Bretton Woods Two and the impact on interest rates

A great thread on currencies and interest rates at Brad Setser's blog.

Bretton Woods Two Lives
The Fed has started to tighten, Greenspan said anyone who has not hedged their interest rate risk desires to lose money. Yet higher short-term rates have not led to higher long-term rates. In the jargon of the market, the yield curve has flattened.

Why is the yield on long-term Treasuries still so low?

My tentative answer: a surge in reserve financing in the fourth quarter from emerging economies largely made up for Japan's absence from the Treasury market. As central banks intervene in the foreign currency market to defend a fixed exchange rate or to prevent their currency from appreciating, they buy dollars -- dollars that are then invested in the US fixed income market, whether in Treasuries, Agencies or something else. That is the Bretton Woods two hypothesis: foreign central banks will finance the US trade deficit in order to keep their exchange rate from appreciating...

Sum up the estimated reserve accumulation of [China, Russia, India, Brazil, Korea and Taiwan] in the fourth quarter -- call my little grouping the BRICs plus the non-city state NICs -- and you get a total of $156 billion. Assume 75% of that increases, $117 billion, comes from an increase in their dollar assets, not valuation gains on their euros, yen and gold. The US current account deficit in q4 is likely to be around $175 billion. In other words, to find two-thirds of the financing the US needed in q4, you only really need to look at the balance sheets of six big financial institutions...

Does the surge in q4 reserve financing mean that the Bretton Woods two system is stable and sustainable, that rising reserve accumulation in the emerging world will finance a rising US current account deficit? Or is it evidence that the system is being stretched to its breaking point, and the People's Bank of China and the Bank of Korea are being asked to do too much, and to take on too large a share of financing the US deficit?

The scale of the financing these countries are providing the US is truly staggering. If my reserve accumulation numbers are correct, the central banks of six emerging economies added reserves at a $600 billion annual pace in q4, and added dollar reserves at annual pace of between $450 and $500 billion. That pace of reserve accumulation, should it continue, is enough to finance a large chunk of the United States' 2005 current account deficit, which is likely to be in the $750-800 billion range.

Europe complains that it alone bears the burden of currency adjustment v. the dollar. Emerging Asian central banks could just as well complain that they alone are stuck with the burden of financing the United States.

Most observers believe that "Bretton Woods two" is ultimately not sustainable. Even the Chinese authorities have acknowledged that some flexibility of the foreign exchange rate of the renminbi is desirable.

I think the more important question is how quickly the system unwinds, how painful the process will be and what are the possible steps to take to minimise the pain.