It can be argued that one of the biggest sources of market volatility in recent months is the emergence of a major change in the global monetary order, the first since the early 1970s. The root of this change is China’s integration into the global financial system, highlighted by its inclusion last November in the IMF’s foreign reserve asset, the SDR (special drawing rights). This integration is momentous, affecting foreign exchange rates, interest rates, capital flows and capital markets more generally.
While China’s integration into the global economic system began decades ago with trade, its recent integration into the global financial system has been far less seamless.
The main source of the disruption in financial markets is uncertainty over China’s foreign exchange rate. Market participants ask: What exchange rate is China targeting? Against which currencies will it manage its currency? At what speed does China want its exchange rate to move? When will China make all of this clearer? Many market participants believe China should communicate its intentions better.
So what has changed in the global monetary order? China’s integration into the global financial system, in particular its inclusion into the IMF’s SDR, has reintroduced an element of state control back into the world’s foreign exchange system, something that has been missing ever since the end of the Bretton Woods system in the early 1970s. Since then, markets have experienced a free-floating free-for-all that many believe is at the root of a very volatile era in exchange-rate movements.
What is so bad about having an element of state control returned to the global foreign exchange system? Unlike the Bretton Woods era, when investors operated with an understanding of what the governing states intended with respect to exchange-rate movements, markets today are unsure because China hasn’t yet made it clear.
Uncertainty over the direction, depth and speed of movement in China’s currency complicates policymaking throughout the world, and it clouds the global economic outlook, especially for nations that compete with and trade with China, which is a large portion of the world. For example, if China weakens its currency sharply, it may adversely affect trade flows in some nations. Investors in companies in those nations can be negatively affected, too, because it will reduce cash flows for those competing with China, potentially lowering their stock and bond prices.
Finally, weakness in financial markets and the impact on economic activity can compel central banks to take actions that may have unintended consequences and contribute to the volatility.
While an element of state control could be a positive development owing to the certainties it creates, for now uncertainty is the dominant force. Market participants eventually will adapt once China’s intentions are clearer.