Bretton Woods and after

The Bretton Woods System was a lineal descendent of the gold-exchange standard as envisaged in Genoa. Under Bretton Woods the key currency, now the dollar, was convertible into gold (albeit, now exclusively for official foreign holders), other currencies were convertible into dollars, and central banks other than the US Federal Reserve were encouraged to hold their reserves not just in gold but in key currency form. "Key currency form" meant dollar form, since only the dollar was freely traded in deep and liquid markets open to international investors, official as well as private.
In practice, the system was not as simple or uniform in its structure and operation as implied by the capsule description in the preceding paragraph. Much as in the earlier gold-standard era, different countries used a variety of different instruments and structures to intervene in the foreign exchange market and manage their reserves. A case in point is Belgium, which operated a dual or two-tier foreign exchange market for much of the period, buying and selling foreign exchange at the official price (par value) to finance transactions on current account but allowing agents to transact at a market determined "free rate" for permitted capital account transactions. At the same time the National Bank adjusted policy to limit the differential between the free and official rates and hence the scope for arbitrage.
Another example was Canada, which operated a floating exchange rate from 1950 to 1962. Floating is different from freely floating, however; the Canadian authorities regularly adjusted policy in response to exchange rate movements and, in extreme cases, intervened in the foreign exchange market (Bordo, Gomes and Schrembi 2010). The Bretton Woods System was evidently more complicated than met the naked eye.
This system was also subject to the same contradictions as its 1920s predecessor, in the form of the Triffin, or M?ynarski, dilemma. The decision for reserve managers at the level of individual central banks was in what proportions to hold gold and dollars. Once U.S. foreign monetary liabilities exceeded U.S. gold reserves in the early 1960s, the incentive was to shift from dollars to gold to avoid 1931-style capital losses on the former. That, in turn, threatened to precipitate the very crisis and collapse of the system that reserve managers and other policy makers presciently feared.  Or so goes the textbook story. The reality was more complicated. First, in the aftermath of World War II, the vast majority of global foreign exchange reserves - as much as 85 per cent of the total - were in fact in the form of sterling. The disproportion reflected less the attractions of sterling in the 1930s  than the accumulation of sterling balances by Britain's Commonwealth, Empire and allies during World War II, which they acquired to help finance their joint war effort. At the war's conclusion, overseas sterling was more than £3.5 billion, nearly six times the British government's gold and dollar reserves.
Starting in 1945, the vast majority of these balances were, necessarily, blocked. That is, they could be sold only to finance imports from other members of the Sterling Area, if at all (Shannon 1950; Schenk 1994). Moral suasion was applied to the governments and central banks of Sterling Area countries. Starting in October 1946, the British government signed a series of agreements with the non-Sterling Area countries that permitted only newly earned sterling (not existing balances) to be freely converted into dollars.
These arrangements then gave way to a set of four formalised arrangements designed to maintain the usefulness of sterling, and therefore its reserve currency role, while at the same time preventing its wholesale liquidation. Members of the Sterling Area were free to use sterling to settle payments among themselves, subject only to local controls on capital account transactions. Similarly, sterling held by so-called Transferable Account economies was not convertible into U.S. dollars or any other currency, although countries with Transferable Accounts were free to use sterling to transfer payments among themselves as well as with members of the Sterling Area. So-called American Account economies (the United States and other mainly Western Hemispheric members of the dollar bloc) were able to negotiate more far-reaching concessions: they were free to convert their sterling into dollars and to use it to settle payments among themselves as well as with members of the sterling area. At the other extreme, so-called Bilateral Account countries could use sterling to settle payments with another country only with the express permission of the Bank of England. The nature of these arrangements reflected both the perceived danger of wholesale conversion (members of the Sterling Area with a historical allegiance to Britain were thought unlikely to engage in such practices, but Bilateral Account countries were a different matter), as well as the negotiating leverage of the foreign countries in question (as with the very different treatment of American Account and Transferable Account countries).
Interest rates on these British liabilities were artificially suppressed insofar as the demand for sterling reserves was artificially supported by these blocking measures. Although central bank reserve portfolios were still dominated by sterling as late as the Korean War period, to see this as the persistence of a sterling-dominated international monetary system would be a misapprehension. The sterling balances were a dead weight on central bank reserve portfolios, which managers would have sought to shed had they been able to do so, rather than an active element in the monetary system.
The dollar was not subject to analogous restrictions. Consequently, after 1953 the dollar, already the key source of global liquidity, overtook sterling as the leading component of central bank reserve portfolios. The immediate postwar dollar shortage - the difficulty that other countries, especially in Europe, encountered in attempting to earn dollars - was overcome with help from the 1949 devaluations (Kindleberger 1950, Eichengreen 1993). From this point, the accumulation of dollar reserves proceeded apace. Restrictions on the use of sterling balances were progressively relaxed, and central banks engaged in their orderly liquidation. Three "Group Arrangements" were negotiated in 1966, 1968 and 1977, under which central banks pledged lines of credit to limit the impact of any large scale flight from sterling. The UK, responding to pressure from other central banks, committed in 1968 to guarantee the U.S. dollar value of 90 per cent of the reserves of other countries, with the goal of forestalling flight from sterling and slowing reserve diversification.
The result, as Schenk (2010) describes, was the relatively orderly decline of sterling as a reserve currency, albeit not without outbreaks of turbulence and even crises along the way. But the key point for present purposes is that central bank reserve managers were constrained in optimizing the share of sterling in their portfolios as late as the 1970s by a combination of regulatory restraints, policies and politics. They were not able to engage in active reserve management in the normal sense of the term.
In the absence of other alternatives, the key decision in the 1950s and 1960s, the latter especially, was the proportions in which to hold dollars and gold. Here too there were restraints: contemporaries were aware of the existence of the collective action problem whereby the decision by one central bank to convert dollars into gold might provoke a run on U.S. gold reserves that collapsed the Bretton Woods gold-dollar system. Moral suasion was used to encourage central banks to maintain their dollar balances. Geopolitics - the U.S. commitment to defend its Western German ally against aggression from the east - was invoked to encourage compliance by the Bundesbank and the government of the Federal Republic. A gold pooling arrangement was negotiated under which other governments (those of Belgium, France, Germany, Italy, the Netherlands, Switzerland and the UK), acknowledging their collective interest in a solution, agreed to reimburse the United States for a portion of its gold losses. The gold pool did not long survive France's withdrawal in 1967. But it succeeded in putting off the day of reckoning.
These measures and others working in the same direction were designed to support the operation of the system while a successor free of its contradictions was under negotiation. Those negotiations were less than completely successful, as is well-known. There was the agreement to create Special Drawing Rights to supplement dollar reserves in 1968, but their issuance was too little, too late. There was discussion of a Substitution Account to retire dollar balances in the portfolios of central banks and replace them with SDR-like instruments, but no action was taken. The result was a continued increase in the share of dollars in the portfolios of central banks, not just in the latter part of the 1960s but as late as 1977, when the share of dollar reserves peaked at close to 80 per cent of the global foreign exchange reserves. The ascent of the dollar was not interrupted, to the considerable surprise of contemporaries, by the collapse of the Bretton Woods System in 1971-73. As Hori (1986) described, "after adjusting for factors which affect the currency composition of global exchange reserves but which are unrelated to changes in countries' currency preferences, there was no large-scale diversification out of dollars into other currencies during the period under review by groups of countries. In the 1970s the adjusted proportion of dollar holdings in their foreign exchange reserves remained virtually unchanged…" Indeed, the dollar's subsequent ascent was strikingly steady if Eurodollars are included along with conventional dollar reserves.
An important force supporting the dollar in the post-Bretton Woods period was the absence of alternatives. Britain was suffering ongoing economic and financial problems; the final liquidation of sterling as a reserve currency began around 1970 and was complete by 1976, the occasion of yet another sterling crisis (Burk and Cairncross 1976). After 1972 the deutchmark was a more important component of reserve portfolios than sterling, but that was not saying much. The German authorities resisted rapid internationalisation of their currency, fearing that erratic foreign demand might somehow undermine domestic inflation control (Tavlas 1990). Starting in 1970 they introduced a special reserve higher ratio on the growth of German banks' liabilities to nonresidents as a way of discouraging foreign holdings of deutschmarks. This was then followed by a cash deposit requirement of 40 per cent on most types of new credits by nonresidents to German nonbanks in 1972 (where the cash deposit, held by the Bundesbank, did not bear interest). Variants of this measure remained in place through 1974. In addition, mid-1972 through early 1974 the federal government permitted nonresidents to purchase fixed-interest deutschmark securities only with prior authorization.
Similarly, the Japanese authorities resisted more rapid currency internationalisation out of fear that the financial liberalisation it entailed might constrain the conduct of industrial policy. The capital account of the balance of payments remained strictly controlled in the 1960s; upon joining the OECD in 1964, Japan maintained exceptions ("reservations") to 18 items in the organisation's Code of Liberalisation. Throughout the 1970s, the finance ministry retained the authority to order the modification or cancellation of overseas lending and cross-border issuance of securities, both domestically and abroad, when it judged that the transaction would have an "adverse impact" on the economy. When the Japanese finally turned to financial liberalisation in the 1980s, the result was an asset bubble, a bust and a banking crisis, which hardly enhanced the yen's attractions as a reserve unit.
Markets in other currencies, meanwhile, were too small and/or illiquid to much change this global picture. Thus, to the extent that there was active reserve management in this period, it was reserve management at the margin. There were only limited opportunities for reserve managers to move out of dollars in favour of other currencies. The story of continuing dollar dominance is less first mover advantage, incumbency or persistence (as the point is variously put) than the failure, or unwillingness, of policy makers in other countries to offer alternatives.
The creation in 1999 of the euro, a currency with the scale, stability and liquidity necessary to potentially function as a first-class reserve unit, had the capacity to transform this state of affairs. The first decade of the 21st century saw a significant rise in the share of euro reserves, plausibly coming at the expense of the dollar. Starting in 2010, however, the Eurozone descended into crisis, and the euro lost some of the gains it had achieved previously. It is not inconceivable that Europe will draw a line under its crisis and that the euro will resume its ascent as an international and reserve currency. But neither does this prospect seem eminent.
The other runner in this race is the Chinese renminbi. Chinese policy makers are serious about internationalising their currency and enhancing its attractions as an international unit of account, means of payment and store of value, preconditions for making it a more attractive form of international reserves. They are making visible progress, but they also face challenges. Currency internationalisation requires capital account liberalisation, and capital account liberalisation is a progress fraught with risks and difficulties. Successful currency internationalisation also requires the maintenance of economic and financial stability; currently, doubts about this centre on the country's shadow banking system. Successful currency internationalisation requires developing the deep and liquid financial markets; currently, Chinese financial markets remain illiquid by the standards of the United States.
Finally, attracting foreign investors, official as well as private, requires convincing them that contract enforcement is reliable and that China abides by rule of law. Those foreign investors will want to see, inter alia, an independent central bank and independent financial regulator. In other words, many developing countries still has a lot of work to do before the foreign currency begins to change.  
Jamaluddin Ahmed, PhD FCA  is the General Secretary of Bangladesh Economic Association and a
member of Board of Directors of Bangladesh Bank.
[email protected]