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It's time for emerging-market countries to ditch Bretton Woods II and either revalue their currencies against the dollar or let them float freely, which would probably achieve the same result.
A system originally considered a boon to help developing countries boost exports and achieve price stability, Bretton Woods II is evolving into an inflation monster, fed by food-and-oil price surges, domestic subsidies, increased consumer spending and governments' hesitation to slow economic growth.
By directly or indirectly tying their currencies to the dollar, many developing countries suffer the imported inflation that normally accompanies a weak currency. It also ties their monetary policies to those of a central bank whose key lending rate is two per cent in a country with 3.9 per cent inflation.
Bottom line: By linking their monetary policies to the Federal Reserve, which has aggressively cut interest rates in a bid to avoid recession, developing countries are pursuing a path inimical to their best interests.
At least 11 Asian economies boast inflation rates higher than official borrowing costs.
Chinese inflation is near a 12-year high of 8.5 per cent, yet the central bank's key lending rate of 7.47 per cent is unchanged since the end of last year.
The Reserve Bank of India's benchmark rate is 6 per cent, almost two percentage points below inflation. While the Monetary Authority of Singapore's three-month domestic interbank rate stands at 1.25 per cent, the city-state's consumer-price inflation rate is 7.5 per cent.
Consumer inflation in Russia, Saudi Arabia, the Czech Republic and Chile is also outpacing official borrowing costs.
1944 Conference
Bretton Woods II is a phrase coined by three Deutsche Bank economists to describe a variant of the international trade and gold-standard system agreed on at the 1944 United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. The first system collapsed in the early 1970s.
Following the 1997-98 Asian currency crisis and 1998 Russian default, Bretton Woods II initially involved Asian countries pegging their currencies to the dollar at highly competitive exchange rates and using their foreign-currency reserves to lend money to America by purchasing US financial assets, especially Treasuries.
Tying their currencies to a strong dollar helped these countries harness inflation and confer legitimacy on their monetary policies by shadowing the Fed.
It also absorbed developing nations' surplus production and allowed them to pursue export-oriented strategies that foster growth and employment. An overvalued dollar let Americans borrow from Asia at low rates, spend more than they save and keep buying cheap imports.
As such, Bretton Woods II resembles a huge vendor-financing programme. It worked like a charm. Asia emerged from its crisis relatively quickly. Asian export prices to the US fell 25 per cent from late 1995 to March 2008, while export volumes more than doubled, according to BCA Research.
At the same time, real interest rates as measured by 10-year US government bond yields have been driven near postwar lows, even though the US has a current-account deficit equal to 5.2 per cent of gross domestic product.
Middle East oil exporters and Russia voluntarily jumped on the Bretton Woods II bandwagon early this decade. Pegging their currencies to the US's was a no-brainer, considering that most commodities, particularly oil, are denominated in dollars.
So long as the greenback was regarded as a widely accepted median of exchange and store of value, it was a good move.
Key culprit
Like a child in an ice-cream parlour, Bretton Woods II has become too much of a good thing.
For several years, the cheap-currency policy at the heart of the Bretton Woods II scenario helped rescue Asia from the deflation that accompanied the late 1990s crisis.
"Over time, however, it has begun to outlive its usefulness,'' says Chen Zhao, Montreal-based chief global strategist at BCA Research. "Now the cheap-currency policy has become a key culprit behind rising inflation.''
Other measures
Oil exporters have found themselves being paid in a dollar that has fallen 39 per cent against the euro and 25 per cent against the British pound since the start of 2001.
Middle Eastern countries have traditionally imported more from Europe than the US, so removing the dollar peg would reduce inflation and lower the cost of the region's imports.
It's time for emerging markets to adopt policies that permit them to contain inflation without anchoring their currencies to the dollar and US monetary policy. China is the key.
"It's not in the interest of any of the other Asian countries to let their currencies rise against the renminbi, because of the amount of trade and foreign investment they do in China,'' Barry Eichengreen, an economics professor at the University of California, Berkeley, said in October.
Unfortunately, China appears reluctant to act, letting the yuan rise only 19 per cent against the dollar in the past three years. Too bad, because the price of inaction will be more financial bubbles, economic dislocation and maybe social unrest.
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