Back in the 1960s, a French finance minister called the U.S.’s ability to borrow in its own currency — thanks to the dollar’s pre-eminence and reserve-currency status — an “exorbitant privilege.” It’s an advantage that the rest of the world has to pay for, one way or another. This has lately given many emerging-market governments cause for complaint.
If they had the will, one or two of them could do something about it. Maybe it’s time they did.
The issue has been highlighted in recent weeks as the Federal Reserve unsettled global markets by signaling its intent to start tightening monetary policy — at least, that’s what investors thought it said. There was a sell-off in global fixed- income markets, and many emerging economies saw the value of their bonds, equities and currencies drop.
Not long ago, emerging-market governments complained about the Fed’s stimulus policy. They pointed to destabilizing inflows of hot money and called it a “currency war,” an attempt to export unemployment and price emerging-economy exports out of the U.S. market. Now they’re alarmed because the policy is ending. Such is life on the receiving end of the exorbitant privilege.
New York Federal Reserve President Bill Dudley, a former colleague of mine at Goldman Sachs, once warned me, “Be careful what you wish for.” The context wasn’t quite the same — we were discussing the dangers of shrinking the U.S. current-account deficit too quickly while global demand was still weak — but it’s still good advice.
The Fed’s shift to ever-increasing stimulus after the crash had wide-ranging financial effects, including a flow of new money into substitutes for U.S. bonds. As quantitative easing ratcheted up, the effects were compounded. Many investors chose to believe they’d devised a smart investment strategy when all they were doing was looking for yield pickup. You can tell the difference when the process goes into reverse, especially if it takes people by surprise. That’s when another phrase comes to mind: Escalator up, elevator down.
For emerging economies, these surges and reversals can be very difficult to deal with. It’s hardest of all for countries with large and/or rising trade and current-account deficits because they may have become addicted to easily available capital. Replacing it requires either more domestic savings or policies that attract stable longer-term inflows, or both.
It’s best to stop an excessive current-account deficit from building up in the first place; that’s usually a sign of overdependence on hot capital inflows. In general, emerging economies should try to avoid running too large a “basic balance” (the current-account deficit minus long-term capital inflow). That rarely ends well. Strong net inflows of foreign direct investment are relatively reliable; portfolio inflows, sensitive to interest rates, are much less so. Among the larger emerging economies, India and Turkey are now exposed in this way. Brazil has been creeping in the same direction.
Abrupt changes in the actual or perceived direction of Fed policy can make life difficult for countries that don’t allow sufficient exchange-rate flexibility, even if their balance-of- payments position isn’t bad. The reason is that they are letting Fed policy override their domestic monetary policy — a fixed exchange rate shuts down domestic monetary policy altogether — and sacrificing the ability to stabilize their economies. Hong Kong is an extreme case: Its currency is firmly pegged to the U.S. dollar. China’s renminbi has been allowed more flexibility, but many would say it’s in the same category.
Is it all the Fed’s fault? Not really. The central bank has a legal obligation to keep inflation low and stable, as well as maintain full employment — in the United States. The value of the dollar and the consequences for the rest of the world’s economies are not its concern unless they have implications for the domestic economy.
It is probably fair, however, to ask the Fed to be careful about its statements — especially when it hints at a change in the direction of a well-established monetary policy. This is likely to be disruptive because investors all over the world tend to be trend followers and because so many have adopted the mantra “Never fight the Fed.”
Because the Fed is going to carry on doing what it does, emerging economies have to consider two other remedies for the exorbitant privilege. First, countries with large current- account deficits — such as India — should focus on attracting bigger inflows of long-term capital, maybe in addition to raising domestic savings. Second — and this applies more to China — big emerging economies should favor more exchange-rate flexibility and use of their currencies in global markets.
China is too big an economy to give U.S. monetary policy as much power as it has over its business cycle. Beijing should continue to free up trade and liberalize the capital account of its balance of payments — and, consistent with that, consider greater movement of its currency.
I understand that the recently announced $270 billion, 25- year oil deal between Russia’s Rosneft OAO and China National Petroleum Corp. will be transacted in rubles and renminbi. That’s how you deal with the mighty dollar and the Fed’s domestically directed monetary policy. Too much of the world’s trade and finance is conducted in dollars. The exorbitant privilege has lasted too long.