

Today the SDR basket consists o the euro, Japanese

yen, pound sterling, and US dollar. In addition to its role as

a supplementary reserve asset, the SDR also serves as

the unit o account o the IMF and some other internationalorganisations.

The SDR is calculated as the sum o specic amounts

o the our basket currencies valued in US dollars, on the

basis o exchange rates quoted at noon each day in the

London market.

The basket composition is reviewed every ve years

by the Executive Board to ensure that it refects the

relative importance o currencies in the worlds trading

and nancial systems. In the most recent review last

November, the weights o the currencies in the SDR basketwere revised, based on the value o the exports o goods

and services and the amount o reserves denominated in

the respective currencies held by other members o the

IMF. These changes became eective on 1 January 2011.

The next review will take place by 2015.

speciaL DraWing righT (sDr)

These consequences are similar to

those eared by John Maynard Keynes,

who argued at Bretton Woods in 1944

that the system proposed by the

US Treasurys Harry Dexter White

would result in countries attempting

to create a currency surplus throughcompetitive devaluations, and in the

hoarding o oreign exchange reserves

by surplus countries.

Indeed the evidence today is that

Bretton Woods created a system which

encourages and allows the reserve

currency country to run persistent

and large decits. However, countries

holding these US dollar reserves are

exchanging their goods and services

or pieces o paper that represent

claims on uture US production (or

tax receipts, though this amounts to

the same thing).

There is a point at which the

ability o the US to honour these

claims certainly at the same real

rate o exchange at which they were

accumulated is called into doubt.

And it looks as i that point has

now been reached. But there is noagreement as to what to do. Politicians,

most notably in France and China,

are calling or a new Bretton Woods,

but none o them has put orward a

cohesive solution.

However, there are alternatives.

Earlier this year Joseph Stiglitz, the

Nobel Prize winning economist,

proposed creating more Special

Drawing Rights (SDRs) so that they

could play a greater role in the global

currency reserve system and act as

a supplement to the role o the US

dollar. There is, though, the more

radical way o expanding the role

o SDRs as a replacement or the

dollar as the worlds reserve currency.

This is arguably the only way to

respond to what is already happening

in the real world.

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element o their surplus into long

term investments in both emerging

and developed economies through

their Sovereign Wealth Funds.

In addition, China has been taking

action through bilateral arrangements

to internationalise the renminbi as a

currency o account or bilateral trade

although, as the renminbi is not

reely convertible into other currencies,

this process is as yet strictly limited in

its applicability.

Moreover, there have been a

number o comments that imply that

Keyness rejected Bretton Woods

solution is being re-examined. It

appears that there is some support or

using the SDR as a so-called basket

parts o the SDR basket currency

would be regularly recalibrated, or

example according to the relative

GDP (or possibly relative per capita

GDPs) o a wide range o countries

whose currencies would comprise the

reconstructed SDR basket.

There would be clear implications

or any country growing its GDP

relative to other countries and

running a trade surplus. It would see

an increasing proportion o the value

o its reserves becoming a claim on its

own uture production, as the SDR

basket would be re-weighted towards

its currency. In those circumstances, it

would become pointless or a country

to export goods and services and

However, i this idea were adopted,

the SDR would itsel need to dier

signicantly rom its current orm,

both as to its component parts and to

its process o revaluation.

Clearly the ideas about a new

reserve currency are not yet as well

developed as those o Keynes and

White were in 1944. But we would be

deluding ourselves i we thought that

the nancial challenge today was not

extremely serious, so it is important

that new ideas are explored. There is

an old saying: I it aint broke dont

x it. Well, the current global reserve

currency system clearly is broke it

just has not broken down yet, But it

will unless we get on with xing it. Q

There is some support or using the SDR asa so-called basket currency which would

operate as a unit o account in trade. A lotdepends on how this idea is taken orward, butit could involve revisiting one very importantaspect o Keyness proposal a system thatincentivises adjustment by both defcit and

surplus countries.

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A number o large surplus currency

countries are no longer holding their

structural surplus oreign exchange

balances overwhelmingly in US-dollar

Treasury bonds. Instead they are

beginning to diversiy their reserve

holdings, most notably into euros,as well as limited amounts o Swiss

rancs, sterling and gold. They are

also placing a signicant structural

currency which would operate as a

unit o account in trade. A lot depends

on how this idea is taken orward,

but it could involve revisiting one

very important aspect o Keyness

proposal a system that incentivises

adjustment by both decit and surpluscountries.

Each country would hold its

reserves in SDRs. And the component

incur claims on its uture production;

so such a system would pass Keyness

incentive test rather well.

But there is one signicant

dierence in that this solution is more

markets-based. This means it would

suit the greater development o andreliance on markets that is a eature

o the modern global economy and

was not a signicant actor in 1944.



Attempts to stabilise currencies in the wake of the

monetary crisis could impose new strains on the delicate

balance of global trade, Paul Wharton of Deutsche Bank

UK examines where the fault-lines may develop.

UnintendedConsequences

One o the most signicant aspects

o the currency wars currently taking

place is that there is still a race tothe bottom, as growth economies

dependent on exports try to weaken

their currencies, even as continuing

weakness in the US dollar drives those

currencies upwards.

Clearly no exporter likes to see

their currency strengthening unduly,

since it damages their ability to sell

into oreign markets. At the moment

China and Germany seem to be the

main winners, with Germany coming

out rather better than China.

The linkage with the dollar means

that the yuan weakens as the dollar

weakens, and that helps to make

Chinese exports even more price-

competitive. However, the major

negative consequence o this is that it

creates serious infation in ood prices

in China, since the Chinese have to

spend more to buy the same amount

o grain. Food prices rose by a third

in 2010, and this in turn threatens tolead to social unrest in China. So or

them there is a very marked downside

to the second round o quantitative

easing (QE2) being implemented in

the United States.

Germany also has its diculties.

On the one hand there is a real irony

in the act that the more the European

sovereign debt crisis perturbs the

markets and weakens the euro, the more

it boosts Germanys burgeoning export

sector. On the other hand, much o the

burden or unding the bailouts alls

on Germany as the European Unions

biggest economy. However, since the

European sovereign debt issues have

very little to do with the currency

wars, one would have to say that

Germany will remain a net beneciary,

provided that the dollar doesnt

weaken too much against the euro.

Our ocial view is that we think

that China will allow the renminbi toappreciate by around 4 per cent against

the dollar in the medium term and

will allow wage costs to rise. That will

put more money into the pockets o

workers and will also help to rebalance

the global economy. We have already

seen some quite sharp wage rises in

China, and more along these lines

would be very helpul.

I China were to revalue the

renminbi, the cost o their ood imports

would drop, and it would also have the

benecial eect o making the Chinese

ocus more on domestic consumption,

since it would generate some alling o

in exports.

Manuacturers would have to look

to sell the extra capacity locally. The

Chinese labour orce is 850 million

strong, more than 20 times the size o

Finance

z



the entire UK labour orce. Moreover,

economic commentators are starting

to talk about the end o the global

export model, since the big importer

o last resort, the United States, is

running out o steam. No country

can both de-leverage massively andimport strongly.

This could be good or China

in the medium term, since it should

orce them to become much more

eective when it comes to deploying

their investment cash. China has

really got to stop wasting resources.

The country looks like a late-cycle

version o the Asian tiger economic

boom, the problem there being that

ever-increasing investment generated

ever-smaller rates o return until we

were suddenly hit by the Asian crisis o

1998. All investment booms zzle out

i consumption and nal demand are

not able to keep pace with the capacity

that the investment is generating.

The most interesting element

o all these linkages which we see

particularly vividly in the currency

interrelationships is perhaps theunexpected and rather unintended

consequences o globalisation, where

everything ends up being linked to

everything else. There was, or example,

a problem in US mortgages along with

a problem about excess savings in

China generating massive capital fows

to peripheral eurozone economies. The

debt that generated cannot be revalued

away, so we now have a very ragile

global model.

The challenge or policymakers

now, as they address this ragility, is

to manage an orderly adjustment o

the major developed economies

and, in doing this, the scal stimulus

that we saw in the United States, the

United Kingdom and the European

Union, as well as in Japan and China,

is important.

Finance



The big risk o printing cash is that it

uels rallies in paper assets.

As for the eurozone, there is no doubt

that the markets are testing its resolve,

and there are denite parallels here with

Britains unortunate experience in

trying to deend its membership o the

European exchange rate mechanism

(ERM). Everyone knows how that

ended, but it would also be wrong

to underestimate the political will in

Europe to keep the euro going.

From an investment standpoint, one

thing that emerges very strongly rom

this is that Germany will probably be

one o the saest homes or some time to

China too, i it cannot get a grip on

infation while maintaining the 7

per cent or so growth it requires to

keep the fow o new jobs in synch

with movement o people rom the

countryside to the cities. Failure here

carries a very high risk o social unrest

which, at the least, would severely

impede Chinas ability to drive global

growth in the medium term. It is a

paradox that many in the West who

regard liberal ree market capitalism as

undamental to incentivising innovation

and growth are hoping that Chinese

economic development will bail out the

global economy.

worrying set o downside scenarios.

Into this already complex mix we

now have to add the second round

o quantitative easing in the US, and

see how it will aect its relationship

with China, currency issues, and the

European sovereign debt crisis. The

interactions between all these actors

makes it next to impossible to predict

the outcome.

Market participants do not have a

clear perspective on how this is going

to end up. What we can see is that in

the rst round o quan

jim rogers quantummagissue15 lowres

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