As India wakes up to 79th year of its freedom on Friday, it is interesting note that it has been 54 years since the end of Bretton Woods System. On Aug 15, 1971, then the US President Richard Nixon announced that the US currency is no longer convertible to gold, and thus begin the new era of globalisation.
Initially, it created financial instability as economies across the globe hastened to incorporate new monetary policies and adapt fiat currencies and floating exchange rate amid a surge in bullion prices. Hence, this event in monetary history acquired the name of ‘Nixon Shock’.
Three years down the line, the US Federal Reserve formed the dollar index which calculated its strength against major currencies, making the greenback a free-float currency. The present dollar index calculates the US unit’s value against six major currencies unlike 10 in the original index.
The Bretton Woods System dates back to 1944 and was introduced to promote greater economic stability and full employment in the industrial world. In this system, other countries pegged their currency against the US dollar which in turn can be converted to the gold.
The monetary management system started to collapse in 1960 as the US economy started to weaken because of Vietnam War and growing involvement in international affairs As a result, the US was no longer able to bear the financial burden of converting dollar to gold.
India which had little exposure to international trade back then will eventually find itself opening its economy to the world because of this distanced external factor. But how did it impact emerging economies like India back then? Let’s dive in.
Exchange Rate Volatility
Nixon Shock exposed emerging market economies to exchange rate volatility. Latin American countries were most impacted by the floating exchange rate.
Earlier, fixed exchange rate provided predictability in capital flows and international trade but now economies were had to face the dilemma of ‘impossible trinity’ — fixed exchange rate, free capital movement, and independent monetary policies.
Left to be determined by market forces, value of emerging-market currencies depreciated sharply against the US dollar and brought front high imported inflation, imbalance in balance of payment and trade deficit.
Despite being closed economy at the time, India had to deal with external shocks especially oil price spikes in 1973 which increased its trade deficit. Maintaining trade competitiveness also became harder for the nation.
Rise Of US Dollar As Reserve Currency
The Nixon Shock ended the old system of ending linking a currency’s value to a precious metal. Meanwhile,he event raised the value of US dollar across globe despite it being the free-floated currency.
In 1970s, there was no competitive currency to become reserve currency other than the US. The reasons are size of US economy and America’s relations with numerous countries provided depth and liquidity a reserve currency.
Offshore US dollar markets swelled as many central bank started to keep and lend the greenback. As a result US dollar liquidity rose. Many banks also started to keep US Treasury notes noticing how the US attracted the most capital inflows.
Moreover, commodities like oil started to be priced in the US dollar which further increased the dominance of the US unit.
Debt Bubble
As developing countries struggled to grapple with trade imbalances because of high import bills, they started to borrow from external sources. Often these loans are dollar denominated and variable rate based which further increased their vulnerability global factors and currency volatility.
By 1980s, emerging market economies were so over-burdened with dollar-denominated loans that they could not finance their loans. The crises compelled the International Monetary Fund to come up with structural adjustment program. Many emerging-market economies adopted liberalisation.
“The accumulated macroeconomic imbalances, partly rooted in the post-Nixon monetary order, culminated in the 1991 balance-of-payments crisis. That crisis became the catalyst for India’s full-scale economic liberalization, moving toward deregulation, trade openness, and market-driven growth,” said Krishna Raj RBI Chair Professor, ISEC, Bengaluru.
Gold Emerges As Safe Haven
As imported inflation fuelled, debt increased, and balance of payment issues weighed on economies across developing nations, gold emerged as the dependable source to hedge against uncertainties and currency devaluation. Gold prices soared following Nixon Shock because of the high demand.
“The strategic importance of gold was most dramatically demonstrated in 1991 when a severe balance-of-payments crisis forced India to pledge 67 tonnes of RBI-held gold to raise foreign currency loans,” said Raj.
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