What will Bretton Woods III look like?

The current conflict will not lead to the demise of the dollar-based system

By blocking the Central Bank of Russia from accessing about 2/3rd of its USD 630bn reserves, the US, the UK and the EU acted boldly which ought to have far reaching consequences for Russia and potentially for the international monetary system. The reserves freeze reduces Russia’s war-chest immediately, and undermines its ability to stabilize the exchange rate, support its financial system in the event of a run on hard currency and meet its international payment obligations (sovereign, financial and corporate). Russia is left with little more than the private hard currency held in its banking system, its gold reserves in the vaults of the Central Bank and its deposits held in more friendly jurisdictions, notably China.

It is hard to overstate how critical this is both for Russia and for the international monetary order and this why some have been prompt to suggest that this could mark a turning point for the dollar-based system. Zoltan Poszar, one of the best thinkers on global monetary issues, argues that since the store of value function of the dollar has been fundamentally undermined, it can only be restored by grounding fiat currencies back in physical commodities and by replacing the dollar as the pivotal currency in the system. According to this view, the commodities that could best perform this function may not be gold any longer but could be those that Russia exports: oil and gas and metals like palladium or nickel that are critical to the workings of the modern economy. This new Bretton Woods III system — an alternative to the existing Dollar system (Breton Woods II) — would essentially be based on the Renminbi but backed by physical commodities. The PBoC would effectively be running a large substitution account by gradually driving its foreign currency reserves down and securing hard commodities in their place and encouraging the use of the RMB for international transaction, such as the settlement of oil, as is currently being discussed with Saudi Arabia.

Thinking about such radical evolutions of the monetary order is necessary and grounding these changes around the fault lines of the international security order is usually something economists have failed to do. But while geopolitics matter and have certainly played their part in the collapse of the Gold standard in the interwar period and the crowding out of Sterling by the US dollar, economics matter too. In particular, several elements appear critical to shape future developments of the international monetary order.

First, it is useful to be reminded that the Yuan was on course to a rapid internationalisation between 2010 and 2015, largely motivated by the consequences of the global financial crisis, and China’s dissatisfaction with the Dollar trap in which it had found itself and accelerated by the inclusion of the RMB in the SDR basket, a move that was also designed to anchor China in the governance of the international financial institutions at a time when it was tempted by regionalisation (launch of the AIIB and the Belt and Road Initiative). But this rather brisk internationalisation process was stopped by China’s own brutal closure of its capital account in 2015 to avoid CNY devaluation, capital flight and the resulting financial instability. China’s capital account has not meaningfully reopened since. In fact, the evolution of the domestic financial system since then, partly driven by domestic financial stability and control considerations have led to a growing inelasticity of the RMB’s supply, which is more and more controlled by the PBoC directly as the financial system’s clean up process imposes a more centralised system. The RMB becoming the central currency of the international monetary system would require China accepting the opening of its capital account, a more elastic and less controllable supply of RMB and in essence a loss of control that seems wholly inconsistent with Xi Jinping’s political and financial operating model. Adopting this currency as a global anchor, irrespective of the underlying geopolitical arrangements, would expose the world to a currency whose convertibility is highly uncertain, one that may also be subject to the same extra-territorial sanctions than the dollar and whose issuer has not proven its willingness nor its ability to ensure its supply in case of need, even within its sphere of influence.

Second, over the last few years, anarcho-libertarian and techno-enthusiasts of all kinds have suggested that crypto currencies could come to replace the dollar system by providing an alternative pivotal currency whose supply would be controlled, its value secure and its storage free from government interventions and supervisions. But this is chimera. For those still in doubt, the fact that Coinbase (the largest crypto exchange and wallet provider) just blocked 25,000 Russian accounts, and that China (an 8 other countries) banned crypto mining in January 2022 all point to the fact that crypto money is subject to the arbitrary decisions not only of sovereign governments but also of fragile exchanges and wallet companies. It illustrates with force that minting money will remain a fundamentally sovereign prerogative that can’t be bypassed by technological sophistication.

Yet the CBR freeze cannot be overlooked and will provoke important changes with international reserves managers. Russia is liable to fight back as it is doing now by forcing its oil & gas customers to settled in RUB and therefore sell hard currency to the Central Bank. But these disruptive changes could be an incredible opportunity to set in a motion a real transition towards a more multipolar and cooperative international monetary order. The uncertainty over the availability on demand of reserves offers an important role to international financial institutions like the IMF and the Bank of International Settlement who must continue to serve the community of central banks.

The IMF should perform its role of market maker of last resort in SDR, thereby allowing the Central Bank of Russia to carry-on trading its hard currency for SDR. This could in fact be an incredible opportunity for the IMF to organise a slow and gradual de facto substitution account allowing international Central Banks to gradually sell their hard currencies for SDR against a commitment that the BIS and the IMF would always maintain the convertibility at par of the SDR for any currency in its basket and vice versa. This would effectively turn the current unipolar and dollar-based system on its head by establishing a more multilateral system where the IMF would run the SDR like an alternative international settlement system between central banks. The BIS for its part would aim to substitute the current web of bilateral and highly politicised FX swap lines for a more multilateral and predictable system.

Such a fiat-based multilateral currency system appears wholly unrealistic today, but it is not any more so than a Yuan/commodity based one. This cooperative system would reduce the dependency of the world on the Dollar, it would reduce the overwhelming responsibility that the Federal Reserve has for managing the global financial and monetary cycle. It would more firmly embed China into the international financial system and avoid the weaponization of money by guaranteeing their perfect convertibility at any point in time by the IMF. It would live up to Keynes’ dream of an international clearing union and the emergence of global money but it requires bold leadership both at the IMF and the BIS.